Earnings, earnings, earnings! Often, that is all pundits dissect. How much profit did a company report? Did it meet Wall Street’s expectations? Will firms’ earnings soar or sag next year? Fine questions! But investors stuck in this myopia miss a far better gauge of future growth: gross operating profit margins. That they’re rarely considered gives them power, particularly in late-stage bull markets—like now. Here is why “fat” margins offer you an edge—and how to deploy them now.
Earnings do matter—stocks are ownership stakes in firms’ future profits, after all. But past profits lack predictive power. Why? Accounting gimmickry lets firms twist and tweak short-term results. I am not referencing Enron or WorldCom-type chicanery. Firms perfectly legally decide when to readjust depreciation, take write-downs, repurchase shares or upgrade facilities. One time expenses can whack profits one quarter, yet never recur. All this distorts reported earnings, obscuring what matters most: a firm’s core business strength and long-term growth capability.
Equally important: The huge attention net earnings receive means new forecasts or results are pre-priced near-instantaneously. When the actual release comes, markets will have largely anticipated the results. When the profit data hit newswires, the stock may zig zag briefly as reality and expectations line up. But that happens too fast for almost anyone to act—with little lasting effect.
What to do when ubiquitous, pre-priced data leaves no one an investment edge? As I explained last summer, analyze the data devotees themselves. Look for what they miss—or dismiss. Today, most see gross margins as relics of a pre-digital era, when traders barked orders across bustling exchange floors and desktop computers had less power than today’s smartphones. Data-driven managers claim gross profit margins are too rudimentary to compete with their complex algorithms. Ironically, when I started 50 years ago gross margins were still taught exactly because they are so simple! No need for supercomputers. Just subtract the cost of goods sold from sales—easy to find even then. Divide the result by sales. Done! Nowadays, with so many pundits dismissing them, gross margins aren’t only easy to calculate, they have power.
As I detailed in July, this bull market looks late stage, despite its young age. The value stocks that normally lead the beginning of bull markets didn’t—quality growth stocks did, a late-stage regularity. After a few month value surge growth stocks have resumed their leadership. That should continue—and gross margins are key to finding them.
Crucially, gross margins offer a clear view of a firm’s ability to self-finance future growth. Fatter gross margins enable more capacity for sales, marketing and R&D expenses to fuel growth. They allow easier financing of capital expenditures, mergers and acquisitions or anything else driving future expansion.
Fatter gross margins also provide a downturn buffer, letting firms profit even as costs rise or demand drops, trashing lesser competitors. Late-bull-market investors crave such stocks. Consider: As bull markets age, those invested throughout the upturn develop acrophobia, worried a bear market will erase their gains. Newly optimistic buyers, meanwhile, want growth with some stability. Fatter gross margins offer both groups relative comfort. Thin-margin, typically value, firms get punished during downturns when profits evaporate. They fare best in early bull markets’ relief rallies.
Presently, America’s market is among the world’s fattest. Its profit margins average 33.1%, compared to 26.0% for the non-U.S. developed world. Among the plumpest of the plump: big Tech stocks. In the US, the sector boasts 48% gross margins, with Software industry firms leading the blubberbrigade at 71%. Tech-like companies in the Communication Services sector’s Interactive Media & Services industry carry whopping 63% gross margins. In Health Care, US Pharmaceuticals firms average 64% and Biotechnology an even-better 74%. Health Care Equipment & Supplies firms are a stellar 56%, too. Pockets within Consumer Staples—like Household and Personal Products—also top 50%.
The overseas world offers pockets of fat margins perfect for diversification. European Health Care sports 56% gross margins. Look to Switzerland, France, Denmark and Germany for that. Japan and the UK offer plenty of fat Pharma, too—the former’s gross margins sparkle at 75% and the latter’s aren’t far behind at 65%. The Luxury Goods industry averages 54% worldwide. Europe dominates it—target France, Switzerland and Germany. For more fat-margin Consumer Staples stocks, look to the UK and Japan.
What about the value sectors pundits have hyped for months on end? Gaunt! Globally, the Materials, Energy, Industrials and Utilities sectors all fall short of 25%. Value-heavy Financials? Gross margins don’t work on them, due to their business models. For banks, net interest margins are key. Banks borrow at short-term rates to finance long term loans. The gap between the two determines net interest margins. Long rates are low globally, with America’s 1.3% 10-year yield among developed markets’ highest. With the Fed and other central banks pinning short rates near zero, net interest margins should be weak.
While most investors focus on minutiae and complexity, don’t be fooled: There is magic in gross operating profit margins’ sneaky simplicity. Use fat gross margin stocks to beef up your portfolio in America and globally.