High Margins and Stock Picking

I am of the opinion that a stock with high margins does not make it more valuable then a company with lower margins. Lets assume that company A has margins of 20 percent and company B margins of 10 percent. If both companies double there sales, company A and company B both have identical growth in profit. Margins play a vital role in making an investment decision, but for other reasons then a company simply having high margins.

The best scenario when dealing with margins is that a company is growing there margins. However, it is important to distinguish whether the margin increase is more of a cyclical or fundamental nature. If the growth in margins is coming cyclically, then it is more of a temporary increase because of the business cycle. The optimal choice for margin growth is that it is of a fundamental nature. This is when the higher margins come about from some sort of operational improvement in the business. The reason why the fundamental margin growth makes for a better investment because the increase in margins has more of a sustainability and did not just come from the whim of the business cycle.

I have to stress that if you are dealing with a company that has consistently had high margins, you should look at the company skeptically. Because you could see a reverse in margin growth and of the fundamental nature. One of the first things you learn in Economics 101 is that companies with high margins will not keep them for long because it invites other companies to compete and mimic the product/service. The only way a high margin business is sustainable is if the company has a gigantic moat to protect against competition. Coca Cola for example has such a strong brand name that it would be very difficult for a start up to compete and chip away at margins. However, Abercrombie and Fitch has a much better chance of seeing margin deterioration in the future.