High Profit Margin Companies – Though over the last five years the stocks of companies with high profit margins have underperformed the stocks of companies with low profit margins, the scenario is poised to change, believes Barclays analysts. Jonathan Glionna and team said in their “U.S. Equity Strategy” report that they don’t expect the U.S. to enter a recession in the near term.

High Profit Margin Companies – Could profit margins be predicting a recession?

Glionna and team point out that after touching an all-time high in 2014, profit margins for the S&P 500 have dropped by 60bp in the last 12 months to 8.5%. They note that since 1973, profit margins have declined on six occasions:

Decline in profit margins High Profit Margin Companies High Profit Margin Companies
High Profit Margin Companies

The Barclays analysts highlight that declines of this magnitude are rare when the economy is not entering or in a recession. They point out that in the last 40 years, it has only happened once in 1985. The following graph sets forth the link between profit margins and recessions for the last seven business cycles, dating back to 1973.

Decline in profit margin Vs recession High Profit Margin Companies High Profit Margin Companies
High Profit Margin Companies

Glionna and colleagues note that in every period except one, a 60bp decline in margins in 12 months coincided with a recession. However, in 1985, the economy didn’t enter a recession, and the S&P 500 staged a material rally. Drawing similarity between 1985 and 2015, the Barclays analysts highlight that 1985 resembles 2015 because the decline in profit margins is primarily the result of lower oil prices.

1985 Vs 2015 - drop in High Profit Margin Companies

Barclays suggests overweight on high profit margin companies

Delving deep into the relationship between profit margins and future returns for the S&P 500, the Barclays analysts point out that high profit margins usually lead to low returns for the S&P 500, although the relationship is not consistent:

High Profit Margin Companies Vs S&P 500 returns

Analyzing the relationship between profit margins and forward returns at the sector level, Glionna and colleagues point out that for cyclical sectors such as energy, materials, and industrials, high profit margins generally lead to low returns. However, the defensive healthcare sector exhibits a positive link between profit margins and forward returns:

High Profit Margin Companies in cyclical and health sector

Glionna and team also point out that the market hasn’t rewarded high profit margins, though they anticipate that this will change. The following chart depicts the returns of a strategy that went long the 100 companies in the S&P 500 with the highest profit margins and short the 100 companies in the S&P 500 with the lowest profit margins:

High Profit Margin Companies underperform
High Profit Margin Companies

However, the Barclays analysts think the environment has changed. They point out that the stocks of companies with high profit margins do best, on a relative basis, when the cycle is ending. Considering the elevated uncertainty facing the global economy, the analysts expect the stocks of companies with high profit margins to outperform the stocks of companies with low profit margins:

Best to own High Profit Margin Companies

The Barclays analysts believe that in more uncertain times, the stocks of companies with high profit margins outperform the stocks of companies with low profit margins. The following table captures a list of 30 companies with high profit margins:

High Profit Margin Companies