Profit Margin: The Growth Stock Yardstick

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What are growth stocks? There seem to be as many answers to that question as there are investment analysts and stockbrokers. Here is one of the more quotable definitions, offered by the Valley National Bank in Phoenix, Ariz.:

If a stock yields five percent it can't be any good. If it yields two percent, it must be hedge against inflation since there is no other reason to buy it. And if it yields one percent, it is a 'growth situation' meaning that no one can figure out what it is worth.

Evidently, the market doesn't care what the Valley National Bank says. It has gone right on shrinking that one percent yield for many of the supergrowth issues.

We are not concerned here, however, with such supergrowth stocks, but with more earth-bound ones—stocks that should be easier to identify than their stratospheric sisters.

To be a growth stock, according to prevalent Wall Street thinking, a stock should show a record of doubling sales and earnings in about five years.

Why five? Because two or three years is too short to be indicative of future trends. Nowadays, many companies whose stock is going on sale to the public disclose a record of only one to two years to show how excellent their growth record has been. This representation could be highly misleading, since the rate of growth for most companies tends to be the greatest, percentage wise, in the first few years of their corporate existence.

Companies usually start out rapidly, then slow down and eventually halt. To mistake their initial rate of growth as an indication of future trends is to dangerously overestimate them.

Perhaps the surest measurement of corporate growth is profit margin. A widening profit margin always means better cost control, lower production cost and other positive management features which are classic characteristics of a growth company.

Some see a salient growth feature in the plowback of a greater portion of earnings in the business instead of paying them out in dividends. A higher percentage of earnings thus retained does not, however, necessarily mean growth.

Genuine growth companies are the ones that are able to advance their selling prices in line with rising production costs. While inflation means higher costs, wages and taxes, it does not necessarily mean higher prices for manufactured articles. Unlike the seller's market of the immediate postwar years, overcapacity and price competition have forced many companies to forego price increases even in the face of ever-rising manufacturing expenses. For several years now, for example, the prices of lead and zinc have been falling while the cost of production has been climbing.

Airplane and air transport companies are other examples of such shrinking profit margins. The changing fortunes of the airplane makers versus all manufacturing are shown in the following contrasting profit margins: 1957—17 vs. 9.8 percent; 1958—13 vs. 10.7 percent; 1959 third quarter—6.8 vs. 9.6 percent.

As for air transport concerns, their profit margins have been seriously threatened by high wages-to-sales ratios. A major portion of their receipts goes to labor forces, and their profit margins quickly narrow when revenues slide off.

So, you see, other things being equal, investors should definitely prefer companies with a low wages-to-sales ratio over those that have high ones. Belonging to the former industry groups are tobacco, oil, food and distilling, whose labor cost absorbs only about 10 to 15 percent of sales. In the latter groups are such industries as auto parts, steel and electrical products.

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