From
Common Stocks and Uncommon Profits:
From the standpoint of the investor, sales are only of value when and if they lead to increased profits. All the sales growth in the world won't produce the right type of investment vehicle if, over the years, profits do not grow correspondingly. The first step in examining profits is to study a company's profit margin, that is, to determine the number of cents of each dollar of sales that is brought down to operating profit. The wide variation between different companies, even those in the same industry, will immediately become apparent. Such a study should be made, not for a single year, but for a series of years. It then becomes evident 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, whose profit margins also get better but not to so great a degree. 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. The only reason for considering a long-range investment in a company with an abnormally low profit margin is that there might be strong indications that a fundamental change is taking place within the company. This would be such that the improvement in profit margins would be occurring for reasons other than a temporarily expanded volume of business. In other words, the company would not be marginal in the true sense of the word, since the real reason for buying is that efficiency or new products developed within the company have taken it out of the marginal category. When such internal changes are taking place in a corporation which in other respects pretty well qualifies as the right type of long-range investment, it may be an unusually attractive purchase.
