It's all about the margin, Personal Investor editor John Kavanagh writes.

Sharemarket commentators are remarkably bullish about the outlook for the Australian market in 2005. While no one is expecting the S&P/ASX 200 to repeat the 25 per cent growth it has had this year, there are plenty of forecasts in the range of 10 per cent to 15 per cent and not many below those levels.

These optimistic forecasts are based on a view that the economy will continue to grow at a solid rate, inflation will remain moderate, interest rates will go up a touch or not at all, consumers will continue to spend and profits will rise.

However, one note of caution was sounded last week by J. P. Morgan's equity strategist Martin Duncan, who says companies in a number of sectors are coming under margin pressure sales are going up but costs are going up even more. Duncan says wages are rising due to a skilled labour shortage and raw material costs are going up because commodity prices have been booming.

Companies that will be hurt by the looming margin squeeze are manufacturers, such as whitegoods maker Fisher & Paykel, paint maker Wattyl, chemical company Orica and car accessories maker ARB. Higher skilled labour costs will also hit construction, mining and engineering companies.

Hills Industries, the maker of that Aussie icon the Hills Hoist, reported that its steel supplier, BlueScope, has warned of higher prices next year.
And beverage companies such as Lion Nathan, Foster's and Coca-Cola Amatil are facing packaging cost increases.

Duncan says companies that will avoid the impact of the margin squeeze are in areas such as media and insurance.

You can use a ratio called the EBIT margin to keep tabs of whether a company's increased sales are flowing through to the bottom line or are being eaten up by higher costs. EBIT stands for earnings before interest and tax and provides a measure of profit that is independent of a company's financing and tax situation. The EBIT margin is calculated by expressing EBIT as a percentage of sales.

If the margin falls, it means the company is not managing its costs as well as in the past. You should look at a company's ability to maintain or increase its margin over time.

In the case of Hills Industries, trading revenue has climbed steadily over the past decade from $301 million in 1994-95 to $714 million in the 2003-04 financial year. During the same period EBIT has climbed from $21 million to $58 million.

Hills is a remarkably consistent business. Over that period the EBIT margin has ranged as low as 6.8 per cent in 1996, up to 8.5 per cent in 1999-2000 and again in 2002-03. The margin dipped slightly in 2003-04 to 8.1 per cent. If cost pressure is hurting the company, investors will see the margin fall below 8 per cent in the December half results, which could be a sign of trouble.

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