Masters Series: This Anomaly Has Led to Some of the Biggest Gains of My Career
Editor's note: Yesterday, we showed you one of the five important financial clues to look for when finding "slam dunk" investments.
These are the kinds of investments that can make you a fortune with little risk... the kinds of stocks you can pass on to your children or grandchildren.
In today's edition of our weekend Masters Series – previously published in the September 27, 2013 issue of our free e-letter DailyWealth – expert business analyst Dan Ferris discusses another clue he has used to find some of the highest-returning investments of his career...
This Anomaly Has Led to Some of the Biggest Gains of My Career
By Dan Ferris, editor, Extreme Value
Basic economics teaches us this shouldn't happen...
But when it does, it's an important "clue" that a business has a unique advantage. And I've used this clue to find some of the highest-returning investments of my career.
Let me explain...
A company's "profit margin" is simply the amount of profit expressed as a percentage of sales.
For example, if you sell $100 worth of widgets, and your profit is $10 after paying all expenses and taxes, you have a 10% net profit margin.
When I'm looking for a great investment, I look for companies whose profit margins are very, very consistent over a period of several years in a row.
The reason I look for a consistent profit margin is because it's economically unusual. It's an anomaly.
The laws of economics tell us that profit margins shrink over time. For example, suppose a new business is very successful and it's earning a large 20% net profit margin.
That big profit will attract entrepreneurs into the same business. How will those newcomers compete? Easy. They'll accept a lower profit margin for the exact same business... 18%, for instance, instead of 20%.
Over time, this sort of competition can squeeze the profit margins for an entire industry down to almost nothing.
So when you see a business that maintains a fairly consistent profit margin over a long period of time, you should look into the business and see what it's doing to create so much value, so consistently, for its customers.
For example, in Extreme Value, we made 71% in just six months on IMS Health, a medical-information company which had a consistent profit margin when we found it.
And we logged a 201% gain on Alexander & Baldwin, a real estate development company – which also had a consistent profit margin.
The consistency of the profit margin is more important than the size of it.
Take Costco, for instance.
The big warehouse retail store earns a consistent gross profit of around 12% and a consistent net profit of around 1%. Those are razor-thin profit margins, but they're very consistent, every year, year after year, like clockwork.
That's just one clue that tells you Costco is a really wonderful business.
Wal-Mart is like that, too. It has a 25% gross profit margin and a 3% net profit margin every year, year after year.
A consistent profit margin tells you a business is doing something that its customers value year after year.
In the case of Wal-Mart and Costco, for instance, both excel at reducing the cost of essential everyday goods.
If possible, I look for a profit margin that's not only consistent – but thick, as well. That usually means the business is selling a high-value product that costs little to make.
A great example is Microsoft. Its software costs little to make. All you really need is a computer programmer and a computer.
Most of Microsoft's customers are businesses, and many of the people in those businesses can't do their jobs without Microsoft software.
That's why Microsoft consistently has net profit margins in excess of 20%... and why it's one of the best businesses on the planet.
There's one thing you should watch out for... Profits and profit margins tend to fall during recessions. But don't let that scare you away from great businesses.
The fact is, investing in great businesses during recessions can be hugely rewarding.
For example, in Extreme Value, we logged a 104% gain on Portfolio Recovery Associates, and we're up 129% on Automatic Data Processing – both of which we discovered in October 2008, at the height of the credit crisis.
That's why one Extreme Value reader recently told me he no longer has any fear of ups and downs in the market.
So to sum up:
| • | Look for a consistent profit margin. |
| • | Basic economics says that profit margins shrink over time. So a consistent profit margin means the business creates plenty of value for its customers year after year, which is what will drive up the value of your shares. |
| • | Profit margins can fall during a recession – but will always recover for great businesses. |
Good investing,
Dan Ferris
Editor's note: Dan has used his five financial clues – among many other strategies – to help build one of the most impressive track records in the industry. He delves deeper into all five clues in a brand-new tutorial. See exactly how these clues will help you make better choices in the stock market... and dramatically increase your investing results. Listen to Dan's full tutorial – and gain access to his impressive portfolio – here.