Can They Increase Sales For Several Years?

June 11, 2008 by Joe Ponzio

In Common Stocks and Uncommon Profits, Phil Fisher outlined fifteen points to look for when analyzing a company for purchase. When valuing a business, our job is to try and predict the future with a degree of accuracy and confidence. If it were as easy as plugging the financials into a spreadsheet, everyone would achieve consistent, double-digit returns.

Unfortunately, the future is more than a simple mathematical equation. Enter Phil Fisher.

Point 1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

At first glance, this seems fairly self-explanatory. Will the company generate more and more revenue over the next few years? There are three simple answers: yes, no, and I’m not sure. We’ll skip the obvious “no” and “I’m not sure” answers as examples of businesses in which most investors should not be investing, and proceed with the “yes” businesses.

Not even the most outstanding growth companies need necessarily be expected to show sales for every single year larger than those of the year before….The vagaries of the business cycle will also have a major influence on year-to-year comparisons.

If you recall from this post about the business cycle, after a period of growth or sustained operations, companies will often have to take a step back to leap forward to further growth. Rarely do miracles happen in business; so, to develop a new product, introduce it to the market, and add the assets – both physical and human – required to properly sell the new product, a company will usually take on considerable expenses and burn through a ton of cash in the early years of research and sales. (The contraction phase of the cycle)

As early sales come in, the company will be scrambling to recoup its early costs. (The recovery phase) Sometimes it will happen very quickly (eg. Apple and the iPod); sometimes it will take many, many years (eg. Amylin), if at all.

Two Types of Consistent Growers

Those companies which decade by decade have consistently shown spectacular growth might be divided into two groups…”fortunate and able” and …”fortunate because they are able.” A high order of management ability is a must for both groups. No company grows for a long period of years just because it is lucky.

Fortunate And Able: Fisher talked about The Aluminum Company of America (Alcoa), but that was fifty some years ago. A more modern example (in my opinion) would be Google. In September of 1998, co-founders Larry Page and Sergey Brin brought Google online. These two men had a great vision – an internet search engine that ranked sites based on value rather than price. They were also very able on the technology side of Google. With an amazing product and a rapidly expanding potential market, the company then had to figure out how to make “sizable increase[s] in sales for at least several years.” (Early in its life, Google was generating no sales.)

In 2000, Google introduced AdWords, and its ability to generate revenue exploded. Like the founders of Alcoa, Google’s founders correctly foresaw a need for a democratic search engine based on relevancy and “votes” (or backlinks) rather than paid placement.

“But the internet grew like gangbusters. Doesn’t that make Google ‘fortunate because they were able’?” No. Google was a major beneficiary of the growth of the internet and search engines; still, assuming zero or slow growth in internet usage, Google would have likely dominated search engines by introducing a far superior product and grabbing market share in a slow-growing market dominate by pay-for-placement search results.

Thus, Google – at its roots – was “fortunate and able” in a rapidly expanding market.

Fortunate Because They Are Able: Today Google is now a “fortunate because they are able” company. Fisher discusses General American Transportation (GATX):

Yet when the altered outlook for the railroads began to make the prospects for the freight car builders increasingly less appealing, brilliant ingenuity and resourcefulness kept this company’s income on a steady uptrend. Not satisfied with this, the management started taking advantage of some of the skills and knowledge learned in its basic business to go into other unrelated lines affording still further growth possibilities.

Google realized that you can only place so many ads and make so much money from AdWords. Sure, the number of websites out there is growing like gangbusters, as is the number of internet users. Still, there is only so much money to be made on pay-per-click ads above and next to search results and on web pages. Recognizing this, Google decided to capitalize on its good name and existing (and expanding) customer base – to grow ever more “fortunate” because they were “able”.

Under the umbrella of “organizing the world’s information,” Google has rolled out dozens of new products and services – some paid, some free – to continue to capture market share and keep potential customers (AdWord’s clickers, small businesses, etc) coming back to Google for everything. If they can keep the world focused on the quality and speed of Google’s products, they know that Google will be the first place we turn when we need information, or anything to organize information.

“When someone needs driving directions, they come to Google and search for ‘maps’ or ‘mapquest’. Let’s keep them on Google by creating Google Maps.” According to Alexa, Google Maps gets some sixty times more traffic than MapQuest. And at the bottom of the Google Maps search? AdWords.

“Google Video isn’t taking off the way we want. Let’s buy and own the online video market. Once people equate the word ‘video’ with ‘you tube’, we’ll monetize it.” Allow me to introduce you to YouTube’s new advertising section.

Distinguishing Between The Two

This “Point 1” of Fisher’s Fifteen Points to Look for in a Common Stock is critical. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? Whether it is because the company is “fortunate and able” or “fortunate because they are able” doesn’t really matter. What matters is that they are “able”:

A high order of management ability is a must for both groups.

Though Fisher doesn’t really say so, I’ve found that smaller companies tend to fit into the “fortunate and able” category whereas larger businesses fit into the “fortunate because they are able” category. In order for a small company to become large, it must be fortunate and able. A large company can continue to grow large because it has the resources needed to become even more fortunate at the hands of very able management.

A small company doesn’t have the money or personnel needed to take Google’s current approach of “throw enough stuff at the wall, see what sticks, and then monetize it” so it must focus on its core business. (Think about it: Why didn’t YouTube buy Google instead?) A large company has the contacts and reputation to introduce new products and services with immediate credibility, thus offering a greater chance to become even more fortunate because it is able. Google introduced Gmail and it was an instant success, even in the face of strong, well-established competition from Hotmail, Yahoo! mail, AOL, and others. I suspect that my attempt to introduce JoeMail wouldn’t do nearly as well.

Which Is Better?

As Fisher’s Fifteen Points unfold over the next few weeks, you’ll see that “fortunate and able” is neither better nor worse than “fortunate because they were able.” Look for a good business that is run by a first-class management. When you find that, you’ll likely find that the distinction between “and” and “because” is blurred simply because your business flows back and forth between the two.

And that’s a hell of a company.

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