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Why Companies With High Profit Margins Are Not Necessarily Good

When I first started investing, I would religiously follow a set of rules. For instance, the company had to be profitable, have a long track record, maintain a large customer pool, possess a competitive advantage and have high profit margins.

However, as I gained experience and developed a clearer understanding of the stock market and how companies grow, I realised that some of my rules may not necessarily always need to be met. Investing in stocks should be fluid, and investors need to adapt to get the best returns.

In this article, I want to highlight one common misconception that I used to make, and that is, neglecting shares that do not have high profit margins.

High profit margins are not necessarily good

The first thought in most investors’ minds when I mention that we should look beyond high margins is perhaps one of surprise. However, before you close this article and decide that I am a quack investor, I want to assure you that there is a very good and sensible reason for this.

Yes, high profit margins are good for companies. It means that they are cost-efficient and most of their revenues can filter down to the bottom line, which is ultimately what matters to investors and the company.

However, companies that are already cost efficient and have wide profit margins have less room to grow their bottom line. They may have sustainable profits and can survive economic downturns. But they are unlikely to grow at a faster pace than firms that still have lots of room for their profit margins to grow.

The (Amazon) Prime example

Perhaps the best example to illustrate this is Amazon (NASDAQ:AMZN). In the latest quarter, Amazon posted sales of US$51 billion, and operating income before tax of just US$1.9 billion. That translates to a narrow operating profit margin of 3.7%.

But that hasn’t stopped the stock from appreciating. Investors are flocking to get in on the bandwagon like never before, making Amazon one of the most valuable businesses in the world.

The key reason is not only the company can grow its sales substantially over the years, investors also believe that once the expansion phase is over, Amazon will also be able to improve their slim profit margin. Once this happens, Amazon’s profit will sky-rocket based on its colossal revenue base.

With an annualised US$200 billion in revenue, just a one percentage point increase in profit margin will add US$2 billion to its bottom line.

The Foolish takeaway

Wide profit margins used to be one of my main criteria for choosing a stock. Any company that did not fit this would be automatically filtered out. However, this made me miss out on multiple great opportunities in the market. Not to mention that I also missed out on the amazing returns from Amazon.

It is now clear to me that looking for companies that have the potential to increase their margins are more rewarding than finding those that are already at their most efficient.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Amazon. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned.