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When should you sell a share? Take a look at the profit margin

by International Commercial Investment on April 26, 2014

Source: The Telegraph

Profit margins are under pressure from the strong pound and increased competition – and investors need to take note.

Profit margins are among the most important indicators of a company’s success. Unfortunately, margins in many businesses are starting to look a bit green around the gills. This should act as a warning to investors.

Margins matter. They are a measure of how well a company turns revenues into profit, and a company with expanding margins is better able to invest in its business to secure future growth. A company with falling margins may have to cut costs or even downsize its business.

Last week, FTSE 250 group Colt Telecom became the latest player to warn that its margins were set for a fall this year. The company blamed pricing pressure for the fact that operating profits would miss expectations by between 5pc and 10pc.

Colt is not the first company to issue such a warning recently. Primark owner Associated British Foods said its results would be hit by the strength of sterling in the second half, a warning lost in the euphoria about its move into the US.

Other companies warning on margins this year include the advertising group WPP, clothes retailer Asos, the product testing group Intertek, Marks & Spencer, Ocado, the outsourcer G4S, the engineer IMI, the spirits group Diageo and the publisher Pearson, which owns the Financial Times.

This trend is not just confined to the UK. We have also seen warnings from the fast food group McDonald’s, the car maker Ford and the electronics giant Phillips.

So what is the prognosis for profit margins? There are a number of factors that could hit margins at many UK-listed companies over the next couple of years. Increasing competition in specific sectors is one, but three broader themes are emerging that are threats over the medium term.

Firstly, the pound recently hit a five-year high. The majority of profits at blue-chip index companies are earned abroad and, when these foreign-earned profits are translated into sterling, they will be lower.

This may not hit margins in itself, but if businesses have significant fixed costs in the UK, it could be a negative.

Secondly, loose monetary policy by central banks has kept interest rates low for years – a move that has “artificially” boosted margins at companies in the West. When rates rise – as they will – refinancing debt will lead to higher interest payments, which will eat into margins. Many FTSE 100 companies are carrying a lot of debt. It is wise to look at the debt maturity profiles at each of your shareholdings.

Another threat to margins at some major global businesses would be a tightening of the global tax regime. Many companies use complex tax arrangements in havens to reduce their tax and boost their profit margins. The Organisation for Economic Co-operation & Development’s base erosion and profit-shifting (BEPS) project is focused on closing corporate tax loopholes. BEPS refers to tax planning strategies that exploit different tax rules to shift profits to locations where there is little or no real activity but the taxes are low. Whether it will succeed remains a moot point.

Of course, the reality of the situation is a little more complex than “falling margins are bad, rising margins are good”.

Margins can’t be held at all costs – a mistake that appears to have exacerbated problems at Tesco, which has had some of the best margins in the industry, maintaining a target of 5.2pc for many years. However, its UK offering has gone off the boil due to shoppers tightening their belts and the rise of the discounters such as Aldi and Lidl.

The City wanted Tesco to abandon its target so it could take on the discounters with price cuts last year, but the target was only scrapped two months ago. Another year of falling margins appears certain, but this should boost its market share over the longer term.

A company that can maintain its margins during difficult economic times or a period of increased competition could be a sign of underlying strength. It is therefore important to look at the context in which these margins are generated.

Valuations do not appear to be overly stretched just yet, but some are high. Now may be a good time to consider banking profits in shares where you have shown good gains. After all, a profit isn’t a profit until it is put in the bank and it can evaporate fairly fast if things go wrong.

So, take a look at margins in your investments and get a handle on where they are likely to go in the future. This could help you make the most difficult decision in investing: when to sell.

International Commercial InvestmentWhen should you sell a share? Take a look at the profit margin