Margin Expansion in Small Cap Stocks: How Profits Quietly Drove 2025’s Best Performers

Introduction: Why Margins Mattered More Than Headlines in 2025

With small stocks especially, investors tend to focus on sales. While top-line growth matters, margin expansion in small-cap stocks is often a better indicator of long-term value creation.

That dynamic was particularly evident in 2025. Our analysis showed that companies improving margins were able to fund growth internally rather than rely on higher-cost debt or shareholder dilution. At The Bowser Report, we focus on a systematic approach rather than individual outcomes and view margins as part of our comprehensive Bowser Rating System.

This article explains why margin expansion won in 2025, how to identify it and what questions to ask when applying these insights to your own disciplined small-cap process.

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What Margin Expansion Actually Means

Before identifying margin expansion, we need to cover a couple definitions.

Beyond net income, we focus most often on two margins:

• Gross margin, which considers revenue after direct costs such as materials and labor.

• Operating margin, which considers profitability after accounting for operating expenses such as selling, general and administrative (SG&A) and research and development (R&D).

Using Daktronics (DAKT) as an example, for the fiscal year ended April 30, 2025, the company reported $756.5 million in revenue. After subtracting $561 million in cost of revenue, gross margin was approximately 25.8%. After further subtracting $123.5 million in SG&A and $40.5 million in R&D, operating margin was approximately 4.2%.

Absolute numbers matter less than trends over time. Repeatable margin expansion drives shareholder value and occurs when margins improve or hold steady as revenue grows over time. In such cases, profitability is scaling alongside the business rather than being driven by one-time cost reductions.

Therefore, margin improvement is most useful when viewed as part of how we evaluate small-cap stock setups, rather than as a signal in isolation.

Operating Leverage: Where Small-Caps Gain an Edge

Revenue growth alone does not guarantee profitability. Without cost discipline, higher sales can still result in weak or declining earnings. An important factor to consider is operating leverage, or a company’s ability to generate disproportionately higher earnings as sales increase.

Small-cap companies often have higher operating leverage because a greater portion of their cost structure is fixed. In other words, a large portion of costs remain fixed even as sales fluctuate. Once scale is reached, incremental revenue can flow more directly to the bottom line.

This is why modest or even slight revenue growth can translate into significant earnings growth, particularly in small-cap and micro-cap businesses that have already absorbed much of their fixed cost base.

Why Margin Expansion in Small-Cap Stocks Outperformed Revenue Growth in 2025

Companies demonstrating margin expansion outperformed in 2025 because profitability mattered more in a higher-rate environment. When capital is expensive, internally generated cash becomes a competitive advantage fueling growth without debt or dilution.

To further this point, free cash flow is a useful confirmation signal. Expanding margins should be accompanied by improving cash generation. When margins rise but cash flow does not, it often signals accounting noise or unsustainable cost adjustments.

Case-Style Example: Margin Normalization Through Cost Discipline

One common margin-expansion pattern in small caps is margin normalization following operational cleanup, rather than rapid revenue acceleration.

In several recent cases, companies entered the year with stable sales. Instead of pursuing aggressive growth, management focused on simplifying operations, tightening procurement and reducing inefficiencies.

In these cases, revenue growth remained modest, but operating expenses grew more slowly. Gross margins stabilized first, followed by gradual improvement in operating margins and free cash flow. Importantly, these improvements were visible in quarterly filings before earnings estimates materially changed.

A prime example is Daktronics. From fiscal 2022 through fiscal 2024, revenues grew 25% yet gross margin expanded from 19% in 2022 to 27% in 2024. Operating margins grew from 0.7% to 11% over the same period, and free cash flow grew from negative $10 million to positive $78 million.

The takeaway is not the specific companies involved, but the signal itself: cost discipline paired with stable demand often precedes stronger earnings power, especially in small-cap businesses emerging from uneven growth cycles.

A Simple Checklist to Spot Margin Expansion in Small-Cap Stocks

When reviewing a company’s income statement, ask:

1. Is revenue stable or growing modestly?

2. Are margins improving sequentially?

3. Are operating costs scaling more slowly than sales?

4. Is free cash flow improving alongside earnings?

These questions help filter out surface-level growth stories and focus attention on durable value creation. They become even more powerful when paired with other confirming signals, including high-quality insider buying.

Conclusion: Why Margins Still Matter in 2026

While the interest-rate environment is evolving, rates remain elevated relative to recent history. That continues to favor companies who prioritize expanding margins and generating internal cash flow.

Beyond macro factors, investors have and will continue to consistently reward businesses that sustainably improve efficiencies to create value for shareholders. In small-caps, these improvements often appear in financial statements before they are reflected in share prices.

By applying the margin-expansion checklist consistently alongside a disciplined approach to small-cap stocks, investors can improve the odds of identifying high-quality opportunities earlier in the cycle.