The financially sound companies whose attractively priced stocks make up the Barron’s 400 Index have larger sector profit margins than those in the Standard & Poor’s 500.
This is the second Diary entry on profit margins. The first (B400 Companies Have Larger Profit Margins Than Those in S&P 500) looked at the overall indexes and found that the Barron’s 400 companies’ margins were about 20% fatter than those in the S&P 500. Thus, it is no surprise that the same pattern prevails at the sector level. However, a closer look reveals some interesting nuances.
To recap, profit margins are measures of how well companies convert top-line revenue into bottom-line earnings. It’s calculated simply by dividing income by revenue. Financial analysts peruse two variations. The first uses net operating income, which is revenue minus all expenses except interest charges and income taxes. The second uses net income, which is operating income minus interest charges and income taxes.
Data from 11 years, 2006 through 2016, were calculated by dividing aggregate trailing 12-month income by aggregate trailing 12-month revenue of both indexes’ component stocks as of each year-end. That means some companies in both indexes were omitted from the calculations because their stocks didn’t happen to be components on Dec. 31. For the Barron’s 400, which is reconstituted semi-annually, that includes many companies added in March of each year but dropped six months later, in September. Other companies were omitted because their year-end data didn’t stretch back a full 12 months, usually because of acquisitions, mergers and spin-offs. Here are the results of these calculations:
|Median Profit Margins 2006-2016|
|Operating (%)||Net (%)|
|B400||S&P 500||B400||S&P 500|
Those are a lot of numbers to stare at. Here is a visual portrayal of operating margins:
And here are the net income margins:
The most interesting observation is that the S&P 500 bettered the Barron’s 400 in only one sector, consumer staples. It wasn’t by much, less that one percentage point for both operating and net margins. Still, it raises the question of why the financially sound consumer staples companies in the Barron’s 400 didn’t prevail. For one thing, competition in this sector is quite keen, so it may have been that some Barron’s 400 companies happened to be on the short end of those struggles during some parts of these 11 years. A year-by-year comparison shows that the two indexes traded the lead three times, but the Barron’s 400 sector suffered more in the recession and in 2012.
The S&P 500 was helped by consistently including far more consumer staples companies—31 to 36—than were in the Barron’s 400—eight to 31, with most years at around 20. The chart below shows the details. Those additional companies gave the S&P 500 more opportunities for larger margins, even if overall they weren’t among the strongest financially.
Another sector worth examining is energy. In this case the Barron’s 400 prevailed in all but one year during the entire period, as the following chart shows.
But what about that yawning divergence in 2016? Everybody knows oil prices have been pounded down by oversupply, so shouldn’t the Barron’s 400 margins be headed down instead of up? The answer lies in component count again, just as it did for consumer staples but with the opposite effect. And there is a direct link to the different missions of the two indexes. The Barron’s 400’s purpose is to measure the stock prices of financially strong, growth-oriented companies of all sizes. The S&P 500 aims to measure the representation of mega- and large-sized stocks in the overall market. The important consequence is that sector component count can vary sharply in the Barron’s 400, depending on how many companies excel in MarketGrader’s semiannual financial-strength assessment. The S&P 500’s component count tends to fluctuate very little—except over long periods—as long as the sector’s “weight” in the overall market remains about the same.
The chart below shows how component counts varied in the two indexes over the 11 years.
In the first three years of the period, the Barron’s 400 was heavy in energy stocks, which were doing very well financially. But then the component count tapered off for the next six years as fracking and other techniques began to bring more and more oil aboveground. By the final two years, the component count was down to 16 in 2015 and 14 in 2016 as oil prices remained low and fewer energy companies passed the financial strength tests. Meanwhile, the energy component count in the S&P 500 began and ended at 35, with minor variation in between. Thus, the S&P 500 continued to measure the prolonged bloodbath in the energy sector while the Barron’s 400 focused on the few companies that were doing well. Among them in 2016 were limited partnerships focusing on such services as the transportation, storage and distribution of petroleum products—for which low oil prices were largely irrelevant.
One final observation is in order, harkening back to the beginning table and charts. For both indexes, consumer discretionary was the sector with the slimmest operating profit margins. That held true for the Barron’s 400 in net income margins as well. But for the S&P 500, the smallest net income margin was posted by telecommunications, a sector in which competition is fierce.
The honor of plumpest operating and net income margins in the Barron’s 400 goes to the financials sector, even with the 11-year span including the housing crisis and Great Recession. The operating margin of 31.82% was 19% higher than the next fattest. The net income margin of 21.8% was 37% above second place. It’s obviously lucrative to build a business around other people’s money. For the S&P 500, technology was the sector with the highest operating and net margins, though only by a whisker over financials.
A future Diary will examine profit margins of Barron’s 400 and S&P 500 companies from the perspective of size.