Fool.com: A Look at Margins (Workshop) September 1, 1998

A Look at Margins

Atlanta, GA (Sept. 1, 1998) -- In writing up the The Daily Double/Daily Trouble features over the last year and a half, I've had numerous occasions to refer to the rising margins and falling margins screens here in the Foolish Workshop. Simply put, companies with nicely growing sales (at least 15% year-over-year) and nicely improving margins (here measured by EPS) can see their stock prices soar -- assuming the happy trend continues. The opposite holds true for businesses reporting souped-up sales but contracting profitability: materials costs or operating expenses are outpacing revenue gains, suggesting the company may be growing into trouble.

Though we're still discussing what changes to make in the Workshop, it seems likely I'll be dropping in once a week to talk about the rising margins screen (and maybe another screen). So, what's my approach going to be? Well, I'm generally going to follow the method outlined by Randy Befumo last September. Randy discussed how to sift through the screen for ideas and how to do preliminary research of an idea to see if it's worth additional time. I think this is the way an investor should use the margins and estimates screens here in the Workshop -- as a starting point for more research.

Unfortunately, I must confess that I don't have Randy's boundless knowledge. And like you, I often won't have time to sift through more that a few of the screened candidates. I'm not going to sweat it. My goals are twofold: 1) to model how I use these screens so you can see how you might, and 2) to find some legit investment ideas.

Here's what I dream of finding: the next American Woodmark <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMWD)") else Response.Write("(Nasdaq: AMWD)") end if %>. Say what?

You may think that's not as exciting as finding the next Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>. But from April of '96 when this kitchen cabinet maker delivered its first rising margins after a difficult transition, good old boring American Woodmark has been a runaway freight train, barreling ahead by as much as 718% (it's still sitting on a 616% gain over this period). That beats Bill Gates' little engine that could, which has tugged along over the same period for a comparatively asthmatic 379% gain at its peak, and 300% now that the market's blown off some steam.

I laid out the American Woodmark story in one of my first Daily Doubles, and the stock has made an impression on me. It had just seen an astonishing run to $20, and yet I was right to be bullish: It's up nearly 50% since I wrote about it.

American Woodmark has been a great investment for several reasons. First, capital improvements made in FY95 and FY96 (its fiscal year ends in April) led to improved labor productivity and better materials utilization (thus better gross margins). Second, a strong housing and home improvement market has been great for business, boosting sales. Third, improved profits have allowed the firm to pay down debt while funding expansion.

As good as the fundamentals have been, the intangibles have also been terrific. Peter Lynch has said that great investments often can be found 1) among boring or downright unpleasant sectors, and 2) beyond the vision of Wall Street analysts. The latter maxim is why I prefer the rising margins screen to the beating estimates screen: small-caps offer the most delicious gains when you spot them before even a single analyst does.

American Woodmark was virgin territory throughout most of its spectacular rise-- no analysts in site. The company also met the first criteria in that it's an easy to understand manufacturer that sells its wares at your local Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %>. I'm going to try to stick to such boring businesses because I'm convinced they offer individual investors the best opportunities with the most readily understandable risks.

So, American Woodmark is my nomination for an ideal investment -- and one that a rising margins screen could have found early on. Look at this chart. (Sales are in millions of dollars. With 3Q98, fully diluted EPS was introduced, accounting for the slight discrepancy versus earlier periods.) [AOL users please expand screen to view table.]

 
  
 Qtr  Sales Year Ago  %Change  EPS  Year Ago  % Change 
 3Q96  46.8  48.1      -2.8    0.07    0.15    -46.7 
 4Q96  53.3  49.7       7.2    0.31    0.16     93.8 
 1Q97  53.4  47.3      12.7    0.28    0.05    460 
 2Q97  57.0  48.9      16.5    0.45    0.08    462.5 
 3Q97  51.6  46.8      10.4    0.27    0.07    285.7 
 4Q97  57.4  53.2       7.9    0.37    0.31     19.4 
 1Q98  56.0  53.4       4.9    0.34    0.28     21.4 
 2Q98  62.7  57.0      10.1    0.53    0.45     17.8 
 3Q98  55.5  51.6       7.6    0.32    0.26     23.1* 
 4Q98  67.4  57.4      17.4    0.48    0.37     29.7 
 1Q99  72.7  56.0      29.8    0.53    0.33     60.6

When the 4Q96 ended in April '96, American Woodmark's stock was at $4. The earnings report would reveal the first signs of a turnaround, with year-over-year sales turning positive (+7.2%), and even this little bit of growth producing a huge leap in profits (+93.8%). That trend continued with outsized margin increases in the ensuing three quarters. Sure, those margin gains diminish once you start hitting the tougher year-over-year comparisons. And the sales gains have been relatively modest (until the latest quarter), which is about what you'd expect from a slow-growth biz and a company that (sensibly) only recently added new capacity. But American Woodmark has managed to keep profits growing faster than sales throughout this run. That's what you want to see.

Investors who didn't find the stock until after the October '96 (3Q97) earnings report (and that's when our Fool screen picked it up) could have enjoyed a double in just a few months and a three-bagger over 22 months. That's pretty terrific. But it would have been even better to spot the story after 4Q97. Margins were exploding even though sales growth was slight.

The Foolish Workshop's screen requires at least a 15% year-over-year sales boost. The theory behind this threshold is that revenues must be increasing to a substantial degree for a stock to enjoy massive appreciation. Having seen numerous examples in the Double/Troubles where that's not the case (see Craftmade <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CRFT)") else Response.Write("(Nasdaq: CRFT)") end if %>), I'm going to lobby for a lower sales growth threshold for our screen.

Well, that's enough for today. Friday I'll probably start sifting through the latest week's screen. Then again, I might take a closer look at American Woodmark since the company's sales are rising even faster of late and margins accelerated in the latest period. The best new idea may be an old one.

Check out the latest file updates for the Workshop:
New Rankings | 1998 Returns | New Database

What Happened to Robert Sheard?