Chapter One
Adjusting to Key Influences of the 1960''s
From time to time, fundamental changes of great investment significance affect large groups of common stocks. Usually for some time after these new influences are felt, the great majority of the investment community have little appreciation of their true importance. Then as the real significance of what has happened dawns, a spectacular change occurs in the market price of the affected securities. Fortunes are sometimes made by those who appreciated the significance of what was happening early-before it was importantly reflected in changed quotations for individual stocks.
Let us examine two of the great adjustments to new conditions made by the financial community during the 1950''s. Examining such readjustments of the past will better enable us to understand and anticipate some of those that will come during the 1960''s.
One of these was the awareness of what a quarter century of progress in the art of corporate management had done to bring real investment stature to "blue chip" industrial equities. It is easy to forget that as recently as the late 1940''s large segments of the investment community felt that those not in a position to face sizable risks should confine their security holdings to bonds, high-grade preferred and possibly a few public utility common stocks. Still remembered were the days when corporate management was largely a family affair. Those who controlled a corporation might be quite capable or just the opposite. However, following the practices of the times, authority was delegated only occasionally and almost never with the thought of building up continuity of management in the interest of the outside stockholder. When training a successor was thought of at all, it was usually from the standpoint of eventually handing authority to some favorite young relative who would continue managing in order to maintain the family interest. The corporate head was usually an autocrat, making decisions, good or bad, on the basis of personal conviction. The idea of assembling vast amounts of background material and a variety of outside specialized experts to provide a better factual basis for decision making was never considered. It hardly is surprising that the eventual realization of the enormous stride made by the more alert managements in the handling of their day-to-day affairs, in long-range planning, and in a sense of deep responsibility to the outside stockholder eventually caused a major upward revision in the price investors would pay for the shares of companies benefitting from these important new influences. What is surprising is that this trend toward making certain stocks intrinsically more valuable through radically improved management factors had been running on so long before stock prices began to reflect in a major way what had been going on for years.
Let us consider another and possibly equally important new development affecting certain classes of common stocks. This was the awareness by increasing numbers of companies of how properly guided "research" into one or another field of the natural sciences could open up a technique for ever greater growth in sales and profits through the creation and marketing of endless new but related products developed in this way. Again, important developments along these lines had started many years before. By the late 1940''s, this trend had attained quite considerable stature. But it was not until the 1950''s that the financial community gave widespread recognition to the enormous investment significance of companies that had genuinely learned to master this tremendously profitable management art. It was only as the 1950''s progressed that these most promising companies began to sell at price earnings ratios actually reflecting this attribute.
I believe there are two important lessons that can be learned from studying the (then considered) "new" factors to which stock prices adjusted in the 1950''s. One is a realization of the profit (or at times the avoidance of loss) which can accrue to those who take such new influences into consideration before everyone else also does. The second is that these so-called new influences only start to affect most stock prices after they have been running on for quite some time. Therefore, to anticipate some of the comparable influences that will make themselves felt in the 1960''s, it is not necessary to anticipate future background forces. Rather, it simply requires examining some of the more recent background influences to which certain groups of stocks have either not sufficiently adjusted themselves or adjusted themselves in an unjustified manner.
A. Stocks and Inflation
In the 1960''s (as in the preceding three decades), the threat of further inflation will continue to be of major importance to all investors. However, as the 1960''s progress, I believe it certain that the true relationship of common stock ownership to inflation will become more clearly understood. As a result, certain groups of stocks may sell at rather different price levels than they now do. Those who now understand these relationships may save themselves from considerable loss in the years ahead.
Because this whole matter has such great investment importance, I believe it may be worthwhile to explore inflation''s fundamental nature before examining its relationship to various groups of common stocks. When its true cause is understood, the investor is unlikely to be confused in his basic thinking by various dogmatic comments of some of our political leaders.
The first thing to consider, of course, is just what we mean by inflation. While there are many complex definitions, I do not believe that for investment purposes it is either necessary or desirable to become involved in intricate definition. For practical purposes, it is sufficient to consider inflation as a condition whereby (with only minor and temporary reversals) the total amount of things and services that can be obtained for the same number of dollars (or other monetary units) grows less and less. Such a situation is in sharp contrast to the background condition that has prevailed over most of American history when the fairly long periods of years when the dollar would decrease in value were succeeded by roughly equivalent, lengthy cycles when the level of all prices would tend to fall and the value of the dollar to rise correspondingly.
The first and probably the most important thing for the investor to recognize about inflation is this: As long as the overwhelming majority of Americans maintain firmly held existing opinions concerning the duties and obligations of their government, more and more inflation is inevitable. Eliminating governmental waste and balancing budgets are highly desirable goals. If brought about without touching off a sharp downward spiral in general business, they can be extremely beneficial in slowing down the rate of further inflation and may even appear to have stopped it completely for a while. However, any talk by political leaders that in present-day America this by itself will put a permanent stop to further inflation is merely talk and nothing more. Why is more inflation so sure to come? Because under the economic system we have established, the seeds of inflation sprout not in times of prosperity but in times of depression. About eighty per cent of our federal revenue is derived from corporate and individual income taxes. This basic source of federal funds is notoriously sensitive to the level of general business. It shrinks sharply on even moderate downturns in the general economy.
However, this is not all that happens when general business gets bad. We have enacted laws, including unemployment insurance and farm relief, which make mandatory a sharp increase of government payments in just these same periods of bad business when federal income is lowest. Furthermore, these laws already on the statute books are almost certainly but the smallest part of the special outpouring of government money that would occur whenever a truly severe depression might develop. Examine the actions of Congress in even the mild depression of 1958, and this becomes obvious. All sorts of proposals were immediately advanced for helping the economy at the expense of the national treasury. These ranged all the way from drastic reductions in taxes on individuals and corporations (so as to expand shrinking purchasing power) to setting up organizations to make special loans to distressed groups and to vastly expanded programs of public works. While most of these proposals failed to be enacted, the interesting thing is why they failed. Hardly a voice in either major party was raised in opposition to such a program "if it were really needed to end the slump." Rather, the Republicans took the stand that the slump gave promise of ending so soon anyway that it would be better to wait and only enact such inflation-producing measures if the expected upturn failed to materialize and "such measures became necessary."
