Do you want to know how to identify a great business? I’m talking about the type of business that you can simply buy at a fair price and sleep soundly in the knowledge that it will have a high degree of likelihood of outperforming the boarder market for years and years without you having to do a thing?
Well the laws of economics tell us that profit margins should shrink over a period of time because the higher the profit margins the more competition this industry or business should attract, as these thick margins prove enticing for new entrants into the field.
So in theory, if a business is able to maintain fairly consistent profit margins over a period of several years in a row, this is a clue that the business in question might have a unique competitive advantage.
A profit margin of a company is simply the amount of profit it makes when compared as a percentage of sales. For instance, if you sell $50 worth of pot plants, and your profit is $5 after paying all the taxation and expenses, you have a net profit margin of 10%. According to Dan Ferris, the editor of the Extreme Value newsletter from Stansberry Research, businesses whose profit margins are highly consistent over time should generally be considered high quality businesses. This is because a consistent profit margin is economically unusual. It tells you those businesses are doing something that their customers value year after year.
Suppose a new business is very successful and it is earning a huge 20% net profit margin. This large profit will attract entrepreneurs into this industry. In order to compete with the existing business, the newcomers will accept a lower profit margin for the exact same product or service; say 18%, instead of 20%. Over a long period of time, this kind of competition can squeeze the profit margins for entire industries down to almost nothing.
Therefore, when you observe a company that maintains a relatively consistent profit margin over time, you should look into the company and see what the business is doing to create so much value for its customers.
And according to Dan Ferris, it’s the consistency of the profit margin that is most important, not the size of it.
Take a look at those big warehouse retail stores, Costco and Wal-Mart in the US, or Woolworths or Coles here in Australia. According to Dan, “Costco earns around a 12% gross profit margin and a consistent net profit of 1% every year, where Wal-Mart has a 25% gross profit margin and 3% net profit margin. 1% and 3% profit margins are razor-thin profit margins, but their consistency imply that Costco and Wal-Mart both excel at reducing the cost of everyday essential goods and create plenty of value for their consumers.
Another great example is UGC favourite Microsoft (MSFT). The profit margin of Microsoft is not only consistent, but thick. A thick and consistent profit margin normally indicates that the company is selling a high-value product with low production costs. Microsoft’s software costs little to make. All you really need is a computer and a programmer, but Microsoft software is in high demand. Most of Microsoft’s customers can not complete their daily jobs without the basic office software that Microsoft provides such as Word, Excel, PowerPoint etc. This is why the net profit margins of Microsoft are consistently in excess of 20% and why it is considered one of the best businesses on the planet.
Dan also explains that you should be aware that, profits and profit margins are likely to decrease during recessions, but they will always recover for great businesses.
If you are considering how you can safely take the next steps to invest in great businesses and build a portfolio that will perform consistently and safely through the years and in all market conditions, contact United Global Capital today and speak with one of our financial strategists for a No Cost, No Obligation consultation on 03 8657 7640 or email [email protected] to learn how you can take advantage of the opportunities available to you.
The information contained in this report is General in nature and has been prepared without taking into account your objectives, financial situation and needs.