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A Dangerous Headwind Your Stock Investments Are FacingBy
Monday, April 11, 2011
One of the vulnerabilities in today's market is that profit margins are near peaks.
Investors tend to like companies with fat profit margins. But high profit margins are like honey pots that attract competitors. They are rarely sustainable for long.
What is more important for stock prices is not the profit margin itself, but the direction it moves. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome.
The problem today is that most of the big blue chips reported record profit margins, as Horizon Management pointed out in a recent research note.
Here is a list of the profit margins of the top 10 technology stocks of the Nasdaq 100 by market cap. They represent more than 40% of the Nasdaq 100.
"The average net profit margin is roughly 25%," Horizon observes, "which is without any historical precedent whatsoever."
This, then, is the Achilles' heel of the market, as far as the fundamentals go. Profit margins are extremely high and unlikely to stay there, which ought to lead to earnings disappointments down the road. It was no surprise Cisco Systems fell 16% in a day after the market fretted over weakening profit margins at the tech giant.
This phenomenon extends well beyond just the tech set. As Horizon points out, the same thing is in evidence in the S&P 500, which is a broad measure of the overall market. Let's look at the top 50 market caps in the index. This includes a mix of companies such as Chevron, GE, and DuPont.
What do we find?
Horizon notes, "There are quite a few companies with very high absolute profit margins. For example, Apple, Coca-Cola, Oracle, Schlumberger, McDonald's, Occidental Petroleum and Freeport-McMoRan Copper & Gold all have the common feature of after-tax net profit margins well in excess of 20%... In general, a 20% profit margin for any company is a historical rarity."
This is important because many investors seem to be banking on the idea that such companies will enjoy fat margins in perpetuity.
In some ways, the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going into a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.
Today, though, I doubt many of these firms have much more to cut. Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All these put enormous pressure on margins. We should expect to see them fall.
So perhaps the valuations of many of these stocks – often with price-to-earnings ratios between 12 and 16 – are more spot-on than they appear if you assume falling profit margins, falling returns on equity, and the like.
As an investor, I think it is better to focus less on what profit margins are today and more on where they will go in the future. It's like hockey great Wayne Gretzky's advice: "Go where the puck is going to be, not where it is."
In 2009 and 2010, almost every stock appreciated due to the rising tide of the overall market. Now that profit margins are likely headed south, it's important to be extremely picky on what you'll buy now... and at what price.
Regards,
Chris Mayer
Further Reading:
Last time Chris Mayer wrote to DailyWealth readers, he warned of an impending food crisis... and how it would affect your portfolio this year. It's good advice...
Brian Hunt has covered this idea frequently in his Market Notes column. One of our "farm income through the stock market" recommendations is up 80% in just nine months. And you'll find a clear picture of why the spike in food prices is causing a worldwide panic here: The Ag Complex has Exploded.
Market NotesNEW HIGHS OF NOTE LAST WEEK
Gold, silver, and crude oil
Hundreds of oil and gas-related stocks
Silver Standard (SSRI)... we told you!
BHP Billiton (BHP)... world's largest miner
Costco (COST)... wholesale goods
U.S. Ecology (ECOL)... environmental clean up
Westmoreland Coal (WLB)... coal
Yanzhou Coal (YZC)... Chinese coal giant
China Unicom (CHU)... Chinese telecom giant
Sohu (SOHU)... Chinese Internet giant
Calpine (CPN)... natural gas and geothermal power
Moody's (MCO)... credit ratings
Financial Engines (FNGN)... investment advice
Landstar System (LSTR)... trucking
JB Hunt Transport (JBHT)... trucking
Heartland Express (HTLD)... trucking
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