Spotlight on Ken Fisher

06/01/2016 1:10 pm EST

Focus: MARKETS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

Most investors don't have the patience to deal with problems. They are gung-ho on a company and its shares until the water gets choppy. Then, unable to deal with some short-term turbulence in business performance and/or stock performance, they jump ship.

In his classic book Super Stocks, Kenneth Fisher talked about how disciplined investors can profit from those impatient short-term thinkers.

Fisher believed that young, fast-growing companies were the best way to make big profits on Wall Street. But he said that investors needed to understand the cycles involved in a company's growth in order to take advantage of these firms' success.

When young companies start to thrive, Fisher found, investors raised expectations to unrealistic levels. Eventually, these darlings of Wall Street have a setback -- maybe their earnings drop, or maybe they continue to grow but simply don't keep pace with investors' lofty expectations -- and their stocks can then plummet as investors overreact and sell, thinking they've been led astray.

"Instead of appreciating a normal sign of evolution, many investors condemn a company that fails to live up to their expectations," Fisher wrote. "Disappointed, Wall Street finds it easier to blame management ineptitude than to see its own prior excesses. As disenchantment with the stock becomes more pervasive, its price tumbles further and further."

But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. "The best managements reacts to difficulties and overcome them," he wrote. "In time, sales pick up. Later, profits begin to pick up. Simultaneously with the profit resurgence, the stock price begins to rebound."

If you can buy a stock when it hits a glitch and its earnings and price are down, you can make a bundle by sticking with it until it rights the ship and other investors jump back on board.

The trick is evaluating a company during those periods when its earnings are in flux, or even negative, so that you can find good candidates for a rebound (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings).

The answer, Fisher said, was to look at sales, and the price/sales ratio, which compares the total market capitalization of a company to its annual sales.

Earnings can be highly volatile, including the earnings of good companies, while sales rarely decline for top-flight businesses. They may be flat, but they generally tend to be less volatile than earnings.

Earnings, however, can be moved quickly and dramatically by a wide variety of variables that do not necessarily portend how the company will perform, such as changes in accounting procedures or in the amount of research and development the company engages in.

Wall Street focuses on earnings and abandons companies with earnings troubles, even if those earnings dips are likely to be short lived, which is why Fisher liked to look at sales.

Part of Fisher's thinking was that, if a company has a low PSR, even a slight improvement in its profit margins can produce a big gain in earnings, which will then drive the stock's price up since most investors react to earnings. Companies with high PSRs don't have this leverage.

Another part of Fisher's thinking was that investors should focus on causes, not results, when it came to evaluating a firm's prospects.

"What is the bottom line?" he wrote. "To buy stocks successfully, you need to price them based on causes, not results. The causes are business conditions -- products with a cost structure allowing for sales. The results flow from there -- profits, profit margins, and finally earnings per share."

More than 30 years after he wrote Super Stocks, I think Fisher's "glitch" advice still probably holds true. But to me, one of the most important lessons to take from his discussion of the glitch is broader in nature: Good companies -- even great companies -- go through difficult periods.

The business world is messy; competition is fierce and unrelenting. In that sort of environment, it's impossible for a company to start strong, and continue to improve without any hiccups.

Just look at Apple as an example. It set the world on fire from the early 2000s up until just a year or two ago. Now growth has slowed -- it had to eventually. But many investors are seeing the slowdown in growth as a death knell, and Apple shares have been sinking.

Apple appears to have strong management and a great brand, however, and the declines are likely allowing value-conscious investors to get shares of a great firm at a very good price -- I think that's what Warren Buffett and company were thinking when they recently snatched up $1 billion worth of Apple shares.

What great investors like Buffett and Fisher know is that the impatience and short term thinking of the masses create big opportunities for savvy investors.

The trick is having the stomach to take action when fear is hanging over a stock or the broader market and the masses are heading for the hills. That's no small task, but doing so gives you a chance to succeed where so many other investors fail.

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