Margin Expansion – One of the Strongest Levers of Value Creation
We as Investors always try to look for Value Creation Opportunities. Value Creation from a Fundamental Standpoint instead of Short Term/Manipulation Type Calls.
We look for Triggers such as Growth, Margin Expansion, Growing Market Share, Weak Competition, Market Leadership, Ability to Pivot etc. which could structurally change in the Company’s Favor therefore driving Sustainable and Long Term Value Creation.
We have back tested a lot of Permutations and Combinations within the Above mentioned Triggers of Value Creation and can Confidently say that “Margin Expansion remains One of the Strongest levers of Value Creation.”
In this Blog, we try to put out our Findings on the Topic while also focusing on:
–> Our Process of Identification of the Strategy
–> Examples
–> Limitations in following the Approach
Our Process of Identification of the Strategy and Our Findings
We in our Day to Day work, run across many screens, do many different calculations, back test various different strategies with a sole objective of finding ideas which could help up create large returns. The above Conclusion of Margin Expansion leading to some of a Very Strong Value Creation opportunity remains an Outcome of those simple daily tasks.
Let me give you an understanding on our Back Testing Process here.
–> We first collected Data for Prices and Margins for all Companies (Listed on NSE) from 2013 to 2022.
–> We then Calculated Rolling 3 year Returns on such Prices and kept filtering the names of Companies with the highest returns in that period. (Especially Companies that returned 500%+) (Periods of Calculation: 2011-2014, 2012-2015, 2013-2016 etc.)
–> We then looked for Stocks which have had a Margin expansion for at least 2 consecutive years (In the Year of Calculation) to give us an understanding as to How many Stocks went higher with Margin Expansion.
We did this Exercise on the Entire list of Stocks to remove any kind of Survivorship biases and present to you the Actual findings of almost the entire Group set focused on finding:
— How many Stocks went higher with Margin Expansion over Consecutive 2-year period ?
— This however in no way tells us to know the Quantum of the move which could be as little as 10-20% or as large as 1000%+.
— The Quantum depends on Research, Conviction, Direction that the Business is taking and Market’s potential to re rate the same. (That is where the additional work comes in)
Our Research on the Stocks provided us with the Following Findings:
Takeaway from the Findings:
— At an Average Only 20-22% of Companies are able to Expand their Margins consecutively over 2 Years.
— As we can see on an Average, almost 75-80% Companies which go higher have Margin Expansion for 2 consecutive years. (By higher I mean have positive returns over a 3-year period. The Returns however range between periods)
— 2017-2020 looks like an aberration because the prices of Stocks remained very low because of the COVID Sell off and hence is not the right year to look at. 2018-2021 has some impact of that as well and in 2019-2022 the Stock has returned back to the normal 82% number.
— This gives us confidence that there remains a high probability that Stocks mostly go higher, as and when Margin Expansion takes place.
We then looked at Stocks which have returned 500%+ and their Relationship with Margin Expansion.
The Stocks that have generated more than 500% Returns over a Rolling 3-year period between 2011 to September 2022 are 667 in Total (There is also some Double Counting here, because of the Rolling nature of Calculation but that gets negated on both the sides). Out of 667 Stocks (Sample Size)-
• 52 Had Margin Expansion for 4 years (8%)
• 117 Had Margin Expansion for 3 Years (17.5%)
• 259 Had Margin Expansion for 2 Years (38.8%)
• 428 Had Margin Expansion for 1 Year At least (64%)
This goes onto show that there is a high likeliness of Stocks have Margin Expansion leading to Large Returns.
While Margin Expansion is One of the Factors, we cannot blindly bet on a Stock Undergoing Margin Expansion. We should also try and find Answers to:
• How is the Company placed Individually and within the Industry?
• What is the likelihood of Growth being maintained?
• How is the Competitive Intensity of the Industry?
• Does the Company have enough levers to make sure their Margins Sustain or Grow?
• What are the Underlying Factors of Margins Expansion and How Sustainable are they?
• Is the Industry/Company Cyclical in Nature?
The more Structural Nature of a Stock the better chance of making and sustaining the Large Returns here. Cyclicals will always give away the upside as and when the Cycle turns and timing is the hard part here which should be avoided as much as possible.
Paytm, PB Fintech are undergoing a Large Change in Margins with Growth and Sustainability in the Picture. We will have to hence see if they can replicate the Past winners or not.
Now let’s look at some of the Charts and their Potential Entry Points which once could have looked at as and when things started to evolve.
Some Examples
There are somethings I would like to put in Context before we move forward on this. Markets were much less Efficient even 3-4 years ago than they are today. A lot of things were never factored in and there always were a lot of surprises than we have today.
We have lately seen that Market knows things much in Advance and the Price reflects a lot of the Upcoming events much before they happen. Moreover, a Large Return only flows through in case of a Large Surprise relative to Smaller ones which has One off kinda effects.
I will here try to show you how the Prices kept on Climbing as the Margins expansion kept following through. I have taken 5 Examples from different time frames to demonstrate the same.
Margin Expansion with Growth allows PAT to grow at a much faster rate relative to the Revenues which further contracts the PE Ratio thereby leaving Room for an initial catch up and further PE Expansion which creates some unexpected a Large kind of Upsides.
Limitations of the Approach –
1- Margins don’t go up forever, they go back to the Mean faster than they have risen. (Especially in the case of Commodities, Chemicals). Value Destruction then is just unreal; hence it is necessary to actually know the reasons for Margins going higher. (Look at HEG- 2018, Alkyl-2022, you will get an idea of the Loss one can have)
2- Only 20-22% Companies of the Total Peer Group are able to expand their Margins of which around 75-80% go higher. When I talk about Higher It could be as low as 10% as well which means 10% returns over a 3-year period which is not even half of Inflation. And Hence it remains important to study the Industry, Company and its positioning to get an idea of the sustenance of the Expansion and other additional factors.
3- There is some Double Counting of Data given the Overlap in the periods. But looking at Rolling periods helps us in understanding winners across time periods.
4- Very Few Companies have been repeated in the Large Winners list, and only 4% of Companies have actually delivered 500%+ Returns over the last 12 years now. (2011-2022) (Ex-2023 Data)
Improvement in Margins = Improvement in Competitive advantage of the Company.
Improvement in Margins led by Demand-side factors are much more durable. This can be led by New products or services, premiumization of the existing portfolio. Though, the demand side changes are slow and are reflective over a period of time.
And, improvement in Margins led by Supply-side factor, due to demand supply mismatch leads to lollapollaza effect on the P&L. Consolidation of industries, regulatory kickbacks, capacities shutting down etc. etc. are the large causes of this impact. These aren’t rare, it happens and it goes off in 2-4 years, as the competition catches up.
There are companies where both the margins improvements align very well i.e. Demand-side and Supply-side. The impact on the value creation is mani-fold. This would be the best combination of the value creation in any Company.
