Attractive Low Profit Margins

Not all low profit margins are the same. While some should be avoided, others can be okay in the right circumstances. Learning to tell the difference could make a big difference in your portfolio.

Obviously, all else being equal, investors should prefer higher profit margins to lower ones. Why wouldn't you want a company you own to wring as many pennies of profit as it can from every dollar of revenue it takes in? Still, a company whose margins seem unimpressively low might become more attractive once you look at the big picture.

Is inventory moving briskly?
To find out, start by examining inventory turnover, which reflects how frequently a company sells out its stock of goods. For any given period of time, you can calculate it by dividing the cost of goods sold by the average inventory level. High inventory turnover can help make up for a company's low profit margin.

Let's look at a few specific examples. Industries with typically lower profit margins include retailers and supermarkets. In the following table, I've selected six companies that appear to have low profit margins, but are stronger than that one metric might suggest. Each is a solid business that ranks among the dominant players in its industry.

Data: CNBC.com, Yahoo! Finance, Motley Fool CAPS.

While Whole Foods' 1.8% margin may seem paltry next to typically-high-margin companies like Apple and Microsoft, it's still much richer than its competitors. And on top of that, Whole Foods also sports steeper inventory turnover.

Among the discount retailers, Target's margin may be a little better than Wal-Mart's, but Wal-Mart is restocking its shelves more often.

It makes sense that Apple's margin, while high, is still considerably less than Microsoft. Apple makes and sells devices, while Microsoft mainly sells software. It costs Apple more to make each additional iPod or iPhone, but it doesn't cost Microsoft too much to just burn another CD of software.

High inventory turns or high profit margins aren't enough to guarantee stellar performances, but they're certainly promising signs. If you look at the average stock returns above, you'll see that in general, the high-turnover companies turned in relatively strong results.

Gather more data
The more calculations you master, and the closer you look, the better you'll become at identifying compelling bargains. Remember that you need to answer two key questions for yourself: Is this a high-quality company? And is its price attractive? Profit margins and turnover address the first question, while our valuation nook can help you learn more about the second.

What metrics do you examine most often when you study a stock? Let us know -- leave a comment below!