In 1969, Philip Fisher paced an airport, deciding whether to buy shares in an equipment company. Technology stocks had become expensive, and he had resisted many new offerings. This company had a real commercial purpose and a president he considered brilliant and honest. After a long discussion with him, Fisher finally bought. The company grew respectably. Years later, when further growth looked less certain, he sold for little more than he had paid.
His judgment about the business had largely held up. His investment had barely increased. Inflation had meanwhile reduced what his dollars could buy, so a small gain on paper concealed a loss of purchasing power. Fisher needed both future business growth and a purchase price that left him room to benefit. Neither an impressive company nor an apparently cheap stock could supply both answers automatically.
The earnings behind a cheap price
A price-earnings ratio divides the price of a share by the profit earned per share. A low ratio means paying relatively little for the earnings being measured. The difficulty is deciding how much those earnings tell you about the years ahead.
Fisher learned that difficulty painfully in 1929. Although he thought the wider stock market dangerously overpriced, three companies looked inexpensive enough to buy. Their low earnings multiples reassured him. One made locomotives, whose customers could sharply reduce equipment purchases when business deteriorated. He barely investigated the operations and management of the other two. By 1932, the three holdings were worth only a tiny fraction of what he had paid.
Strong earnings near the top of a business cycle can make a vulnerable company look cheap. When demand falls, the attractive denominator in the ratio shrinks with it. Some industries also face forces such as weather that can make one year's profits a poor guide. And some declines persist through the cycle. As automobiles displaced streetcars, urban railway shares sold at progressively lower earnings multiples. Unpopularity correctly reflected a deteriorating business. Fisher needed a broad estimate of earnings several years ahead and an explanation for why today's price was low.
When disappointment goes too far
The market could also misjudge a sound business. A failed project can hurt its earnings while making investors willing to pay less for each remaining dollar of profit. The share price then suffers from two changes at once. If the damage is lasting, a large decline may be warranted. If competitive strengths survive, the loss of confidence can outrun the loss of future earning power.
Food Machinery showed Fisher how a reputation could obscure those strengths. It had gone public among the speculative offerings of 1928. When many failed, investors dismissed the group. Yet this company had strong positions in specialized equipment, established customers, inventive engineering, and capable managers. Fisher investigated and bought for clients. He attributed much of their later gain to buying a business that could progress at a price depressed by its association with weaker companies. The fallen share price had identified a possibility; investigating the business established his case.
That investigation becomes especially important when a company promises recovery. Research failures and reorganizations can impose heavy current costs while leaving valuable skills intact. Ending a failed development effort may free money and researchers for more promising work. A reorganization may improve service to customers after temporary disruption. But neither cancellation nor a new organization chart proves future growth. Fisher looked for capable managers, surviving competitive strengths, and evidence that the changes were working. He wanted years of increasing earning power, not merely a rebound from one unusually bad year.
Depressed prices relative to sales, assets, and normal earnings helped him check that judgment. They could show how little investors were paying for a functioning business. They could not establish that it would function well in the future. That depended on what its people and products could actually accomplish.
What the accounts and the past can hide
Asset figures themselves need interpretation. Book value reflects recorded accounting amounts. A factory bought long ago may appear in the accounts at far less than the cost of replacing it. Inflation can therefore distort comparisons between companies and across decades. Fisher considered replacement values alongside reported values. His appendix also suggests that profit relative to sales can sometimes be more informative than ratios distorted by old asset costs. None of these measures replaces an examination of demand, competition, and management.
After World War II, a different comparison depressed valuations. Earlier postwar prosperity had ended in severe financial trouble, and many investors expected another collapse. Corporate earnings kept rising while the fear persisted. By about 1949, some shares jumped when investors learned the companies would close and liquidate. Selling their assets was expected to bring more than the market valued the operating businesses. The historical analogy had obscured current evidence.
Fisher also placed conditions on his own optimism near the end of the 1970s. Energy costs and excessive credit could not be dismissed just because earlier fears had proved exaggerated. His favorable comparison depended on how serious those problems were and on resolving the credit problem. History could suggest where to investigate. It could not supply missing earning power, or make an excessive purchase price sensible. The airport investment remained a reminder that a company could fulfill much of its promise without rewarding the person who paid too much to own it.
Three things to keep
A low earnings multiple needs an explanation of future profits.
Business growth cannot rescue every purchase price from inflation.
A setback bargain needs durable earning power beyond the initial rebound.