Small Advantages, Big Wins

The blink of an eye
One of the most sobering lessons you learn by watching the Olympics is just how small the difference is between winning and losing. In most timed events, there's less than a second between glory and anonymity. Italian speed skater Enrico Fabris beat American favorite Shani Davis by a mere 0.16 seconds over 1,500 meters. But that's a lifetime compared with other races. On the mountain, in the men's super giant slalom, Kjetil Aamodt beat Hermann Maier by 0.13 seconds. In the men's giant slalom, Benjamin Raich won by a mere 0.07 seconds.

That's often the way it goes in business, too. A tiny lead over a competitor can be all the difference between first place and second, and it might be the difference between riches and bankruptcy. If you can beat the other guy to the line by 0.1%, year after year, chances are you'll take a lead and never look back. What's in a tenth of a percent? A lot, in the right business.

A tenth, a few billion times
Here are the latest year-over-year margin improvements from Home Depot (NYSE:HD).

As you can see, the company eked out nearly a 0.1-percentage-point improvement in gross margins. What's that mean? Well, across $81.5 billion worth of sales, it comes to an incredible $81.5 million worth of gross profits. Once more, with feeling: That's $81.5 million Home Depot wouldn't have had if it had kept gross margins where they were the year before.

Where are the winners?
How well you hang onto your margins -- or even improve them -- depends on what business you're in. Computer hardware, for instance, can see some brutal fights on the gross-margin front, while computer software can have phenomenal numbers. That's because hardware tends to be more susceptible to competition, if not outright commoditization, whereas the leaders in the software pack know that the costs of switching are huge, and they can charge a premium price. Solid brand-name consumer-product companies also have enviable gross margins, while retailers and commodity producers tend to finish last.

Here's a quick look at gross margins along the continuum.

Stronger, faster, higher, and so forth
You might judge by that table that some of the sweetest businesses out there are software and consumer staples, since they command premium margins for their goods. You'd be right. The trouble is, however, that software is usually priced at a premium already, and ditto for the consumer staples.

That's why many of us value guys keep a close eye on retail. The Street tends to write these companies off -- even the best of them -- as soon as they hit a sales snag, either a slowdown (gasp!) or a slowdown combined with in-store markdowns, which reduce gross margins (double gasp!). But those who take a longer-term view know that good retailers can get their sales back. Better yet, the real champions among them take advantage of their scale to constantly improve their profitability.

A lesson from Uncle Sam
Sam Walton has the reputation of making Wal-Mart a powerhouse by squeezing his suppliers and therefore getting lower prices, which would increase gross margins, even in the face of Wal-Mart's consumer-end discounting.

But in fact, predecessors at many other firms, including Sears Holdings' (NASDAQ:SHLD) Kmart or even department stores like JC Penney (NYSE:JCP) had already been playing this game for decades. Swatting at suppliers while racing for profits is as old as the sport of retailing.

According to other accounts, Wal-Mart's real secret to increasing was not to rely on scale alone to deliver results, but to rely on smarts and constantly seek out innovative tools and methods -- computerized inventory systems, for instance. Opening stores in saturated clusters is another oft-cited example. By doing this, instead of spreading willy-nilly, Wal-Mart could save money on shipping and distribution, thus eking out continual gains in margins -- gains that add up to billions for investors once the scale really kicked in, even in the face of rising costs elsewhere, as this table shows.

Look at that second line again. It shows that although selling costs were on the rise the entire time, continued cost savings in gross margins made up for the difference, so that net margin was also continually moving up.

Closing ceremony
By now, you should know exactly why so many value investors ignore the next big thing to concentrate on the boring ideas right under our noses, like big retailers. When they're priced right, which is to say when they're behind in the sales race, the Street loses interest and begins cheering for the other guys. When you see one of these powerhouses fall back, do yourself a favor and take a look back at its history. If it's got a record of constant improvement, chances are it'll be back, in a big way. And when it gets back into the race, those microscopic advantages will add up to major profits.

Home Depot is one of those continual improvers, having turned an 11.5% sales increase into a 20.4% EPS gain in FY 2005. But if the Street won't take it, Philip Durell will. A 30-day guest pass will let you take a look at his full team of market-beating stocks at Motley Fool Inside Value .

Seth Jayson wishes he could always improve his margins. At the time of publication, he had shares of Home Depot but no positions in any other firm mentioned. View his stock holdings and Fool profile here. Home Depot and Colgate-Palmolive are Motley Fool Inside Value recommendations. Fool rules are here.