Morgan Stanley
  • Wealth Management
  • Oct 18, 2018

How You May Benefit When Profit Margins Dip

With costs rising, many companies are facing shrinking profit margins. Sometimes, that can create buying opportunities.

Rising tariffs, higher wages and increasing energy and metals prices are all reasons why many companies are experiencing lower profit margins this year. If trade tensions, interest rates, and inflation all continue to increase, profits at more companies will likely shrink.

For some firms, shrinking profit margins can signal the beginning of a secular decline. For others, however, margin contractions may be temporary, creating buying opportunities for investors.

The degree to which margins expanded or contracted had a big impact on stock performance for the year to date. My team analyzed the second-quarter earnings of S&P 500 companies, ranking them by the changes in their year-over-year profit margins. As expected, companies that reported falling profit margins lagged in stock-price performance behind those with stable and expanding margins. On average, the top quartile of companies with the strongest margin expansion gained 20%, while the bottom quartile only climbed 5%.

Looking for Quality

While many companies face headwinds at times, the ones that can overcome them usually have a competitive advantage that helps insulate their business during difficult times. For example, if they have pricing power, they can respond to adversity with price increases; economies of scale may allow them to revive margins with cost cuts and market-share gains.

Earlier this year, we used operating margins and return on capital to identify high-quality companies that might keep more of the tax cut rather than compete it away. Now we are using the same financial measures—operating margins and return on capital—to identify high-quality companies where margin compression may be temporary.

For example, geopolitical forces, such as tariffs, or cost pressures such as higher energy prices, may squeeze margins for a high-quality company, but as that company adjusts to new market conditions, perhaps by raising prices, its margins may rebound, potentially lifting its share price. For low-quality companies, on the other hand, management may not be able to implement price increases without suffering a decline in revenues. That’s just one way these same forces could lead to a more lasting reduction in profitability.

Five Industries in Focus

To identify high-quality industries, we first eliminated those with secular issues. For example, e-commerce is threatening multichannel retailers while price competition is taking a toll on diversified telecommunications services.

We then focused on the collection of industries for which margin compression is more likely to be temporary. These include:

-      Chemicals, which face headwinds from oil prices (many chemicals are directly produced from oil or use a lot of energy to manufacture).

     Food products, which may be impacted by tariffs (for example, the cost of packaging, such as aluminum cans for soda, could increase).

-      Commercial services and supplies, where higher freight rates are an issue (think of how that would increase costs for a company that manufactures and ships office furniture and supplies, for example).

     Air freight and logistics, which suffer from labor shortages (the unemployment rate in the U.S. is near a 50-year low of 3.7%).

-      Media, which is contending with rising content costs (online streaming services, cable and satellite television providers are competing for sports and entertainment programming, driving up prices).

Based on our research, we expect quality companies in these industries to either improve their margins or gain share in the next year and move from the low-return quartile to the high-return quartile.

This article was derived from the September issue of On the Markets. Reach out to your Financial Advisor (or find one using the link below) for a copy of the full report.

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