Bookworm: An essential quality of conservative investments from Phil Fisher
Phil Fisher forged a stellar record and is cited by Warren Buffett as a key influence. He liked companies to have this quality.
Welcome to the next edition of Bookworm, where I explore insights from investing and business writing I found helpful.
Each edition relates to one of three core principles: owning high quality assets, fostering a long-term mindset, and putting process over emotion.
Today’s insight
Today’s insight concerns owning high quality assets. As investors in individual shares, we want to understand what qualities might make us more comfortable and confident investing in a business for the long-term.
The insight itself comes from a man who is no stranger to the Bookworm column - Phil Fisher. The great investor famous for writing “Common Stocks and Uncommon Profits” and for being a major influence on Warren Buffett.
Fisher delivered exceptional results by taking a long-term (and at times highly concentrated) approach to investing. He found companies with durable growth prospects, strong competitive positions, and an ability to innovate. And then he held on.
Fisher is best known for the list of ‘fifteen points’ that he sought in long-term investments and shared in his most famous book. Today, though, we’re diving into his less cited work “Conservative Investors Sleep Well”.
In this book from 1975, Fisher laid out qualities underpinning a ‘conservative investment’ – something he defines as an investment “most likely to conserve purchasing power at a minimum of risk”.
A different side to Fisher? Not really…
Much of Fisher’s best-known writing is about the engines of long-term growth. Things like research and development, an ability to innovate, and attractive long-term demand prospects.
In listing in his criteria for what made a “conservative investment”, however, Fisher chose to start somewhere rather different. Before anything else, he stressed the importance of cost advantage.
“To be a truly conservative investment” Fisher starts, “a company – for a majority if not for all of its product lines – must be the lowest cost producer or about as a low a cost producer as any competitor. It must also give promise of continuing to be so”.
Fisher points out two main reasons for this.
In normal or good times, the cost advantaged company will make higher profits. More profits means more money to fund future growth – be it through research and development, marketing, or other activities – without needing to raise outside cash.
During a slump or weaker pricing environment, the cost advantaged firm also has a much better chance of surviving (as long as it hasn’t levered up too much).
If competitors go bust, the lower-cost producer can pick up market share. As I covered in this previous Bookworm on the capital cycle, an eventual recovery could also bring higher profits amid less competition.
Viewed this way, Fisher’s attraction to cost advantaged companies makes a lot of sense. Companies like this are better aligned with the two defining features of his approach: owning companies that invest in growth, and owning them for the long haul.
On the latter point, a lot of investors are focused entirely on what will happen in the current or next cycle within an industry. Not on holding companies through many of these cycles as a permanent owner.
Fisher knew his investments and the industries they operate in would experience good and bad conditions over time. By seeking cost advantaged companies, he wanted to increase the chances that his investments would survive and thrive in both.
How relevant is this today?
Fisher said that his passage on cost advantages was written “with manufacturing companies in mind”. Obviously the nature of global business – and manufacturing in particular – has changed a lot since 1975 when this book was written.
This isn’t just because a lot of manufacturing is now outsourced and/or offshored to cheaper climes. But because the copying of unpatented best practices and innovations (and probably some patented ones!) is probably fiercer and quicker than ever.
Despite this, the idea and benefits of seeking out cost advantages still holds water. You just might not find it in some of the places that Fisher used to find it. Here are two situations where I think it still applies, and some ASX listed companies that benefit.
Cost advantage source 1: Dominant scale and barriers to entry
A famous hedge fund manager, Sir Chris Hohn of TCI, recently said on a podcast that he thinks economies of scale are being forgotten in the presence of more fashionable moat sources.
Big can still be beautiful, though, in situations where it yields a cost advantage. Especially when barriers to entry mean that a company’s relative scale seems unlikely to wane any time soon.
CSL (CSL) is one of three fully integrated players that dominate the market for plasma derived treatments such as the widely used antibody immunoglobulin. Between them CSL, Takeda and Grifols speak for around 80% of the plasma therapies market globally.
CSL’s scale and integrated nature brings cost advantages throughout the supply chain. All the way from collecting plasma (blood) to fractionation, the process by which plasma is separated into its constituent parts for use in treatments.
CSL owns roughly 30% of the world’s plasma collection centres, which ensures access to plasma without relying on expensive secondary markets. Meanwhile, plasma fractionation has high fixed costs. The more you process, the cheaper your unit costs.
CSL and its two integrated peers regularly reap operating profit margins 20 percentage points higher (i.e. not just 20% higher) than smaller competitors. All thanks to scale-based cost advantages that appear to have little chance of being reversed.
There are a couple of reasons for this.
For one, fractionation facilities are expensive. They also take years to be approved and built. The high fixed cost base of these facilities, and of plasma collection networks, means that decent scale is required before a company can dream of breaking even.
All of those things would make investing the huge amounts needed to replicate CSL’s fully integrated supply chain very daunting indeed. As a result, it provides a formidable barrier to entry.
CSL has also used its scale to fund research and development efforts that have borne far more efficient collection and fractionation techniques. Its new Rika plasma donation system, for example, increases collection speeds by 30%. Fisher would likely approve.
Cost advantage source 2: The power of proximity
Proximity to the end user can be another source of cost advantage. This will often apply in situations where a product’s value is low relative to its weight. In cases like this, the outsized impact of transport costs mean that location is key.
Many quarries or gravel pits enjoy local monopolies because of this. Quarries based even slightly further away can’t compete on an all-in basis that includes delivery. Amcor (AMC), which sells plastic packaging, provides another example.
Plastic packaging also has a very low value relative to the weights that companies order it in. Because of this, our analyst Esther Holloway says that Amcor often sets up production facilities next door to its major customers. Can’t get much closer than that!
An interesting sidebar
While discussing cost positions, Fisher makes the point that companies operating at a cost disadvantage will often outperform low-cost producers during industry booms.
Why? Because their profits often grow by a bigger amount in percentage terms. Imagine that a supply/demand imbalance suddenly allows companies X and Y to charge $300 instead of $250 for a product with little differentiation.
Company X, the low-cost producer with total costs of $200 per widget would see their profit per unit rise from $100 to $150. Company Y, a higher cost producer with total costs of $250 per widget, would see their profit per unit jump 100% - from $50 to $100.
This, Fisher says, is why poorer quality companies can see their share prices rise more in boom times than the lower cost producers. And - one would think - ultimately see their share prices bleed a lot more when industry conditions normalise.
Food for thought, perhaps, for those privy to letting recent share price performance dictate their view of a company’s long-term quality. In many cases, the laggard might actually be the higher quality business.
Previously on Bookworm:
- How capital cycle analysis can unearth superior long-term investments
- How Warren Buffett behaved in the last prolonged bear market
- How to avoid falling for a mistaken moat
