Imagine that you want to invest in a business. If your objective is to maximize profit, your main question should be: How much money do I get to keep? What’s my profit margin?
The new trend in investing is to just put all your money in broad based ETFs, set and forget it. And I must admit that since I have been reading about personal finance, this is the best deal in the market for the little guy and for many big guys as well.
This new approach is effective because of its simplicity. If we can just manage to find the low cost ETF provider (avoid actively managed funds) then success is the most likely outcome.
However, A few of us would like to squeeze a little bit more profit out of our invested dollars. To do so we have to look a little bit deeper into the numbers.
Let’s imagine your are considering buying two different business.
- One is a grocery store: After you finish paying for all the merchandise, rent, salaries and taxes, you are left with a net profit of 3%.
- The other business does computer programming. After you pay the rent and all your programmers, you are left with a net profit of 20%
Which one of these two seem to be the better investment? I would say the computer programming business sounds better to me.
How about if we apply the same logic to the stock market. How about if we look for companies with fat profit margins.
The S&P 500 is divided into 10 different industries. As a whole, the profit margin of the S&P 500 is about 9%. But of course, there are some companies that have a fatter profit margins than others. Let’s figure it out.
Here we have the profit margins of the S&P 500 and all of its individual sectors for the 3rd quarter of 2017. The data comes from this research: https://www.yardeni.com/pub/sp500margin.pdf
Consumer staple 6.6%
Consumer discretionary 7.5%
Utilities 10.2 %
Information technology 19.2%
But does profit margins returns actually translate into stock market gains?
Here is my research as of November 15 2017
5 year returns
Consumer staple 104%
Consumer discretionary 100%
2 year returns
Consumer staple 30%
1 year returns
Consumer discretionary 20%
In short, the profit margins of 20% and the stock return of the technology sector of 35% for the last 12 months can lead us to believe that there is a correlation between fat profit margins and stock returns. But there is no such correlation when we look at the other profit margins and compare it to their stock returns.
Conclusion: Maybe the implied relationship between profit margins and stock returns is not as strong as I believed to be true.