While in 1958 events proved the slide so short-lived that few such measures were put into effect, can anyone with the least understanding of the practicalities of partisan politics doubt that in a more prolonged period of poor business our elected officials would almost unanimously choose tens of billions of annual deficits in preference to having the voters again undergo the hardships of a major depression? For that matter, can anyone say with even a semblance of surety that this deficit-producing course is not the right one in the national interest? It can be granted that huge deficits are bound to produce more inflation. We can also be well aware of the injustices and hardships that result from important rises in the general price level. However, are these injustices and hardships as great for those who feel their pinch as the suffering and hardships imposed on workers and proprietors alike by a great depression such as that of the early 1930''s?
Whatever each of us as individuals may think of this matter, it has already been decided for us by the overwhelming weight of public conviction. One hundred and fifty years ago, public opinion would have no more held it was the business of our government to assure constantly prosperous economic conditions than, to mention the example I used when I wrote Common Stocks and Uncommon Profits, they would have thought it was the business of government to guarantee everyone a happy marriage. Fifty years ago, public opinion would have thought it necessary to do such relatively inexpensive things as to establish bread lines and soup kitchens so no one actually starved. At that time, public opinion would have done little more. In the then still strongly agricultural economy, this was hardly enough to have produced deficits of inflationary proportion. The federal income tax, of course, was still a thing of the future. Percentage-wise, the national government''s incoming revenues did not fluctuate quite as violently with every change in the economic weathervane as they do today.
Where does all this leave us? The historically recent but now almost unanimous opinion of both our public officials and their constituents that it is the duty of government to maintain endless prosperity is not likely to change. Unfortunately, when hard times come, the only major cure known to government is to spend enough more than is taken in taxes to create sufficient new purchasing power to reverse the trend. This also produces more inflation. Occasional downturns in business seem as much a part of the price we must pay for all the other advantages of a system of free private enterprise as a lower standard of living for everybody, less goods produced, and a loss of personal freedom seem the price that must be paid by those living in countries where the government is the only employer. Therefore, as long as we maintain the benefits of our free economic system, unexpected downturns will occasionally appear. As long as we are democratically governed and public opinion reacts as it now does, these will be followed by more and more inflation.
However, at this point there is something else to be considered. Just as there are many people who erroneously hold that inflation can be halted short of dictatorship, so there are even more who have an equally false view. This is that there is something inherent in the inflationary process that inevitably makes it proceed at an ever faster and faster pace. Inflation is sometimes compared to a horse that may start at a slow walk but will eventually end in a furious and dangerous gallop. The often heard terms of "galloping" and "runaway" inflation have doubtless arisen from this analogy.
The arguments of those who believe in the inevitability of this speeding-up process of inflation run something like this: As prices start rising, far-sighted people realize the inflationary implications of what is happening. They start buying things they will need in the future before the price of these things rises still higher. This extra demand tends to make the prices of these things rise even faster than they otherwise would. These ever more rapid price increases alert still others to the inflationary implications of what is occurring. As they in turn anticipate future needs, further and further boosts are given to the momentum of this inflationary spiral. Consumers buying today what they normally would purchase in the future, businessmen piling up inventory materials far beyond normal practices, and speculators simply trying to make a quick profit from the situation all contribute their part to the whirlwind.
It is strange that in the face of all of the evidence to the contrary, so many people who evaluate the evils of our existing inflation quite realistically then go on to frighten themselves and totally mislead investors by proclaiming that our present leisurely type of inflation must inevitably break loose in a far more virulent galloping sort of inflation. Although these people have been forecasting this development for years and have so far been totally wrong, their convictions have gained considerable general acceptance. This acceptance has had important implications for the investor, which I will come to presently. But first, why does this view run contrary to what has actually happened? For some years, a sizable part of the business community has accepted the great probability of more and more inflation. Yet nowhere in the business world do we find any tendency in times of peace to build up inventories because of this. In contrast, we find constant effort to find more and more ways to cut down inventory totals. The reason for this is not hard to find. There are so many costs to carrying inventory that it does not pay to stock up just because eventually the general price level will rise further.
To understand this matter clearly, it might be well to examine these costs in detail. First, there is the interest that could be earned on funds tied up in excess inventory. If available funds are not on hand and excess inventory must be carried with borrowed money, this cost is even greater. Then there is the cost of warehousing or storing this inventory. To this must be added the cost of insuring it against fire, theft, or other damage. Next come local property taxes, which will be levied if the inventory is held at whatever time of year such assessments are made in the particular locality. Finally, in the case of certain commodities, there is the risk of physical spoilage with age. In other cases, there is danger of style or technical changes which would give them less value.
For these reasons, with all of the inflation and inflation awareness that has occurred in the United States since World War II, we find no tendency whatever to build up stocks of goods as an inflation hedge. Such advance buying as has occasionally occurred has nearly always been because of fear of physical scarcity (as in the early stages of the Korean War) or fear of a price rise in a particular commodity, but never because of concern about general inflation. At times, advance buying has not been stimulated even when immediate but moderate future price advances for a particular commodity have been announced. The increase was just too small in relation to the carrying charge.
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Excerpted from Paths to Wealth Through Common Stocksby Philip A. Fisher Copyright © 2007 by Philip A. Fisher . Excerpted by permission.
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