Every investor yearns for high net margins and so high net margin companies are always considered as sound investments. However, screening for investments based only on net margins can leave out some well-run companies with low net margins. This is because low net margins do not necessarily mean that the company isn't giving a good return to its investors. So one should always consider how much profit the company is generating on its shareholders' equity (ROE).
Given this, we decided to apply a few filters to identify the companies with low-profit margins but high ROEs:
- Market cap above Rs 500 crore
- Five-year average net margins less than 5 per cent
- ROE greater than 15 per cent in each of the last five years
Our findings show that some companies give above-average returns to their shareholders despite having low net margins. There can be several reasons behind it such as:
- The capital turnover (sales per unit of capital employed) of these companies could be high. It signifies that these companies are able to achieve high revenues as compared to their shareholders' equity.
- These companies may deliberately decide to keep their margins low as part of their customer retention strategy. If they are doing this without hurting their ROE, it depicts the strength of their business model and management.
- It may also be a strategy to keep competition at bay. Companies with low margins can have a commanding share of the market and are able to deliberately keep their margins low in the industry. It helps dissuade new entrants into the industry. Such sectors may also require high investments and funds at reasonable rates, which may not be available to new entrants.
- Another possible reason can be running an efficient set of business operations, with these companies deciding to pass on the efficiency gains (such as lower cost) to their customers. Philip Fisher has captured this with an interesting comparison, "High-profit margins may be compared to an open jar of honey by the prospering company. The honey will inevitably attract a swarm of hungry insects bent on devouring it. The other way for the honey-jar company to keep the insects out is to operate so much more efficiently than others that there is no incentive for present or potential competition to take action that will upset the existing situation."
Return on equity; however, can be misleading at times. ROE may be propped up by using higher levels of debt in the capital structure. Higher debt puts the company's solvency at risk. Hence, we have decided to place such companies on the watch-out list in the following table.
As can be seen in the table, our selection is based on the companies with low margins but with high ROEs. Along with low debt levels some companies have arrived at an optimal capital structure while maintaining a high ROE. All in all, net margins need to be considered in association with ROE, debt levels and the rate of earnings growth. Ignoring companies just because of low net margins may result in investors missing out on a few great opportunities.
Disclosure: The intent of the article is not to recommend any specific stocks. If you wish to invest in any of the above-mentioned securities, please do thorough research.
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