Two companies are expected to double their earnings. Four years later, both have done it. One share price has doubled. The other has gone nowhere.
Philip Fisher makes the comparison with hypothetical companies, and the disappointing one has kept its promise. The problem was what investors paid for that promise. A fine business can become a dangerous purchase when its price already allows for too much future success. Yet Fisher would often keep an exceptional business he already owned, provided its quality remained intact. Buying and continuing to hold require different judgments.
What the doubling buys
Both companies initially trade at twenty times annual earnings per share. That multiple means investors pay twenty dollars for each dollar the business earns per share in a year. In Fisher's example, sound companies with no growth prospects trade at ten times earnings.
After four years, the first company still looks capable of doubling earnings again. Investors continue paying twenty times earnings. Twice the earnings at the same multiple produces twice the share price.
The second company now appears likely to stop growing. Its earnings doubled as promised, but buyers will pay only ten times those earnings. Twice the earnings at half the multiple leaves the share price unchanged. Dividends are excluded from this comparison.
The original growth forecast was right. Its value was already reflected in the purchase price. Keeping a premium required convincing prospects beyond that first doubling. Growth's duration matters alongside its rate, and neither means much without credibility. Heavy borrowing or weak operations can make the same forecast far less dependable. Interest must be paid before shareholders benefit, so a setback leaves less room to finance the business. A lower multiple may reflect that vulnerability.
These forces can reinforce one another too. Rising earnings accompanied by a higher multiple can produce a much larger gain. But a price that anticipates distant success can also fall sharply while the business remains on course. Buyers may temporarily stop paying for growth years away. A lower price is an invitation to recheck the facts, not evidence by itself that the trouble will pass.
Recognition has no timetable
Prices reflect beliefs about a company, its industry and stocks generally. Those beliefs can lag behind facts for years, then swing too far. Sometimes an industry really loses its prospects as technology changes. Sometimes investors simply change which longstanding strengths or weaknesses they notice. The distinction requires investigating the business.
Fisher's account of Motorola in nineteen seventy-four shows how recognition can falter. The public largely identified it with television and semiconductors, overlooking valuable operations, especially communications. One stock guide's short description omitted this division, which accounted for almost half the company. When Motorola announced the sale of its American television plants and inventory, its shares jumped. Fisher thought removing the small loss-making business explained only part of the rise. The disposal also encouraged buyers to expect a better appraisal of what remained.
The gain disappeared in the following weeks as short-term interest rates rose and the market weakened. Higher rates made interest-paying investments more attractive. In the prevailing gloom, favorable company news was slow to gain acceptance. Fisher describes the reverse in rising markets, when bad news meets resistance. A sound case for reappraisal supplied no reliable date for it.
Nor does every movement reveal a changed appraisal. A large order can temporarily push a price around until the buying or selling ends. Market influence depends on the money participants can commit, not how many people agree with them.
What to buy, what to keep
Fisher's preferred purchase combines strong operations, capable people and lasting competitive advantages with a price that understates those strengths. Neglect can create such an opportunity. It still takes investigation to distinguish an overlooked business from one whose problems justify its low price.
Fairly priced quality can also reward an owner through continuing growth. A weak business at a low price offers less protection against adversity, even if a speculative profit is possible. And an old quotation proves little. A share can fall below its familiar trading range and remain expensive if its prospects have deteriorated enough.
Now suppose you bought an exceptional business at a sensible price. Enthusiasm has since made its shares expensive. Fisher would usually stop adding while retaining the existing holding, as long as the business continued to deserve confidence.
Growth may eventually catch up with the price and exceed it. Finding another equally good business is difficult; a promising replacement can turn out weaker. Selling to buy the same shares back more cheaply requires getting the timing right twice. Investors may sell too soon, then wait for a decline that never reaches the price they demand, missing years of business growth.
Capital-gains taxes could make switching more costly under the rules Fisher discussed, but his argument also applied to tax-exempt institutions. It rested on the difficulty of replacing a rare business or reliably timing its price.
Holding still exposes the owner to sharp temporary declines. Continuing quality is the condition that supports Fisher's patience; an excellent original purchase cannot excuse ignoring deterioration. His owner allows a well-chosen company time to develop. A new buyer committing more money must still decide whether today's price leaves enough room for disappointment.
Three things to keep
Growth can meet its forecast while a falling earnings multiple cancels the price gain.
Business quality, growth duration and price must be judged together.
Holding expensive quality requires continued business strength and acceptance of sharp temporary declines.