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High margins...good over time, bad over time?

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September 14, 2012 – Comments (8)

Now, you may be thinking, how could high margins possibly be bad over time?

 

Well, what if the company is the clear leader in its field, like apple.  I constantly hear people sayign apple can not keep its wide margins up forever.  If you took economics in college you were told this as well.   If a field has super high margins, people will flood the field, bringing the margins down to the point where economic profits are zero.

 

So if you have two companies trading at a p/e of 15, both earning the same amount of net income, do you take the high margin one or low margin?  High margin is good because they have more flexibility if we hit a slowdown/recession or if the company has a short term problem.

Low margin, however, may be better, because it may be a company in a field that is already flooded.  If the high margin company starts to get flooded, its margins will go down, and it will have a lower net income than the low margin company.

 Never saw this argument presented before, just thought of it.  I don't have an opinion yet.  Thoughts? 

8 Comments – Post Your Own

#1) On September 15, 2012 at 3:33 PM, somrh (78.29) wrote:

In terms of competition trying to get the piece of the pie, I'd be more inclined to look at something like ROIC over profit margins. After all, if I'm going to enter a new business I will have to invest capital to be able to produce whatever it is that gets the returns.

It's in principle possible for a company to have high margins and low ROIC or low margins and high ROIC.

That said, I'm sympathetic to high margins as a feature of GMO's quality strategy (see here). As you already mentioned, withstanding a downturn is one benefit they cite. 

No doubt high margins most likely won't last forever (nor high ROIC for that matter) but sometimes they can be sustained for quite some time due to various competitive advantages.

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#2) On September 15, 2012 at 3:47 PM, TMFBabo (100.00) wrote:

There's no way to give my entire thoughts in one response, but I'll give a few.

Apple keeps its margins up through multiple things, such as its brand. Some people often joke that iPoop would still sell a ton. Anyway, one of the way to keep gross margin way up is to have a brand that has pricing power. Then, you can wring out operating expenses if you're good at that sort of thing.

The problem with Apple is that its products are in consumer electronics, which is a terrible, terrible space. As competitors enter the space, there will be more choices. For example, I have been waiting for iPhone 5 to come out, since I'm going to get a new phone in December.

Now that I've seen all the phones, Apple might still be the one to beat, but I'm going to take a serious look at some of the other phones out there. When my last contract was up, there was no choice - I went iPhone. This time, it's different for me. I expect the phone will still sell like hotcakes, since it is indeed a nice phone and its ecosystem is quite sticky.

Btw, I'm completely neutral about Apple. I have not taken a position one way or other on this name.

Going back to your example, I think it depends on the industry. For consumer electronics, I'll probably prefer Apple over its competitors because it has a strong brand that is quite rare in an otherwise commoditized market where gross margins go down long-term in a "race to the bottom."

In the consumer electronics space, the low margin guys are probably competing on an undifferentiated segment where it's a total commodity product (TVs, PCs, maybe tablets/phones in the future). I would probably stay away from the low margin guys unless they're the low cost leaders in the space and they can sustainably keep the advantage.

Switching gears, in a commodity space (natural resources), you want the high-margin guys. High gross margin implies better economics from your mine, your oil field, whatever. Commodity cycles are brutal and timing the bottom is damn near impossible, so you want low costs, management focused on returns on capital, strong balance sheets, etc.

I've found that when the commodity gets hit, everyone gets hit and it's doable to pick the strongest (and still cheap) companies and benefit from a rebound, as long as you're not too early. I have seen many a high-cost producer get smacked never to rebound again, so I'm now convinced it's a terrible proposition to try to pick them.

I like that you're thinking about this sort of thing. As always, I think the answer is that it depends (on the industry). Still, it's good to approach each company, figure out what drivers are important, and go from there. I've been finding that there's no one "go to" type of business or space - you have to figure out what's unique in each one and then make your decision.

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#3) On September 15, 2012 at 4:21 PM, valuemoney (99.99) wrote:

Low margin, however, may be better, because it may be a company in a field that is already flooded. If the high margin company starts to get flooded, its margins will go down, and it will have a lower net income than the low margin company.

And if the low margin company gets even more flooded their margins will be lower yet.  If you are comparing apples to apples higher margins are always better. Higher margins give flexablity, lower margins do not. I like looking at companies that are already great....proven business models. If you go with a like company that has lower profit margins you have to hope for a turnaround. That is where value traps come into play. Low margins can get lower and the company makes less money or worse yet LOSES MONEY.

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#4) On September 15, 2012 at 5:24 PM, somrh (78.29) wrote:

Thinking about ROIC and Growth is a good powerpoint. (It looks like the "chapter 6" is in reference to Valuation: Measuring and Managing the Value of Companies which is a pretty good book.)

Page 4 gives ROIC by industry. Some (pharm for example) seem to have consistently higher ROICs.)

Pages 6 and 7 give "decay analysis" which shows mean reversion.  (Pg 7 shows that high ROIC can persist to some degree.) Page 8 is also interesting.

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#5) On September 16, 2012 at 5:54 PM, Mega (99.97) wrote:

Very interesting somrh.

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#6) On September 16, 2012 at 6:48 PM, elcid24 (74.72) wrote:

That McKinsey valuation book is a really good read

You can, more easily, take advantage of operating leverage with lower-margin companies.  Mining companies come to mind.  If you think the price of gold is headed to $2500, should probably take a company like BRD over AUY.  It's obviously much riskier, but the potential for higher returns is there...

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#7) On September 17, 2012 at 2:51 PM, Melaschasm (55.04) wrote:

Often within an industry you will find high volume low margin companies, and lower volume, higher margin companies.  Either one can be a great or terrible investment choice.

A company with high and growing margins, and a moat that indicates the ability to continue to increase profits can be great.  However, some of the most profitable investments are in companies which have found a way to profitably operate with lower margins than the existing businesses, such as early investors of Walmart and Amazon.

While high margins are not sustainable forever, think RIM's Blackberries, they can be a great investment while they can maintain higher than normal margins.  One of the challenges for stock pickers is to identify which companies can sustain or grow their margins, and which are going to face a margin squeeze.

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#8) On September 20, 2012 at 4:47 PM, JaysRage (89.62) wrote:

First movers have many advantages, one of which is brand, that allow them to have higher margins that competitors.   You are correct, though.  

As mentioned in a similar thread, all margins are not created equal.   Is your margin exposed to external things such as the prices of raw materials, or is it relatively fixed, due to low overhead costs.    It totally depends.    

I don't care how my company gets its profit....low margin.....high margin.....etc....as long as the business plan is good and profits are sustainable and growable at a desired rate in my investing horizon.   It's also good to have quality leaders that can adjust their plans to take advantage of changing environments.   

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