Phil Fisher on Profit Margins, Part II

 |  Includes: C, DIA, QQQ, SBUX, SPY
by: Joe Ponzio

As I mentioned in this post, three of Phil Fisher's 15 Points to Look For in a Common Stock are directly related to profit margins. Companies with slim profit margins often feel tough economic or business cycles more vehemently than those with fat margins. Of course, there is a flip side to that coin: When coming out of tough times, companies with thin profit margins tend to rebound much more than those with fat margins.

This is usually because of the bipolar nature of Mr. Market. He'll hammer a company's stock price as soon as earnings take a major hit; he'll send the price soaring as soon as earnings turn around. In the normal course of business, companies with fat profit margins usually do not experience such volatile results with earnings; so, they're prices do not tend to move as quickly as slim margin businesses.

Let's look at another one of Fisher's Points:

What is the company doing to maintain or improve profit margins?

There are three ways to increase profit margins — increase sales while keeping expenses the same, reduce expenses while keeping sales the same, or increase sales while reducing expenses. Great managers will try to increase sales while reducing expenses.

I'm always leery of companies that publicly announce their cost-cutting measures. So-and-so company management issues a press release patting itself on the back for implementing a new plan to reduce overhead and costs. My thought: One of management's primary goals should be to constantly seek to lower expenses.

The Citigroup Plan

Don't get me wrong — I applaud management when they take major steps to reduce expenses. But taking steps to reduce expenses is not a reason to buy. Instead, investors should ask why the company is taking these steps and, more importantly, why these cost-cutting measures were not in place before the press release.

Take, for example, CitiGroup's April 11, 2007 press release about its cost-cutting efforts. The company announced a plan to reduce expenses by $2 billion — a savings that would grow to $4.6 billion by 2009. I think that's wonderful. Question: Why did management let expenses get so out of hand in the first place? Let me bring back a quote about Citigroup (NYSE:C) I wrote in this post:

Citigroup is a classic case of the Institutional Imperative that Buffett speaks of. You have this wonderful investment business, and you go and do something stupid — like buy or start 2,200 more businesses.

It's All About Balance

Citigroup was so focused on increasing revenues and growing in size and stature that controlling expenses became an afterthought. I assume management's rationale was something to the effect of, "Generate enough in revenue and expenses will take care of themselves."

You can see it today with Starbucks (NASDAQ:SBUX). "Open as many stores as possible. If you build it, they will come." Starbucks management was focused on meeting Wall Street's growth targets — shareholders and expenses be damned. Rather than focus on its core business and grow in a way that "makes sense" from a business perspective, Starbucks management decided to throw a store on every corner, and use some of the shareholders' money to branch off into unrelated businesses.

The Starbucks across from my office is closing. Will I miss it? You bet. But it shouldn't have been there in the first place. The three long-standing stores a half a mile away were almost always virtually empty. Why did management think there was enough demand to open another store smack dab in the middle of those locations? Institutional Imperative. And now, three of the four locations are shutting their doors.

I'm sure Starbucks shareholders would have been better off with that money in their own hands rather than in the hands of management.

Look For Increasing Margins That Make Sense

It's not enough to see increasing profit margins. Those increases must make sense from a business perspective. If you look at Citigroup's profit margins for the last ten years, you find that they were increasing, peaked at 31% in 2003, and began to fall again. The Institutional Imperative will only hide unintelligent business decisions for so long.

With Starbucks, profit margins rose fairly consistently for many years. But Starbucks' plan to increase margins did not make sense, and shareholders have suffered — not just because the stock price is in the toilet, but because a lot of money was wasted.

It's a lot easier to explain Fisher's Sixth Point by citing examples of bad practices than it is to lay the groundwork for good practices. There is no way to say, "Look for this, this, and that and you'll know that management is striving to increase profit margins in an intelligent way."

Instead, I'll simply say this: Look for steadily increasing margins and find out why they are steadily increasing. If management's plan makes sense, or if management is so focused on increasing margins that they're not issuing special press releases to pat themselves on the back, you might have a pretty sharp management team at the helm.

Additional Points on Profit Margins

Don't exclude a business from your research just because profit margins have been erratic or have dropped in a particular set of years. Go back and understand what happened to the profit margins in those years so you can best understand your business.

Also, don't shy away from a company specifically because it is issuing press releases about cutting expenses. If the same tired management is issuing a press release saying that they've finally realized that they need to cut expenses, it may be a warning sign in the business. If new management comes in to shake things up and announces a plan to reduce expenses, take a look at their track record (perhaps at other companies) to see if they're serious, or simply paying lip service to boost the stock price.