Invest in companies with high margins – Is it a myth?
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Today’s topic is unique and bizarre to a certain extent. It refers to an investment strategy that may be followed by some people while making their stock picks. We are talking about investing in companies that have a high margin. Does this strategy work? Is this strategy sustainable in the long run?
We will answer all these questions. Let us first understand what high margins for companies mean.
High margins generally refer to companies with a low cost of goods sold and a high selling price, which allows them to realise a higher amount of revenue. In simple words, the revenue-expense ratio for these companies is very low. They produce their products at a low cost and are selling them at high skyrocket prices.
Such companies are highly profitable and enjoy a competitive advantage in their industry. The competitive advantage may arise due to various reasons such as High Entry Barriers, High Research and Development, Patents and Trademarks, Long term involvement in the industry, and much more. These companies may even be the market leaders in their industry.
Now, let us move on to investing in such high-margin companies and whether they are sustainable.
Companies with a high margin will always face competition or interest from other players to have a piece of the profits. These types of industries would be attractive for any businessman. And thus, there are significantly fewer chances that they survive in the long term.
When small companies venture into a new industry and are highly profitable, they are either undercut in cost or acquired by the big company. For example, we can see that the biggest of tech acquisitions happening today, such as YouTube by Google and WhatsApp and Instagram by Facebook at massive amounts. Big players in the industry always want to survive and grow for the long term, and they do this by any means necessary.
Only some of the few big players can survive with a high-profit margin. We can take the example of Google, Facebook, or Apple here. Some industries may even enjoy a high profit margin due to the complexities involved or the type of specialized human resources required, such as Chemicals, Healthcare, or the Pharma Sector. However, companies may find it difficult to sustain such huge margins as competitors are always looking for innovation and investing in R&D to stay ahead.
One of the most important things which investors need to consider while investing in such companies is past history. Suppose the profits have been present for a long time, and the company has been able to fend off competition. In that case, there is a high probability that such companies will maintain these profits in the long term. However, one thing investors need to focus on is that companies that have been generating high profit margins for a long time will generally have a high overvalued share price and a high PE Ratio.
Investing in such companies for the long term may provide investors with huge returns on their investment. So, maybe you can invest in 4-7 such companies with high profit margins, and then the return of even 1 company may surpass the loss generated by other companies. Diversification is the key here as not all the companies you invest in may remain sustainable in the long run.
Value Investors such as Warren Buffett, Charlie Munger, Peter Lynch, and many others invest in such high margin companies enjoying a competitive advantage but only if the share price is undervalued. Peter Lynch even gave a term to this: “Tenbagger.” A tenbagger refers to an investment that has the potential to appreciate 10 times the initial investment made. These stocks generally have explosive growth prospects and a PE Ratio below industry.
Another strategy that some people follow while purchasing such stocks is “Coffee Can Investing.” It involves investing in companies that have performed well consistently and then forgetting about it for the next 10-20 years. The concept originated in the USA and is quite successful. It also allows investors to enjoy the power of compounding their wealth. The concept behind the Coffee Can portfolio originated from the American Old West, where people would protect their valuables by putting them in a coffee can.
Surviving in an industry with high profit margins is difficult, and only a few companies can achieve it. Before investing in such companies, ask yourself the question, “Do you have a high conviction that this company will grow and remain at the top for the next 15-25 years”? If the answer is yes, invest in the company. But remember, Diversification is the key to lower risk and have better chances of gain with such companies.
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