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    The Philip Fisher Approach to Screening Common Stocks for Uncommon Profits

    by Wayne A. Thorp

    The Philip Fisher Approach To Screening Common Stocks For Uncommon Profits Splash image

    Philip Fisher got his start in investments in 1928 as a “statistician” for a bank underwriting securities—and quickly lost a significant amount of money in the 1929 stock market crash.

    Soured by the experience, he started his own investment counseling firm in the early 1930s, following an investment philosophy of selecting deeply researched companies with strong long-term growth prospects and holding them through the gyrations of the economic cycle.

    Fisher stood out as one of the first money managers to focus on qualitative factors instead of quantitative ones. He examined factors that were difficult to measure through ratios and other mathematical formulations: the quality of management, the potential for future long-term sales growth, and the firm’s competitive edge.

    Although Fisher focused on the qualitative characteristics of a company, he was first and foremost a growth stock investor. He felt the greatest investment returns did not come from the purchase of stocks that were undervalued, since a stock that is undervalued by as much as 50% would only double in price to reach fair market value. Instead, he sought much higher returns from those companies that could achieve growth in sales and profits greater than the overall market over a long period of time. Furthermore, Fisher did not seek companies showing promise of short-term growth due to cyclical events or one-time factors. He felt that the timing was too risky and the promised returns too small.

    Over the years that followed, Fisher penned three books regarding his investment philosophy. They were republished as a single work: “Common Stocks and Uncommon Profits and Other Writings” by Philip A. Fisher (Wiley, 2003).

    Fisher Screen

    Even though qualitative factors were high on Fisher’s list, his writings provided enough detail to establish some basic quantitative screens. AAII’s Philip Fisher screen seeks to highlight growth stocks meriting further in-depth analysis with:

    • Consistently strong profitability;

    • Consistent sales growth;

    • Growth exceeding industry norms;

    • Little or no dividend payout; and

    • Reasonable price compared to future growth prospects.

    You will find the exact screening criteria for the Philip Fisher Screen at the end of this article.

    Screen Performance

    Each month, the AAII.com Web site provides a list of the companies passing the Philip Fisher screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1.
    Performance of the
    Philip Fisher Screen
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Figure 1 illustrates the erratic performance of the Philip Fisher screen over the period from January 1998 through the end of August 2008. Despite its gyrations, the stocks passing the screen have produced price gain returns that have outpaced the S&P 500—over the test period, the Fisher screen gained 133.5% while the S&P 500 is up 32.2%. Over the 10 complete calendar years that make up the testing period, the Fisher screen saw an equal number of up years as down. Year-to-date, the screen has gained 5.2%.

    Overview of Passing Firms

    Table 1 highlights some of the characteristics of the companies currently passing the Philip Fisher screen compared to the typical exchange-listed stock, while Table 2 lists the stocks passing the screen as of September 5, 2008.

    Table 1. Portfolio Characteristics of the Philip Fisher Screen
      Philip Fisher Portfolio Exchange-Listed Stocks
    Portfolio Characteristics (Median)
    Price-earnings ratio (X) 12.2 16.4
    Price-to-book-value ratio (X) 2.12 1.54
    Price-earnings-to-EPS-est.-growth (X) 0.5 1.2
    EPS 5-yr. historical growth rate (%) 38.3 13.6
    EPS 3-5 yr. estimated growth rate (%) 24.4 14.0
    Market cap. ($ million) 729.1 367.8
    Relative strength vs. S&P (S&P=0) (%) –17 –5
    Monthly Observations
    Average no. of passing stocks 22  
    Highest no. of passing stocks 82  
    Lowest no. of passing stocks 0  
    Monthly turnover (%) 32.5  

    While Fisher was not in favor of merely seeking “undervalued” stocks, he advocated buying “outstanding” companies when they were out of favor because the market has temporarily misjudged the true value of the company. He also wasn’t against buying “outstanding” companies at fair value, but cautioned investors to expect lower, albeit respectable, returns.

    AAII’s Philip Fisher screen looks for “outstanding” companies—firms with strong growth opportunities that are also trading at undervalued levels. At 12.2, the median price-earnings ratio for the Fisher stocks is lower than the median for the typical exchange-listed stock. In contrast, the price-to-book ratio is above the median for exchange-listed stocks.

