Sep 23, 2021 03:51 PM

Fisher: When Excess ‘Fat’ Is Great for Your Portfolio

Photo: VCG
Photo: VCG

Net earnings are often all Western pundits dissect. How much profit did a firm report? Did it meet expectations in Wall Street, Hong Kong and Lujiazui’s towers? Will its earnings soar or sag next year? And overall corporate earnings? Fine questions! But being stuck in this investor myopia misses a better gauge of future strength: gross operating profit margins. That they aren’t considered gives them power, particularly in later-stage bull markets — like now. Here is why this form of “fat” offers you an edge over others — and how to deploy them now.

Yes, net earnings-per-share certainly matter — stocks are ownership stakes in firms’ future profits, after all. But past profits lack predictive power. Why? Accounting gimmickry lets managements twist short-term results. I don’t mean Luckin Coffee-type chicanery. Firms perfectly legally decide when to readjust depreciation, take write-downs, repurchase shares or upgrade facilities. Legal or other one-off expenses can whack net income one quarter, yet never recur. All this distorts reported net earnings, obscuring what matters most: a firm’s core business strength and long-term growth capability. 

As important: The huge attention net earnings receive means stocks pre-price new forecasts or results near-instantaneously. Just consider the vast coverage earnings “season” receives in China. It is the same in New York, London, Abu Dhabi — almost everywhere. When the actual news releases come, markets will have largely anticipated the results. The stock may zig or zag briefly as reality and expectations line up. But that happens too fast for almost anyone to act — normally with little lasting effect. 

What to do when ubiquitous, pre-priced data leaves you no investing edge? Look past the data to analyze the data devotees themselves. Seek what their mathematical myopia makes them miss — or dismiss. Today, most analysts and pundits see metrics like gross profit margins as relics of some pre-digital era, when frenetic traders barked orders across bustling, paper-littered exchange floors and computers had less power than today’s smartwatches.

Data-driven managers claim gross operating margins are too rudimentary to compete with their complex algorithms. Ironically, when I started 50 years ago gross margins were used because they are so simple! No need for supercomputers. Just subtract the cost of goods sold from sales — easy to find even then. Divide the result by sales. Done! Now, with so many pundits dismissing them, gross margins aren’t just easy to calculate — they have real power.

Several factors make this bull market look later stage, despite its technical youth. One is the IPO frenzy I detailed in July. Another: Globally, the value stocks that normally lead early in bull markets haven’t. Yes, big Hong Kong-traded Chinese growth firms plunged this summer, but that was a regional factor tied to overwrought regulatory fears. Overall growth is well ahead of value in China and globally since last year’s global bear market ended. That won’t change, even as delta and mu Covid variant surges eventually subside. Why? Largely because of the tight global credit conditions I’ve previously discussed here. China’s slowdown in credit growth since last October parallels that global trend, as your economy and others return to pre-Covid norms — heavily favoring big growth stocks.

Gross operating profit margins are key to finding high-quality growth potential. They offer a clear view of a firm’s ability to self-finance future expansion. Fatter gross margins enable more growth inducing marketing, sales and R&D expansion expenses. And more and cheaper financing of capital expenditures, M&A or anything else driving future expansion.

Fatter gross margins also provide a downturn buffer, letting firms profit even as costs rise or demand drops, trashing thinner-margin competitors. Late-stage bull market investors crave such stocks. Consider: As bull markets age, those invested throughout the upturn develop acrophobia, fretting an upcoming bear market may erase their gains. Meanwhile, newly optimistic buyers, previously too fearful to buy, want growth with some stability. Fatter gross margins offer both groups relative comfort. Thin-margin, typically value, firms get punished during downturns when profits evaporate. They fare best in early bull markets’ buoyant relief rallies.

Presently, Chinese stocks — including A-shares and those trading offshore — average gross margins of 25%, just a bit behind the world’s 30%. For fat-margin fuel, you want firms with gross margins near 50% or higher. Where to find them? Start with tech, typically a high-margin hotbed. But be sure to key on the right tech. Consider: More than half of China’s tech sector market capitalization comes from slim-margin hardware firms. Software firms’ margins are much juicer at 57%, but they comprise only a tiny sliver of China’s market. Hence, look to the interactive media and services industry, which I highlighted in June. Technically part of the communication services sector, it includes many big internet firms that behave like tech stocks. Its gross margins? 46%. Options abound — the industry makes up 15% of Chinese market cap. Most of these stocks trade in Hong Kong and are available through Stock Connect.

The health Care sector also provides high-margin rocket fuel. Chinese biotechnology firms’ gross margins are fantastically fat, averaging 79%. Life sciences tools and services stocks also impress at 48%, while pharmaceuticals companies are plump, at 46%.

What about value sectors? Western pundits keep claiming they are set to soar from Chicago to Changchun. How do their margins look? Gaunt! China’s utilities and industrials sectors both barely top 20%. Energy firms average 12% and materials just 18%. This is no slight on Chinese value firms — those figures parallel global averages. Value stocks’ business models simply don’t generate fat margins. They rely on banks for credit to finance expansion, making them extremely sensitive to economic growth trends.

As for value-heavy financials, their business models render gross margins useless. Banks borrow at short-term rates to finance long-term lending. The gap between the two determines net interest margins — banks’ crucial metric. China’s 2.9% 10-year government bond yield dwarfs most countries’ puny long rates — but your short rates are higher, too. With three month government yields at 1.8%, net interest margins should be weak — limiting financial firms’ upside. But also, you have to consider what the government is focusing on from an economic perspective. It seems to want slower credit growth to rein in inflation pressures while returning to focus on economic reforms, including allowing more defaults on credit. That policy direction is good longer term, but it means banks could struggle to boost profits any time soon. It suggests better opportunities beyond banks: namely, growth stocks.

While most investors focus on minutiae and complexity, don’t be fooled: There is magic in gross operating profit margins’ sneaky simplicity. Use fat-margin stocks to beef up your portfolio.

Ken Fisher is the founder and executive chairman of Fisher Investments.

The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.

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