Gross Margin in Equity: A Defensive Play for Achieving a Better Risk-Profile
Highlights & Takeaways
- Gross margin is a financial metric that indicates the profitability of a company’s core operations. It represents the difference between revenue and direct costs. A higher gross margin percentage is generally favorable as it indicates that the company is generating more revenue relative to its direct costs.
- From a stock-picking perspective, our study found that the real value added by gross margin is more in terms of risk management rather than boosting returns. Over the past two decades, stocks with higher gross margins had a slightly higher return-to-risk ratio compared to stocks with lower gross margins. This conclusion holds true across multiple US stock indices, including SP 500, Russell 1000, and Russell 2000.
- While gross margin is not a direct return generator, it can serve as a defensive factor for investors. Considering this metric when picking stocks can potentially improve the risk-profile of investments without negatively impacting returns. Therefore, it is beneficial for investors to look at gross margin when making investment decisions.
Introduction & Intuition
Gross margin is a financial metric that represents the difference between the revenue generated from the sale of goods or services and the direct costs associated with producing or delivering those goods or services. It is typically expressed as a percentage.
Gross Margin = (Total Revenue — Cost of Goods Sold) / Total Revenue
All data items are calculated based on a trailing 12 month basis (to remove the seasonality)
Intuitively, high gross margin generally indicates that a company is generating a significant amount of revenue relative to its direct production or service costs, suggesting that the company is efficiently managing its production or service delivery processes and is able to command higher prices for its goods or services. Conversely, a low gross margin ratio may indicate a company is facing challenges.
In this section, we will examine the above argument from a quantitative perspective.
Factor Study Framework
We will analyze the performance of stocks with higher gross margin compared to those with lower gross margin during the period of January 2000 to March 2023, using the following framework to determine which group delivers better returns.
Gross Margin Factor in SP 500
The following results (Jan 2000 — Mar 2023) are displayed.
- Quintile Annualized Returns (both total return and alpha return).
- Quintile Long-Short Cumulative Returns, where the best quintile (Q1) is long and the worst quintile (Q5) is short.
1. Quintile Annualized Returns
Just as a reminder, we use two types of return measures in our analysis. Total return measures the overall return from the stock, which includes both the market return and the stock selection return. On the other hand, alpha return focuses solely on the stock selection return by removing the market return component from the stock return. This distinction will allow us to evaluate the effectiveness of the gross margin factor more precisely.
Details on two return components can be found:
Quintile Analytics
Observations:
- Over the past two decades, the performance of stocks has not shown significant differentiation based on the gross margin ratio of companies. Stocks with higher gross margins have not consistently outperformed those with lower gross margins in terms of returns.
- However, it is worth noting that holding stocks with higher gross margins provides value in terms of risk control. Companies with higher gross margin ratios tend to exhibit better risk-adjusted returns, as indicated by metrics such as the Sharpe ratio, when compared to the broader SP 500 universe.
2. Quintile Long-Short Cumulative Returns
Long-Short (Q1 — Q5) Return Analytics (Monthly)
Observations:
- Throughout the entire time period analyzed, the return differences between stocks with higher gross margins and those with lower gross margins are not statistically significant, suggesting that gross margin alone may not be a reliable indicator for investors to select stocks.
Gross Margin Factor in Russell 1000 and Russell 2000
It is worth noting that the S&P 500 index consists of the 500 largest and most actively traded companies in the US, where stocks are generally priced more efficiently than in other stock universes.
To determine whether our conclusions hold true in different stock universes, we extended our study to include the Russell 1000 and Russell 2000 universes. This expansion allowed us to compare the performance of stocks with higher gross margin to those with lower gross margin under different market conditions and environments.
- Quintile Annualized Returns
2. Quintile Long-Short Cumulative Returns
Observations:
- The conclusion that gross margin is not a significant factor for stock selection remains consistent when considering the Russell 1000 universe, similar to the observations made in the SP 500. Investing in stocks with higher gross margins does not seem to provide significant benefits in terms of returns.
- However, the scenario changes when examining the Russell 2000 universe, which includes more small-cap companies and is considered potentially less efficient. In this case, it is consistently recommended to choose stocks with higher gross margins for investment over those with lower gross margins.
- The difference in findings between the Russell 1000 and Russell 2000 universes suggests that the influence of gross margin on stock performance may vary depending on the market segment. In the case of the Russell 2000, the emphasis on higher gross margin stocks indicates a potential strategy for investors seeking opportunities in the small-cap space.
Notes:
- All data in the analysis are sourced from Yahoo Finance & Financial Modeling Prep.
- Past performance is no guarantee for future investment results.
