Common Stocks and Uncommon Profits and Other Writings

Before you even consider buying a single common stock, you must first understand how true, lasting fortunes have been made. Many fortunes were built by betting on the business cycle - buying in bad times and selling in good - but this was a perilous game. A far more profitable, and far less risky, path has always been to find the truly outstanding companies and stay with them through all the fluctuations of a gyrating market. These opportunities did not require purchasing at the bottom of a great panic; the shares of these companies were available year after year at prices that would lay the groundwork for a substantial fortune. The opportunities today are not only as good as they were a generation ago, but are actually much better, thanks to the rise of modern corporate management and the immense power of organized research and development.

To find these rare companies, you cannot rely on financial statements alone. You must employ what I call the “scuttlebutt” method. The business grapevine is a remarkable thing; it is amazing what an accurate picture of a company's strengths and weaknesses can be obtained from those who are concerned with it in one way or another. Go to a company's competitors, its customers, its suppliers. Talk to scientists in the field and executives of its trade association. Ask them intelligent questions about the company you are studying. Nine times out of ten, a surprisingly detailed and accurate picture will emerge, revealing far more than any annual report ever could. This is how you learn about the true nature of the people with whom you are considering entrusting your capital.

What, then, are you looking for? First, you must seek a company with products or services that have enough market potential to allow for a sizable increase in sales for at least several years. But this is not enough. The management must be determined to continue developing new products that will extend this growth far into the future, long after the potential of current lines has been exploited. This requires a research and development effort that is not just large, but effective. You must also find an above-average sales organization, because in this competitive age, even the finest products do not sell themselves. Finally, the company must possess a worthwhile profit margin and a clear plan for maintaining or improving it, not by simply raising prices, but through genuine ingenuity and efficiency.

Beyond these business fundamentals, you must look deeply into the human element of the enterprise. Does the company have outstanding labor and personnel relations? The difference in profitability between a company with good morale and one with mediocre relations is far greater than the direct cost of strikes. Is there depth to the management, or is it a one-man show that could collapse if that one man is no longer available? Executives must have confidence in their leadership, a feeling that promotions are based on ability, not factionalism. You must also seek a management of unquestionable integrity, one that possesses a highly developed sense of trusteeship and moral responsibility to its stockholders. If there is any serious question on this point, you should never consider participating in such an enterprise, no matter how high its rating on all other matters.

As you build your understanding, you must avoid the common traps that ensnare so many investors. Do not buy into promotional companies that have not yet proven themselves with a record of commercial operation and profit. Do not overstress diversification; it is far better to own a few outstanding companies that you know well than to own a great many about which you know little. Do not be afraid of buying on a war scare, for war has always been bearish on money, making ownership of real assets more, not less, desirable. And do not quibble over eighths and quarters; if a stock is the right one, the small premium you might pay today is insignificant compared to the profit you will miss if you fail to obtain it.

The right time to buy an outstanding company is not when the stock market is low, but when the company itself is passing through a period of temporary trouble that is misunderstood by the financial community. Often, this is the expensive and difficult period of launching a major new plant or product. As unexpected expenses cause earnings to dip, eager buyers become discouraged sellers, and the price of the stock sags. Word passes that the management has blundered. It is at this moment, when the clouds seem darkest but you know the problems are temporary, that a sensational buying opportunity may present itself. You are not guessing about the market; you are acting on specific knowledge about a company's imminent and unrecognized improvement in earning power.

If the job has been correctly done when a common stock is purchased, the time to sell it is almost never. You should sell only when it is clear a mistake has been made in your original analysis, or when the company has fundamentally deteriorated in its management or its long-term prospects. You should never sell an outstanding company because you fear a bear market is coming, or because the stock appears “overpriced.” An exceptional company will consistently grow its earnings, and what appears high today may look like a bargain a few years from now. If you sell a truly great company, you not only pay a capital gains tax but also lose your position in an enterprise that could grow for decades to come. The investor who is patient enough to hold on through market cycles is the one who reaps the truly spectacular rewards.