Fisher: When Excess “Fat” Is Perfect For Your Wallet


The bottom line is often all dissected by Western experts. What profit did a business report? Did it live up to expectations on Wall Street, Hong Kong and the Lujiazui Towers? Are its profits going to skyrocket or sag next year? What about overall corporate profits? Nice questions! But being stuck in this investor myopia lacks a better guarantee of future strength: gross operating margins. The fact that they are ignored gives them power, especially in late stage bull markets like now. Here’s why this form of “fat” gives you an advantage over others – and how to deploy them now.

Yes, net earnings per share are certainly important – stocks are stakes in the future earnings of companies, after all. But past profits lack predictive power. Why? The accounting gadget allows management to tweak the short term results. I’m not talking about a Luckin Coffee-type chicane. Companies legally decide when to readjust depreciation, write downs, buy back shares or upgrade facilities. Legal expenses or other one-time expenses can weigh on a quarter’s net income, but never happen again. All of this skews the reported bottom line, obscuring what matters most: the strength of a company’s core business and its capacity for long-term growth.

Also important: the huge attention that bottom lines receive means stocks pre-assess new forecasts or new results almost instantly. Just consider the vast coverage of income that the “season” receives in China. It’s the same in New York, London, Abu Dhabi – almost everywhere. By the time the press releases are released, the markets will have largely anticipated the results. The stock may briefly zigzag as reality and expectations align. But it happens too quickly for almost anyone to take action – normally with little lasting effect.

What to do when ubiquitous, pre-priced data leaves you with no investment advantage? Look beyond the data to analyze the data enthusiasts themselves. Seek out what their mathematical myopia causes them to miss – or reject. Today, most analysts and experts see metrics like gross profit margins as relics of a pre-digital age, when frantic traders barked orders in bustling, paper-cluttered trading rooms and that computers had less power than today’s smartwatches.

Data-driven managers say gross operating margins are too rudimentary to compete with their complex algorithms. Ironically, when I started 50 years ago, gross margins were used because they are so simple! No need for supercomputers. Just subtract the cost of goods sold from sales – easy to find even then. Divide the result by the sales. Ended! Now, with so many experts dismissing them, gross margins aren’t just easy to calculate – they have real power.

Several factors make this bull market seem later, despite its technical youth. One is the IPO frenzy that I detailed in July. Another: Globally, the value stocks that normally lead to the onset of bull markets weren’t. Yes, large Chinese growth companies traded in Hong Kong have plunged this summer, but it was a regional factor linked to exaggerated regulatory fears. Overall growth is well above value in China and globally since the global bear market ended last year. That won’t change, even if the surges from the delta and mu Covid variants eventually go away. Why? In large part because of the tight global credit conditions that I have already discussed here. The slowdown in credit growth in China since last October parallels this global trend, as your economy and others revert to pre-Covid standards – heavily favoring large growth stocks.

Gross operating margins are essential for finding high quality growth potential. They offer a clear vision of a company’s ability to self-finance its future expansion. Higher gross margins allow greater growth inducing spending on marketing, sales and R&D expansion. And more and cheaper funding for capital spending, mergers and acquisitions, or anything else that drives future expansion.

Higher gross margins also provide a slowing buffer, allowing businesses to profit even when costs rise or demand falls, crushing lower margin competitors. Investors in the final stages of a bull market look for such stocks. Consider: As bull markets age, those who have invested throughout the recovery develop an acrophobia, worrying about a coming bear market can erase their gains. Meanwhile, newly bullish buyers, previously too fearful to buy, want growth with some stability. Higher gross margins offer both groups relative comfort. Low margin companies, usually of value, are punished during downturns when profits evaporate. They fare better in the early rallies of sustained relief from bull markets.

Right now, Chinese stocks – including A shares and those that trade overseas – have average gross margins of 25%, just a little behind the global 30%. For fat margin fuel, you want companies with gross margins close to 50% or more. Where to find them? Start with the technology, usually a high margin fireplace. But make sure you choose the right technology. Consider: More than half of the market capitalization of China’s tech sector comes from low-margin hardware companies. The margins of software companies are much higher at 57%, but they represent only a tiny part of the Chinese market. Therefore, look at the interactive media and service industry, which I highlighted in June. Technically part of the communications services industry, it includes many large internet companies that behave like tech stocks. Its gross margins? 46%. Options abound – the industry accounts for 15% of China’s market capitalization. Most of these stocks are traded in Hong Kong and are available through Stock Connect.

The healthcare industry also provides high margin rocket fuel. Chinese biotech companies’ gross margins are incredibly high, averaging 79%. Shares of life science tools and services are also impressing at 48%, while pharmaceutical companies are plump at 46%.

What about value sectors? Western pundits keep claiming they should skyrocket from Chicago to Changchun. What do their margins look like? Skinny! Chinese utilities and industrial sectors barely exceed 20%. Energy companies average 12% and materials only 18%. This is no small feat for Chinese value companies – these numbers parallel global averages. Business models for value stocks just don’t generate big margins. They rely on banks for credit to finance their expansion, which makes them extremely sensitive to trends in economic growth.

As for high value-added financials, their economic models make gross margins unnecessary. Banks borrow at short-term rates to finance long-term loans. The spread between the two determines net interest margins – the crucial measure of banks. China’s 10-year government bond yield dwarfs the low long rates in most countries, but your short rates are higher as well. With three-month government yields at 1.8%, net interest margins are expected to be low, which will limit the rise of financial firms. But also, you have to consider what the government is focusing on from an economic point of view. He appears to be keen on slowing credit growth to contain inflationary pressures while re-focusing on economic reforms, including allowing more defaults. This policy stance is good for the long term, but it means that banks may have a hard time increasing their profits anytime soon. It suggests better opportunities beyond banks: namely, growth stocks.

While most investors focus on the details and complexity, make no mistake about it: there is magic in the underhand simplicity of gross operating margins. Use high margin stocks to build your portfolio.

Ken Fisher is the Founder and Executive Chairman of Fisher Investments.

The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.

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