There are really only three ways to run a business.
You can have a super fat profit margin… and a very small number of clients.
You can have a very thin profit margin… and a super large number of clients.
Or, you can have every imaginable shade of grey between the two extremes.
In the economic winter season, sales volumes – or the number of paying clients you can attract – are significantly reduced. That makes the “thin margin, big volume” model especially difficult.
Instead, companies tend to adjust to contracting sales volumes by pumping up profit margins. One way they do this is by cutting costs, usually by trimming the fat in their workforce.
Here’s a chart I ran across today that makes the point well. I mainly want you to see that corporate profit margins have been on the rise since 2001. But also note the strong inverse correlation between profit margins and wages.
This relationship shows that as corporate profits rise, employee wages fall. It makes perfect sense, as the extra cushion in a company’s margin usually comes from money saved after laying off workers.
The left-hand scale shows corporate profit margins. You’ll see these have expanded, from about 4% in 2001 to roughly 10% today.
This got me to wondering…
Could profit margins alone predict stock performance? Like most of my research, it all starts with just a grain of curiosity. So here’s what I did…
I scanned 7,809 stocks. (With a computer… not manually… I have a life… kinda.)
First, I looked for stocks that showed current profit margins ABOVE their five-year average. I looked at two measures – the company’s profit margin from the most recent quarter (MRQ) and its profit margin on a trailing twelve months (TTM) basis. I required both measures to be greater than the five-year average for a stock to make the cut.
On the flip side of this, I ran another scan with the same criteria… only this time I looked for companies that showed recent profit margins (based on MRQ and TTM) BELOW the five-year average.
The question I was trying to answer was: can I use profit margins as a reliable way to find companies that generate above-average returns? To judge the results, I simply looked at the percentage-change in price over the last 52 weeks. Here’s what I found…
There were about 1,600 stocks that now sport profit margins greater than their five-year average. Among these stocks, the average 52-week percentage change came in at a strong 18.6%.
My scan for BELOW average companies revealed about 1,000 stocks. The average 52-week return on these was slightly negative, at -1.4%
To me, that’s some worthwhile information to know if you’re a stock picker! Of course, I wouldn’t build an entire trading strategy around this metric alone. More research is needed, but this is an interesting starting point.