In my more than two decades as a hedge fund trader, I have pretty much seen it all when is comes investment styles and strategies. We continuously hear about things Artificial Intelligence, bid data, machine learning, quantitative funds, computers driving the markets, etc… The list goes on and on.
But I have to believe that as long as we live in a capitalist society, which at least for now we do, one would think that there has to be a market for investing in companies when they are small, watching them grow, and selling them when they are large. This traditional old-school style of investing is referred to as fundamental investing.
Over the years I have known many fundamental managers. Most are mediocre or bad, and typically very arrogant. But I have noticed a common trait in the ones that are consistently successful. We hear all about things like price to earnings ratios, book values, enterprise value, technicals, and so on.
The most successful fundamental investors that I know look at all these data points, but what differentiates them from the average investor is that they spend a great deal of time studying and analyzing the margins of the companies. What, exactly, are are margins? They are measures of profitability, or the ‘bang you get for your buck’, when you invest in a company. This obviously isn’t the only thing that you should look at when considering an investment, but if you are a long-term buy and hold investor then I think that it should be on your checklist.
The two most popular margins that are analyzed are Gross Profit Margin and Operating Profit Margin.
Gross margin is a company's total sales revenue minus its cost of goods sold (COGS), divided by total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells. The higher the percentage, the more the company retains on each dollar of sales, to service its other costs and debt obligations.
The COGS is an accounting term. It is defined as beginning inventory + purchases - ending inventory. It doesn’t include things like payroll, rents, and other administrative costs.
The gross margin number represents the portion of each dollar of revenue that the company retains as gross profit. For example, if a company's gross margin for the most recent quarter is 20%, that means it retains $0.20 from each dollar of revenue generated.
Operating margin measures how much profit a company makes on a dollar of sales after COGS and after paying for variable costs of production such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating profit by its net sales or revenues.
A company’s operating margin, also known as return on sales, is a good indicator of how well it is being managed and how risky it is. Highly variable operating margins could be an indicator of business risk. By the same token, looking at a company’s past operating margins is a good way to gauge whether a big improvement in earnings is likely to last.
To calculate a company's operating margin, divide its operating income by its net sales revenue. Operating Profit Margin = Operating Income / Sales or Revenue.
Operating income is often called earnings before interest and taxes (EBIT). Operating income or EBIT is the income that is left on the income statement, after all operating costs and overhead, such as selling costs, administration expenses and cost of goods sold (COGS) are subtracted.
Operating margin should only be used to compare companies that operate in the same industry, and have similar business models and annual sales. Companies in different industries with wildly different business models have very different operating margins so comparing them would not make sense.
Here are three companies that have had rising operating margins over the past year. They may be worth further analysis.
International Paper Co. (IP) engages in the manufacture of paper and packaging products. It operates through the following segments: Industrial Packaging, Global Cellulose Fibers, and Printing Papers. The Industrial Packaging segment involves in the manufacturing of container boards, which include liner-board, medium, white-top, recycled liner board, recycled medium, and saturating kraft. The Global Cellulose Fibers segment offers cellulose fibers product portfolio includes fluff, market, and specialty pulps. The Printing Papers segment includes manufacturing of the printing and writing papers. The company was founded by Hugh J. Chisholm in 1898 and is headquartered in Memphis, TN.
In the fourth quarter of 2017 the operating income was $288 million and the revenue was $5,711 billion, so the operating margin was 288/5,711 = 5%..
In Q1 2018 it was 517/5,621 = 9%,. Q2 2018 was 685/5,833 = 12%, Q3 2018 was 833/5,901 = 14% and Q4 was 927/5,961 = 16%. So in one year margin grew from %1 to 16%.
The company is followed by 11 research firms and these are their recommendations. Six analysts have it as a ‘strong buy’, one has it as a ‘buy’, three as a ‘hold’, and one as a ‘sell’. ( I would love to hear that analyst’s reasoning)
CTS Corp (CTS) is a designer and manufacturer of electronic components, actuators and sensors and a provider of services to OEMs in the automotive, communications, medical, defense and aerospace, industrial and computer markets. The company manufacture products in North America, Europe and Asia. CTS was founded in 1896 and is headquartered in Lisle, IL
In the fourth quarter of 2017 the operating income was $111 million and the revenue was $1.18 billion, so the operating margin was 111/1,180 = 1%..
In Q1 2018 it was 146/1,135 = 13%. Q2 2018 was 157/1,180 = 13%, Q3 2018 was 171/1,188 = 14% and Q4 was 187/1,200 = 16%. So in one year margins grew from 1% to 16%.
It looks like only one firm follows CTS and they have a ‘hold’ rating on it.
WestRock Co. (WRK) engages in the provision of paper and packaging solutions for consumer, and corrugated packaging markets. It operates through the following segments: Corrugated Packaging, Consumer Packaging and Land & Development. The Corrugated Packaging segment consists of container-board mill and corrugated packaging operations, as well as recycling operations. The Consumer Packaging segment offers consumer mills, folding carton, beverage, merchandising displays, home, health, and beauty dispensing, and partition operations. The Land and Development segment sells real estate. WestRock was founded on March 6, 2015 and is headquartered in Atlanta, GA.
In the third quarter of 2017 the operating income was $335 million and the revenue was $4,061 billion, so the operating margin was 335/4,061 = 8%.
Q4 of 2078 was 164/3,894 = 4%, Q1 was 340/4,017 = 8%, Q2 was 425/4,318 = 10%, and Q3 of 2018 was 491/4,237 = 12%. The margins have grown from 8% to 12%,.
This company is followed be seven research firms. Four of them have a ‘strong buy’ rating on it and three have a ‘hold’ rating.
Margins are not the only thing that you consider when making an investment, but I believe that they can be a valuable part of your investment toolbox. In my experience, the best long-term stock pickers study and consider margins when they deciding whether or not to invest in a company. Expanding margins generally indicate that a company is becoming more profitable. As long as we live in a capitalist society, at least for the time being, there should always be opportunities to invest in companies and to profit from their long-term success. Studying margins can help you make money the old fashion way.