Streetwise for Friday, November 30, 2018

The good news is that the 12-month trailing net profit margin, (the percentage of sales that make it all the way to the bottom line), for the S&P 500 index reached 10.1 percent as of the third quarter, according to Bloomberg data. 

That was a milestone. It was the first time the S&P 500’s profit margin reached double digits and was the product of a multidecade climb.

Consider that the S&P 500 entered the 1990s with a profit margin half of what it is now. The gain has defied the doubters and worrywarts, all of whom have warned about an upcoming weakness in profits.

The current expectation by many on the Street is that net profit margins will continue to move upward next year and beyond, to nearly 12 percent in 2020, based on the latest numbers.

Before you break out the bubbly, there is a point or two to also consider. The strong job market is pushing up wage costs. Tariffs are increasing raw material costs and higher interest rates will lift borrowing costs. All of which will weigh heavily on net profit margins.

The problem is the S&P 500 index itself. The index is weighted by market capitalization (stock price multiplied by shares outstanding), and technology companies tend towards high margins. So, the run-up in the last few years of the big technology companies has made them a greater percentage of the index. Therefore, the increase in the market’s net profit margin may be more mix than muscle.

Apple, Alphabet and Facebook have been responsible for half of the margin expansion in the S&P 500 index since 2009. Alphabet’s roughly 30 percent profit margin raised the S&P 500’s overall profit margin 6 percent during that period even though Alphabet’s own profit margin fell slightly in the same period.

Remove the information technology sector, and the S&P 500’s net profit margins are still up, but at 9 rather than 10 percent. With technology sector profit margins up 22 percent, profit vulnerability is possible. If the recent woes among technology companies widen, the pillar that’s been holding up the bull market may become a bit wobbly.

Meanwhile, with the technology sector a bit out of favor you could possibly reap substantial future returns through careful selection. Companies like Microsoft, Apple and Intel go in and out of favor on a regular basis, thereby creating an excellent opportunity to buy when others are selling.

Keep in mind that at any given moment in time, certain industry groups will be looked upon by Wall Street with kindness, while others are not so fortunate. However, if the stock market is anything, it is fickle.

Stocks that are discarded today could well be the glamour stocks of tomorrow. This particularly significant in December as many investors and portfolio managers engage in tax-loss selling.

Look carefully at the stocks in out-of-favor industries not just technology. Analyze carefully the earnings of those companies that interest you, being particularly cognizant of future potential.

Quality stocks can be kept down because they are unfortunate enough to be part of a lagging industry group. The wheat is trampled along with the chaff. Your job is to scrutinize those out of favor industry groups to find that diamond in the rough.

To do this, you will need to employ one or more highly disciplined selection criteria. While there are countless ways to accomplish this, one of my favorites is to only consider those companies that have continually raised their dividends for ten or more years.

At the same time, dividends should represent no more than 35 to 40 percent of earnings. This allows a company to compound the remaining dollars for continued organic growth and/or acquisitions.

Look for companies whose long-term debt is less than 30 percent of their total capitalization. You might also want to have a price/earnings ratio, or P/E, that is in the lower half of a company’s ten-year range.

Intrinsic value calculations are a mandatory. Start with a model such as free cash flow to the firm. You can find an adaptation at ValuePro.net.

Finally, keep the turnover of stocks in your portfolio to less than 10 percent.

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddInternational.com.