Don't think bad about low margins
Low margins does not equate to a bad investment. Here's why.
This is a slightly different edition of the Wise Investor newsletter.
It’s different because we will talk about a financial concept and not in particular about a company or stock.
Margins mean the amount of revenue a business can turn into profits. Suppose a business earns $10,000 in revenue. But it has to spend around $8,000 on operating expenses, interest payments, taxes, etc. That means, of that $10,000, it can count only $2,000 as profits and has a margin of 20 per cent ($2,000 / $10,000).
So, high margins mean an efficient business, and low margins mean the business is worthless. Right?
Well, not quite so.
Efficiency is important, and as an investor, you should be looking out for both when picking your stocks. But margins are often dependent on industry structure and other factors. In some industries, low margins does not equate to a bad investment.
Take the example of a retail business. Discount, sale, off, there's a reason retailers have these words pasted in front of their stores. Consumers will always go to the retailer that sells a product at the lowest price.
So should a retailer lose business and sell products at a higher cost just to have the bragging rights for higher margins? Surely, that can't be a sign of a good business.
If you can generate more revenue consistently by lowering your margins and boosting your sales, does it really matter if you have low margins? At the end of the day, the lifeline of a business is consistent profits, not high margins.
Walmart ($WMT) is an excellent example of this.
Its five-year average net profit margin is just 2.2 per cent. But because it has a high average asset turnover of 2.4 times (the amount of revenue or sales a business generates using its assets) and high bargaining power over its suppliers, it was able to maintain a healthy ROE of 15.5 per cent.
Margins are important. Efficiency and profitability should always go hand in hand. But judging a company solely on its margins is not advisable. As mentioned above, industry dynamics drive margins more than efficiency. In a segment like retail, where sales volume is far more important than high margins, margins should not be used to gauge efficiency and profitability. Similarly, other sector-specific factors, such as higher taxes imposed on certain segments, also play a key role in how much margin a business can sustain.
So next time you encounter a business with low margins, ask yourself these.
What kind of a sector does the business operate in?
Is it a sector that historically had low margins (such as retail)?
Does it have a consistent record of efficiently using its assets to generate high revenue or sales ( high average asset turnover)?
Does it have a history of generating wealth for its investors (high ROE and ROCE)?
If a business ticks all the above boxes, it may deserve a few more hours in your stock-picking exercise.
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Disclaimer: Please do not consider this post as an investment advice. I am not a registered financial advisor. Nothing in this article should be construed as an investment advice. Please consult a registered financial advisor before making any investment decisions.
Credits: Most of the content of this article is public information that can be found on news articles, government and company websites.