Is the Company Having Increasing Margins or Eroding Margins?
There is nothing technical about this filter that I use. In fact, it’s really more common sense. Of course if you wish to, you can look at various margin charts for the past 10 years for a company. So basically, as investors, we are concern about long term profitability and sustainability of the companies that we choose to invest. If the company has eroding margins, then these are companies or even industries that we want to avoid. Because the logic is simple, companies with eroding margins will struggle to increase their earnings per share. Companies that struggle with consistent growing earnings per share will have trouble with increase their stock prices over time. Simple, right?
So what I do to filter out more companies here is by looking at the industry in general. For example, I will not consider investing in the airline industry because the margins are eroding rapidly over the years. How do I do that? Really easy and simple the way I look at it. I look at their selling price. Ask yourself… is the price of plane tickets increasing or decreasing as compared to 10 years ago. Well it’s much cheaper to fly to London these days as compared to 10 years ago… that’s for sure.
If the selling price is getting cheaper, it can only mean margins are also shrinking. Simple, right? It just means that more and more airline companies are struggling. Take a look at those companies and you will see that they don’t have good earnings track record. In fact, there have been so many big airline companies that have gone bust in the last 20 years. The ones that come to mind are Malaysian Airlines, Japan Airlines, United Airlines, and Delta Airlines – just to name a few. To sum it up, Airlines industry is just a toxic industry that you should avoid as an investor.
Let me give another example. How about the computer hardware industry? Computer hardware like desktop computers, notebooks, servers and tablets. Is this a good industry to be in as an investor? Same thing applies… is the price of a desktop computer cheaper now as compared to 10 years ago? Well, the answer is an obvious YES. It’s much cheaper today to get a desktop computer, a notebook, or even a server now as compared to 10 years ago. Take a look at computer companies like Dell. 20 years ago it was the darling of Wall Street. Today, it’s not even listed on Nasdaq anymore because it’s struggling. It’s earning per share is erratic and declining. HP is trying to get out of the hardware business. IBM has sold off their mobile computing division to Lenovo a few years ago. Packard Bell closed down 20 years ago. A list of examples can be provided for failed or struggling computer hardware companies. If you see companies in the industry are struggling, you know that the industry is toxic or maybe even dying. The smart move is to avoid them entirely. There is no way you can get any good value buy from these companies.
And that’s how I look at the margin test or margin filter. It has kept me out of toxic industries entirely. And if you apply this simple method, you will find it extremely easy to avoid all these investing traps.
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