Do operating margins matter to SuperStock performance?

When I wrote about Three small cap SuperStocks worthy of further research last year, a subscriber, sevenccc, responded by saying:

…there is one big but for all 3 from my perspective. Low Operating Margins. Does this not concern you? To me this largely invalidates the Quality scores, which are all 80+. Is that unfair?

This thoughtful comment has stayed with me. Are low operating margins a sign of a poor business to be ignored, or is that already in the price and then some? The good news is I’ve now been able to test this empirically.

Operating Margin

Before I go into the details, here is a reminder of what the operating margin is:

Operating Margin = Operating Profit / Revenue = (Revenue – Operating Costs) / Revenue

The operating profit excludes taxes and interest payments and allows investors to compare businesses regardless of how they are financed or conduct their tax affairs. A business with a low operating margin has a minimal difference between the revenue it generates and the costs of those sales. A low-margin business works very hard to eke out a small profit. It is likely to operate in highly competitive industries. Typical low-margin businesses include distributors, such as NWF (LON:NWF) , or contractors, such as Balfour Beatty (LON:BBY) . It is often said that contracting businesses are always one onerous contract away from insolvency. While this may be an exaggeration, the low operating margins mean that any slip-up can have a big impact on the profitability of such companies.

The operating margin figure can be found on the StockReport here:

And graphically, like this:

In this example, which is from the StockReport from NWF (LON:NWF) , the operating margin is never above 2%, reflecting their fuel and feed distribution operations.

On the surface, it makes sense to avoid these types of businesses. However, investing is one of the fields that confounds conventional thinking. The reason for this is that every investment opportunity doesn’t just consist of what an investor buys into but also what they pay for it. This is at the heart of the Value Investing anomaly – where cheaply-rated stocks have outperformed highly-rated ones over the long term. Everyone wants to own well-managed companies with great products in exciting, growing industries, and no one wants to own poorly managed companies with poor products in declining industries. However, because of this, the great companies tend to be bid up until they are overvalued, and the bad companies sold off until they are undervalued. Investors who can stomach it are better off being contrarian and buying into the bad companies, on average.

The Data

So, what about operating margins? The data heads at Stockopedia provided me with the list of SuperStocks at the end of March for each year of the last decade, together with their operating margins at the time, and their subsequent one-year returns. I then sorted the stocks into quartiles based on their operating margins, from highest to lowest. After a bit of data cleaning, I ended up with about 40 stocks in each bucket and compared the average returns for each group. Here are the results:

These results may surprise some investors. Rather than being the laggard, the lowest operating margin stocks ended up with the highest average return, and the highest operating margin stocks were the ones to avoid. It is worth noting that this was a period of weak performance for the FTSE All Share, which only generated around 5% compound annual price return over the same period, so all of these figures represent outperformance.

One challenge can be that these sorts of analyses can be prone to being impacted by one or two good years, so it is worth considering the full performance over time:

I don’t have data for portfolio performances in the intervening time, so calculating Sharpe ratios or similar is impossible. Instead, these results are for holding the quartile of SuperStocks based on their operating margin for one year and rebalancing into the same quartile next year. Importantly, these ignore costs and are not indicative of the net returns an investor would have generated.

Looking at the performance over time, I see that the underperformance of the highest operating margin quartile is almost entirely post-COVID. This means I would need longer-term data to conclude that high-operating-margin SuperStocks will always underperform. However, it is clear that investors should not ignore a SuperStock simply because it has low operating margins.

Gross Margin

Many investors, including myself, like to use gross margin as an indicator of business quality. Here is how that is calculated:

Gross Margin = Gross Profit / Revenue = (Revenue – Cost of Goods Sold) / Revenue

The rationale is that companies with a high gross margin sell a product for much more than it costs to make. If they can maintain this gross margin over time, they will likely have a competitive advantage that others find hard to replicate. Take Bioventix (LON:BVXP) , for example, with a gross margin of over 90%. Their knowledge and patent protection mean they can sell their monoclonal antibodies for far more than it costs to manufacture them. One complication is that companies can vary in how they allocate some costs, and some companies may not report gross profit at all, thinking this reveals too much to customers or competitors. The principle is sound, though – companies with consistently high gross margins will likely possess a moat.

The gross margin isn’t immediately visible on the StockReport but can easily be calculated from the income statement data:

So, if operating margins don’t allow investors to narrow down the field of SuperStocks into the best companies to invest in, perhaps gross margins will do the trick.

The Data

Thankfully, the database team also gave me the gross margin data. Following the same analytical methodology of sorting in quartiles, but this time based on gross margin, I get the following results:

With gross margin, the lowest quartile was not the best performer, but the highest was still the worst.

Again, the path of outperformance is variable, but the difference in performance is significant. By consistently favouring low-margin businesses, investors would have around 40% higher returns for the decade. Again, this excludes costs and follows a specific rebalancing methodology, but there is no evidence that SuperStock investors should favour high gross margin stocks.

One possibility is that the very high-margin stocks are not trading companies, such as funds or REITs, and these are confusing the calculation. However, the distribution of gross margin between the quartiles looks as one would expect:

Other factors are likely at play here, such as investors’ preference for high-gross-margin stocks bidding these up to higher valuations. Given the whole picture, investors may actually want to avoid the highest-margin SuperStocks:

Of course, this result may not hold for non-SuperStocks, where paying greater attention to margins may be useful. However, focusing on cheap, high-quality stocks with good momentum and ignoring the margins is a much easier way to outperform the market. The Stockopedia QVM framework helps investors to do exactly that.