As profit growth slows, a sign the economy is reaching the later stages of its cycle, the key to finding stocks that will outperform the broader market is to look for companies with stable and high gross profit margins. That’s the advice of a recent report from Goldman Sachs, in which a basket of 33 Russell 1000 stocks were presented as having five-year average gross margins of at least 35%, including Ralph Lauren Corp. (RL), Zoetis Inc. (ZTS), Cooper Companies Inc. (COO), Qiagen NV (QGEN), McCormick & Co. Inc. (MKC) and Sirius XM Holdings Inc. (SIRI). “The market generally rewards companies with high margins when the outlook for corporate profitability weakens,” the bank’s analysts noted. This is the first of two stories that Investopedia will devote to this topic.
|Stock||Total Return YTD||5-Year Average Gross Margin|
|McCormick & Co.||16.8%||41%|
The Broad View
Goldman’s analysts expect net profit margins across the economy to fall in coming quarters as the boost from lower corporate tax rates begins to fade and input costs continue to rise. Those rising costs come in the form of higher commodity prices, higher interest rates, and accelerating wage growth. Trade tensions in the form of tariffs or disruptions to global supply chains represent another potential source of pressure on firms’ profit margins. (To read more, see 7 Stocks That Are Speeding Past the Market.)
In such an economic environment, investors should look for companies with high and stable gross margins. “A group of stocks with high and stable gross margins has outperformed stocks with low and variable gross margins by 14 pp YTD (+5% vs. -9%),” wrote the analysts. They expect the outperformance of that trade to continue even in spite of the diminishing tailwind effects from tax reform.
A Closer Look
McCormick & Co., a food industry company that specializes in the manufacture, marketing, and distribution of spices, seasoning mixes, condiments and other flavorful food products, saw most of its gains this year in the month of June. The large boost came at the end of the month after the company’s fiscal second quarter report indicated strong sales and profitability gains even while packaged-food rivals struggle. The company saw its sales rise by 16% and net profits increase by 23%. That net profits are rising faster than sales means that the declining net profit margins forecasted by Goldman Sachs have yet to hit McCormick. (To read more, see: 4 Food Stocks to Outperform Amid Trade Uncertainty.)
Zoetis, which makes animal-health medicines and vaccines for livestock and pets, has made solid gains not just this year but has been handily outpacing the market in the last five years as well. One of the reasons for that past and likely future outperformance is that the animal health care industry as a whole is less competitive than that of human health. That means better profit margins, less investor risk, and faster growth, which is more than 5% compared to 3% to 3.5% in human health, according to Bloomberg.
The second story on this topic will appear in Investopedia on Thursday, July 12.