Safeguarding Your Investments & Growing Assets with Lower Volatility: The Role of Operating Margin
Highlights & Takeaways
- Operating income, also known as operating profit or operating earnings, represents the income generated from a company’s core operations before interest and taxes. It is calculated by subtracting operating expenses, such as the cost of goods sold, salaries, rent, utilities, and depreciation, from revenue.
- Similar to gross margin, operating margin plays a defensive role in stock selection, protecting investors from downside risks. Over the past two decades, returns have not shown significant differentiation between stocks with higher and lower operating margins. However, investing in stocks with higher operating margins has been associated with considerably lower risk.
- In particular, during market downturns, such as in the SP 500 universe, stocks with higher operating margins have consistently outperformed those with lower operating margins, averaging a monthly outperformance of 1.5%, equivalent to an annualized return of approximately 18%.
- Furthermore, the operating margin indicator adds value in less efficient indices like the Russell 2000. In this context, stocks with higher operating margins outperform those with lower operating margins by nearly 15% in terms of both absolute and risk-adjusted returns. This suggests that when investing in relatively small-sized companies, it is highly recommended to NOT consider stocks facing operational challenges.
Introduction & Intuition
Operating margin is a financial metric that measures a company’s profitability by determining the percentage of revenue left after deducting operating expenses. It is often expressed as a percentage and is calculated by dividing operating income by revenue and multiplying by 100.
The formula for calculating operating margin is:
Operating Margin = Operating Income / Revenue
All data items are calculated based on a trailing 12-month basis (to remove the seasonality)
A higher operating margin indicates that a company is more efficient at managing its costs and generating profits. Conversely, a lower operating margin suggests that a company has higher operating expenses relative to its revenue and may have challenges in generating substantial profits.
It is important to note that operating margin does not take into account non-operating items such as interest income, interest expenses, taxes, and one-time extraordinary events. Therefore, it provides a more focused view of a company’s operational efficiency and profitability.
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 operating margin compared to those with lower operating margin during the period of January 2000 to March 2023, using the following framework to determine which group delivers better returns.
Operating 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 operating margin factor more precisely.
Details on two return components can be found:
Quintile Analytics
Observations:
- Over the past two decades, stocks with higher operating margins have not demonstrated higher returns compared to stocks with lower operating margins. However, they do offer a more favorable risk profile, characterized by lower return volatility, a better sharpe ratio, and significantly lower maximum drawdown.
- It is NOT recommended to invest in stocks with the lowest operating margins since doing so would expose investors to unnecessary additional risk without any significant return potential.
2. Quintile Long-Short Cumulative Returns
Long-Short (Q1 — Q5) Return Analytics (Monthly)
Observations:
- Statistically speaking, there is no notable difference in returns between stocks with higher or lower operating margins. However, in a downturn market scenario, stocks with higher operating margins have consistently outperformed stocks with lower operating margins by an average of 1.5% per month. This performance advantage can be beneficial in reducing investment drawdown during stressful periods.
Operating 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 operating margin to those with lower operating margin under different market conditions and environments.
- Quintile Annualized Returns
2. Quintile Long-Short Cumulative Returns
Observations:
- The behavior of operating margins varies slightly in the Russell 1000 and Russell 2000 indices compared to the SP 500 universe. In addition to reducing risk, stocks with higher operating margins in these two indices also deliver better returns. This effect is particularly pronounced in the Russell 2000 index, where stocks with the lowest 20% operating margins are associated with significantly lower returns compared to other stocks. This suggests that for small companies, if they exhibit operational inefficiencies, investors should exercise caution and consider avoiding them.
Notes:
- All data in the analysis are sourced from Yahoo Finance & Financial Modeling Prep.
- Past performance is no guarantee for future investment results.