    The screen also looks for stocks with positive sales growth over each of the last three years and a three-year average sales growth rate that matches or exceeds its industry’s median sales growth rate over the same period.

    The stocks currently passing the Fisher screen have shown an average increase of 38.3% in earnings per share over the last five years, while exchange-listed stocks have seen earnings grow at a median rate of 13.6% over the same timeframe. While, looking forward, earnings growth is expected to slow to 24.4% a year for the next three to five years, this still exceeds the expected earnings growth rate of 14% for exchange-listed stocks.

    The median market cap for the Fisher stocks is just over $729 million, almost twice that of exchange-listed stocks, which have a median market cap of almost $368 million. The stocks currently passing AAII’s Philip Fisher screen have underperformed the S&P 500 by 17% over the last 52 weeks. By comparison, the typical exchange-listed stock has underperformed the S&P 500 by 5% over the last year.

    Currently, 23 companies pass the Fisher screen, which is slightly above the monthly average of 22 over the last 10 and a half years.

    Table 2 ranks the passing stocks in ascending order by their ratio of forward price-earnings ratio (current share price divided by the consensus earnings per share estimate for the current fiscal year) to the estimated earnings growth rate (PEG ratio). Fisher believed that the only value in looking at historical price-earnings ratios was to help gain a perspective on the base valuation over time. Comparing the price-earnings to the earnings growth rate is a common valuation technique. Companies with higher expected earnings growth should trade with higher price-earnings ratios. Stocks with a price-earnings ratio half the level of the earnings growth are considered attractive.

     

    Republic Airways Holdings (RJET) has the lowest forward price-earnings ratio of 4.5, based on the consensus earnings per share estimate for the current fiscal year. The company also has the second-lowest forecasted earnings growth rate for the next three to five years at 15%. This translates into a forward price-earnings to estimated earnings growth value of 0.3. The company’s net profit margin is slightly higher than the average for the airline industry, but its sales growth over the last three years is significantly higher than that of the industry. Given the woes of the airline industry in the face of record-high oil prices, it is probably not surprising that the company has underperformed the S&P 500 by 39%over the last 52 weeks.

    Sohu.com (SOHU), a Chinese Internet media firm, has the highest forward price-earnings ratio of 19.2 among the Fisher stocks. However, its forward PEG ratio is 0.4 due to the company’s high forecasted earnings growth rate of 48.5, which is also the highest among these passing companies. Sohu.com’s net profit margin of 28.5% is well ahead of the typical computer services company, which is currently losing 1.2 cents for ever dollar of revenue it collects. The company’s sales growth over the last three years is only slightly better than its industry—24.9% versus 17.1%. Over the last 52 weeks, SOHU shares have outperformed the S&P 500 by an impressive 131%, despite having fallen almost 20% between the close on July 24 and the close on September 5.

    Conclusion

    Philip Fisher was a strong believer that the market is not efficient. Occasional fads and styles in the market may produce distortions in the relationship between existing prices and real values. With the same set of facts, the market may reach different conclusions depending upon its physiology of the moment. Realities not only terminate these distortions, but also often cause the emotion to swing to the opposite extreme.

    To succeed in investing, you must be able to see through the market opinion and discover the actual facts. Do not blindly accept or reject the market opinion. You must be knowledgeable, exhibit good judgment, and have enough courage to act based upon your conviction.

    As the saying goes, nothing is worth doing unless it is worth doing right. While the rewards of investing in growth stocks are tremendous, the penalties for making judgments based upon superficial analysis are equally large. Fisher felt that making some mistakes is an inherent cost of investing for major gains. He said that the key to long-term success is to do your homework, recognize mistakes as soon as possible, and learn how to keep from repeating the same mistakes. Luck tends to even out in the long run.

    What It Takes: The Philip Fisher Screen

    • Net profit margin for the last 12 months and each of the last five fiscal years is greater than the industry’s median net profit margin for the same period
    • Sales have increased on a year-to-year basis over each of the last three years and over the last 12 months
    • The three-year average growth rate in sales is greater than or equal to the industry’s median average sales growth rate over the same period
    • The company is not expected to pay a dividend in the next year (indicated divided is zero)
    • The ratio of the forward price-earnings ratio (based on the consensus earnings per share estimate for the current fiscal year) to the estimated growth rate in earnings (PEG ratio) is greater than 0.1 and less than or equal to 0.5


→ Wayne A. Thorp