Why Profit Margins Matter Mightily to Small Company Growth
Posted by: Doug Gerlach 4/5/2024 12:00:00 AM

Can a company's earnings per share grow faster than its sales over time?

The approach we utilize to dissect companies in the SmallCap Informer leans heavily on developing an understanding of and outlook for a company’s profit margins. In fact, margin analysis is the primary component of our understanding of company quality (the “Q” in Q-GARP).

One area in which small company analysis can differ from investing in large- or mega-cap stocks is in how smaller companies can boost earnings by increasing profitability.

For large companies, there is a practical limit to how much economies of scale can contribute to the bottom line, at least in any meaningful way. If Walmart can reduce its cost of bananas by a penny a pound, it might increase its profits by $10 million (since it sells one billion pounds or more of the fruit each year). But that is just a drop in the bucket compared to the $648 billion in sales or $15.5 billion in net income the retailer booked in 2023. It is going to take a lot more for a company of Walmart’s size to improve its margins in a way that significantly impacts its earnings.

Sure, if Walmart repeats this process thousands and even millions of times on its entire inventory, the results would be considerable. But inflation and SG&A costs have a way of rising over time, so managing the costs of its goods might have little or no impact on profit margins, and might only serve to keep the company above water.

During times of turmoil, large businesses often turn aggressively towards measures intended to improve the profitability of their enterprises, such as by laying off massive numbers of employees or shuttering hundreds of locations. These efforts may indeed result in better margins, but they also serve to reduce sales and earnings, which is contrary to the objective of growing the business, and is not sustainable. The profitability gains end after money-losing stores have been closed and workers released.

Compare these to smaller and emerging companies that are in an expansion mode that can last for a decade or longer. Managements can reap the benefits of continuously lowered costs of goods by making larger orders with suppliers. SG&A expenses can be spread out over a wider operation base. Debt can be acquired less expensively as the company matures. Profit margins of these businesses can gradually but measurably expand over the course of many years. In turn, this drives EPS growth faster than revenues growth.

In BetterInvesting methodology, investors are taught that revenues drive earnings, and earnings drive prices. In simplest terms, without earnings growth there is no long-term impetus for a stock’s prices to grow, and without revenues growth there is no long-term volition for earnings to grow. When projecting future long-term growth, it is thus prudent to not expect earnings to grow faster than revenues.

This is where profit margin analysis and stock selection come together to benefit of savvy small company investors. Get a handle on margin components and trends, and you can gain a better understanding of likely future earnings growth and when it may exceed the pace of revenue expansion.

Many businesses we follow in the SmallCap Informer are at the early stages of their company life cycles and it is not uncommon for them to be in the midst of extended margin expansion. For instance, high startup costs quickly become a smaller percentage of revenues as the company gains speed.

Certainly, larger and more established companies may work on cost reductions and margin improvements that result in increased income, and these can certainly continue for a few years before they inevitably begin to regress to the mean once again.

Besides by improving their margins, companies can grow EPS faster than revenues by buying back shares. Increasingly, companies today resist initiating dividends at meaningful levels or, once started, increase dividends at particularly fast rates in favor of using excess cash to buy back shares and thus “return capital to shareholders.”

The key advantage of buybacks is that a company can start and stop them, but they cannot effectively stop or reduce dividends (without being dinged by the markets). Outside North America, dividends are often paid at variable rates depending on current profits, but this policy rarely flies in the U.S. As a result, many managements prefer the flexibility and cushion of keeping dividends modest or absent.

This sea shift in dividend payment policies by U.S. companies over time is evident in the history of yields. Current dividend policies means that companies have more capital available to make share buybacks than they did in the 1980s and much of the 1990s, and nearly all of the market’s history before that.

Peter Lynch wrote about the benefits of share buybacks in his books published in the 1990s. Around that time a school of thought emerged that dismissed share buybacks in favor of focusing on “organic” or core growth in fundamental growth analysis.

Are these changes in how companies today manage capital use and growth objectives evidence of a generational shift? We have had two decades of low interest rates, which mean that companies have not had to be especially careful in their use of capital, since it has been easy and cheap to get money if you need it, and with interest rates so low, companies do not have to pay a high dividend in order to compete with savings and bonds.

If borrowing costs continue to grow, companies may be happy to sit on cash to collect interest, or increase their dividend so that their yields will pull some investors out of cash. Each management team will approach their use of cash differently.

Certainly, our new Dividend Informer newsletter looks at stocks through a slightly different lens: adjacent to the Stock Selection Guide approach but not driven by it, with a focus on shareholder-friendly capital practices like yields and buybacks that drive lower but hopefully less-volatile returns over time.

This approach seems to fit with the mindset of a long-term investor in his/her 70s who likes stocks but does not require the same levels of capital appreciation that is sought by investors when in their working years. They like the idea of slowing down and looking for total return opportunities that are not going to simulate a roller coaster ride.

As always, it is important to set reasonable expectations with respect to earnings and sales growth, and long-term earnings growth requires commensurate revenues growth.

A revenue trend-based method of identifying future earnings growth using margin expansion can be very useful for small company analysis. Many of the companies we cover in the SmallCap Informer are in the stages of their company life cycles in which they can boost margins on a fairly consistent basis, and thus see their earnings per share grow faster than revenues.

Neither share buybacks or margin improvement are especially easy to maintain over the long-term for large or small businesses, but small companies do have some advantages in the margins department.

We often tend to file away the potential upside from companies like this under a “hidden” “margin of safety” category, and refrain from projecting EPS faster than sales.

And so the rule of thumb remains—do not expect EPS growth to run faster than revenues growth when studying a stock. The exceptions to the rule should be clearly defined and not considered sustainable over the long-term.

Thanks to Liz Rodda for inspiring the thought exercise about margin expansion and its role in small company analysis. I always appreciate hearing from subscribers with comments and questions.

In this issue of the SmallCap Informer, we discontinue one company from coverage over concerns about near-term growth. In its place, we unlock hidden treasure in  another company in the same industry which promises better opportunities at its present price and given current macroeconomic and sector trends.

As always, stay the course!


Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the April 2024 issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 47 high-quality small company stocks currently covered in the newsletter.