Should you Invest in Companies with a High Margin? - A Myth Buster

It’s a general consensus that investing in companies with high margins is a good bet. Sure, it works. But, is it true every time?

Value investing starts with the realisation that when you are picking a stock, you are actually investing into the business of that company, and you are not merely betting against the price movement.

After this, naive investors tend to run after companies with high margins. Why, you ask? Obviously, a business that operates with high margins would provide higher returns to the investors.

But, does this strategy really work every time? Is this strategy sustainable in the long run?

What do High Margins for Companies mean?

High margins generally refer to companies with a low cost of goods sold and a high selling price, which allows them to realise a higher amount of revenue. They produce their products at a low cost and sell them at sky-high prices.

Such companies are highly profitable and enjoy a competitive advantage in their industry. The competitive advantage may arise due to various reasons such as High Entry Barriers, High Research and Development, Patents and Trademarks, Long term involvement in the industry, and much more. These companies may even be the market leaders in their industry.

Is investing in high margin companies sustainable?

Companies with a high margin will always face competition or interest from other players to have a piece of the profits. These types of industries would be attractive for any businessman. Thus, there are significantly fewer chances that the profitability will survive in the long term.

First of all, since the profitability of a business is high, the company will start facing competition and would now be required to reduce its prices or spend additionally on sales, thus lowering the margins. The growing competition has the capability to force companies into operating with minimal margin. So, the table could turn anytime!

Secondly, when small companies venture into a new industry and are highly profitable, they are either undercut in cost or are acquired by a bigger company. For example, we can see the biggest tech acquisitions happening today, such as YouTube by Google and WhatsApp and Instagram by Facebook, at massive amounts. Big players in the industry always want to survive and grow for the long term, and they do this by any means necessary.

Only some of the few big players can survive with a high profit margin. We can take the example of Google, Facebook, or Apple here. Some industries may even enjoy a high profit margin due to the complexities involved or the type of specialized human resources required, such as Chemicals, Healthcare, or the Pharma Sector. However, companies may find it difficult to sustain such huge margins as competitors are always looking for innovation and investing in R&D to stay ahead.

One of the most important things which investors need to consider while investing in such companies is past history. Suppose the company has been making good profit margins, and the company has been able to stave off competition. In that case, there is a high probability that such companies will maintain these profits in the long term. However, you must also take note of the fact that companies that have been generating high profit margins for a long time will generally have a high overvalued share price and a high P/E Ratio (a hot company in a hot industry).

Value Investors such as Warren Buffett, Charlie Munger, Peter Lynch, and many others, invest in such high margin companies enjoying a competitive advantage, but only if their share price is undervalued. Peter Lynch even gave a term to this: ‘Ten-bagger’. A ten-bagger refers to an investment that has the potential to appreciate 10 times the initial investment made. These stocks generally have explosive growth prospects and a P/E Ratio below industry.

What overpowers high margin?

Companies operating with high margins, may or may not provide the best results for an investor. For example, a company may be earning Rs 5 lac on selling 1 car, and it is able to sell 10 cars in a year, bringing the net profits to Rs 50 Lac. Another company, with the same capital structure, makes a profit of Rs 1 Lac/car (lower margin), but is able to sell 100 cars in one year, bringing the net profit to Rs 1 Cr. Which company would you prefer to invest in? A company with higher margins? Or the company with higher turnover? Do the math.

Which side would you like to be on? What if it’s a battle between High Margins & High ROCE. What would you prefer? 

ROCE is a measure of a company's profitability and the efficiency with which its capital is employed. But what does it indicate and why is it so important? Click here to find out everything important about ROCE.

If a company’s margins are high but ROCE is low, it means that despite high profit margins, you, as an investor, could still be earning low! So, naturally, you must choose ROCE over margins, right?

But, here are a few companies with profit margins of more than 40% and ROCE of less than 10%. Have a look -

You could find a long list of such companies at the Screener section on Ticker by Finology by using the query mentioned below:

To Sum Up

Surviving in an industry with high profit margins is difficult, and only a few companies can achieve it. We at Finology, don’t aim to invest in companies with higher margins or higher turnover. It is like choosing between Maruti (higher turnover) and Mercedes (higher margin). Not the car, the stock. What would be yours?

A true multibagger stock operates with a high margin due to a sustainable moat and manages to achieve a high turnover with its market credibility and demand. The likes of Apple Inc. Can you think of any other such company? Would love to hear from you.