Warren Buffett has frequently acknowledged a debt of gratitude to Phil Fisher. While Graham taught Buffett about Mr. Market and investing with a margin of safety, Fisher taught Buffett about the merits of investing in a good business, ideally one with good growth prospects.
In Fisher’s classic book Common Stocks and Uncommon Profits, Fisher lists fifteen points to look for in buying a stock. Fisher makes it clear in the opening paragraph of the chapter where he enumerates his fifteen points that he is looking for criteria that can identify stocks that can advance several hundred percent in a few years and show a “correspondingly greater increase” if held for the long-term.
Although he does not say that the points are in order of importance, it is suggestive that the first point is about the company’s future growth prospects.
“Point 1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?”
As I have pointed out, Buffett’s 1951 article on Geico provides one of the clearest examples of an investment thesis that passes this test.
In his article on Geico, Buffett shows Geico’s track record of growth over the prior fifteen years: premiums written up 36% per year and policyholders up just under 30% per year, albeit from a small base. Then Buffett writes one of the most important sentences of the article and one that investors should focus on in their own analyses.
“Of course the investor of today does not profit from yesterday’s growth.”
It’s a simple sentence and a simple idea, but it encapsulates a great deal of wisdom. It’s the reason that investing can never be reduced to a spreadsheet or a database. It’s the reason why there is no substitute for thinking. As Buffett points out, it’s the reason that all librarians aren’t rich.
Buffett next lays out his case that Geico still had the potential for strong growth. He cites two areas of growth: 1) geographic expansion – prior to 1950 Geico operated in only 15 states, and 2) increased market share in states where they already operated – they only had 3,000 policyholders in New York State.
Equally important, Buffett explains why Geico could expect to capture business in these markets. Geico had no agents or branch offices and could offer policies at discounts of up to 30% off competitors’ rates. These savings would be amplified in periods of recession and would be even more meaningful as Geico expanded in states where the cost of insurance was high, such as New York State.
You did not need an MBA or CFA to understand why the odds were stacked in Geico’s favor.
Geico also enjoyed excellent profit margins (Fisher’s Point 5 – “Does the company have a worthwhile profit margin?) and a formidable Chairman of the Board, Ben Graham, whom Buffett trusted completely (Fisher’s Point 15 – “Does the company have a management of unquestionable integrity?”).
The most remarkable thing about the Geico story is that, in spite of its excellent economics and strong growth prospects, Buffett paid only about eight times depressed earnings for the stock. In short, he paid nothing for the company’s growth.
When pressed, many investors in growth companies cannot clearly identify where the growth will come from and, on top of that, they pay a hefty premium for that growth that leaves no margin of safety.
I think it is also worth mentioning that in 1950 Geico was unknown. Buffett’s conviction was grounded in the facts, not in the opinions of others.
Finally, although Buffett humbly and rightly acknowledges his debt to Fisher, the Geico article, which was published in 1950, eight years before the publication of Common Stocks and Uncommon Profits, suggests that Buffett already understood quite well what was involved in analyzing and valuing a growth company.
The Geico article should serve as a template for writing up an investment thesis. It can also be distilled into a highly useful checklist for investing in growth companies.
Here’s a checklist based on the article. Buffett hits all the points in his article.
Can you identify the reason the stock is undervalued? (In Geico’s case, stock casualty companies had poor earnings in 1950 and did not participate in the prior “bull market enthusiasm”.)
1. Is the company’s product or service a necessity?
2. Does the company have advantages or disadvantages in the following areas: inventory, collection, labor or raw material production?
3. What is the earnings and growth record of the company?
4. What is the reason the company can continue to grow?
5. Does the company enjoy any durable competitive advantages over its competitors, such as being a low cost provider?
6. What are the company’s profit margins and how do they compare to those of the competition?
7. What is the quality of management and the board? Do they have a meaningful stake in the company? (Geico’s directors owned one-third of the company.) You could also look for whether other leading value investors have been purchasing the stock.
8. Is the stock available at an attractive price?