In Common Stocks and Uncommon Profits, a book written amost 50 years ago, Phil Fisher made a point that resulted in an epiphany for this analyst when he read it some years ago. It's a long quote, but worth repeating.
Fisher explained that an in-depth study revealed that 'nearly all companies have broader profit margins—as well as greater total dollar profits—in years when an industry is unusually prosperous. However, it also becomes clear that the marginal companies—that is, those with the smaller profit margins—nearly always increase their profit margins by a considerably greater percentage in the good years than do the lower-cost companies... This usually causes the weaker companies to show a greater percentage increase in earnings in a year of abnormally good business than do the stronger companies in the same field. However, it should also be remembered that these earnings will decline correspondingly more rapidly when the business tide turns... For this reason I believe that the greatest long-range investment profits are never obtained by investing in marginal companies... Investors desiring maximum gains over the years had best stay away from low profit-margin or marginal companies.'
We've been banging on about overpriced stocks and unsustainable profit margins for a while, so now seems a good time to take a closer look at Fisher's conviction. Why is it that less impressive companies provide the biggest boom-time gains?
Lotsa Profits meets Thin Ice
Let's consider the example of two Australian widget makers, Lotsa Profits Pty Ltd and The Thin Ice Company. In year one, an 'average' year for widget demand, each company achieves sales of $100m. But profits are anything but equal, as Lotsa has been far superior in managing costs. It has negotiated a much better deal on factory rent, ensuring lower fixed expenses. And due to superior staff and better use of new manufacturing techniques, Lotsa also has lower variable expenses—equating to 40% of sales, compared to 45% for Thin Ice. In this normal environment, Lotsa recorded earnings before interest and tax (EBIT) of $20m—which amounts to a profit margin of 20%. Thin Ice only managed $5m, or 5%, for its efforts.
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