Does obsessing over margins lead to missed investment opportunities?
Today’s world is characterised by fast-money investors looking for high-growth and high-margin businesses, such that businesses with lower margins are considered “boring” or are frowned upon. At surface level, higher margin businesses, in both the gross margin and operating margin sense of the word, must be “better businesses” as they are capable of manufacturing their products and operating their business more efficiently – so more of that initial revenue generated is available for their shareholders.
This couldn’t be further from the truth – in this article I will explore how a myopic view of margins, failing to acknowledge the context surrounding the numbers, can lead investors to overlook attractive opportunities.
When looking at a company’s margins, they cannot be viewed in isolation. Investors must analyse the changes in the business’ margins over time. If we see that a business’ gross margin has declined over the last 5 years, then we can deduce they have become relatively less efficient at manufacturing or selling their goods. To identify the reason for this lapse in efficiency however, requires more analysis – did the prices of a key input in their process balloon in price? Etc. Hence, astute investors will concentrate on changes in a company’s margin profile which will reveal to an investor where they should concentrate their efforts.
Beyond analysing a company’s margin profile at face value, investors must also consider the broader competitive environment in which the business operates within. For example, if the business operates in a market that is in the process of consolidation then we can expect to see an improving margin profile as there is expected to be less immediate competition pushing down prices. It is important to understand that a company’s margins are ultimately a function of how a business operates within the broader market. Hence, investors should refer to margin profiles of competitors and ask themselves why there could be a source of difference between the two businesses even if they are similar in operations. By undertaking this further step, investors will be able to deduce the competitive advantages that one business is able to enjoy over its competitors.
Most importantly, margins should be analysed in tandem with asset turnover ratios, as combining an analysis of the two enables investors to calculate a business’ returns on investment capital – the ultimate measure of management’s efficiency in capital allocation. This measurement captures how much of each dollar of invested capital in a business is converted into pure operating profit and hence is a far more telling indictor of a business’ viability compared to margins by themselves.
For example, Costco (NASDAQ: COST), an American retailer with a global footprint, has generated extraordinarily low operating margins in the range of 2-3 per cent over the last 10 years. At face-value, investors may be deterred from taking a further look, however, upon peaking beneath the hood, we see they’re turning over their invested capital 7-8 times per year in sales, resulting in strong mid-double digit returns on invested capital between 15-18 per cent; despite their razor thin margins. It is no wonder their shares have more than doubled over the last 3 years.
Understanding a company’s margins can be an important starting point for further analysis, however it is not the be-all and end-all measure of company performance – it is merely a tool to be used in conjunction with other methods to complete the picture of a business’ viability. Maintaining a myopic or static view of margins can lead investors to forego high-quality businesses that could’ve been attractive investment opportunities, like Costco.