How Large Should Profit Margins Be?

If you analyze investments, you would certainly want the answer to this question to be as high as possible. But they are often within the industry threshold for the company's industry.

That makes sense. It’s not likely that a grocery store is going to have 40% margins (unless it’s a specialty grocery store). Most grocery stores accept that their profit margins will be much lower than that. In fact, it is often in the single digits.

Conversely, the current AI stock lineup can certainly achieve at least 40% and often much higher. It’s hard to say how long this trend will last, which is why some investors prefer the less high-flying industries.

This isn’t advice on whether to invest in AI stocks or grocery stores. My goal for this article is to illustrate that the industry numbers can serve as guidance on where a company should be, roughly.

Stocks won’t always conform to these ranges, but in many cases, they will. Standout companies will often be higher than their industry peers, but not by blowout numbers (except for unusual circumstances).

The Nature of Competition

Companies with high moats, that is, companies that have a competitive advantage, often report consistently higher margins than their peers. They are considered the leaders in their industry. But you can bet that their peers will try to dethrone those leaders. And the leaders can get complacent and lose market share as a result.

Look for signs that companies are in danger of becoming complacent. The key is to check for a lack of direction in the management reports. For instance, if a company has always been innovative and ramped up its research and development, then one year it scaled way back, that could be a sign of either complacency or that the company could be in trouble (both are bad and not necessarily mutually exclusive).

You can also check boards like StockTwits and other investor forums. While you have to take what people write with a grain of salt, you still can glean useful information from what they say. It can give you a starting point.

While companies with high moats are ideal, it’s not always possible to find them. You could choose not to invest until you find companies with high moats. Even though they may be difficult to find, they are not impossible. Passing on investments until you find high-moat companies is a perfectly viable investing strategy, as long as you invest enough money in these types of companies.

Strategies like this, though, can leave you underdiversified. Suppose you only find two companies that meet all your criteria. You’d need to invest a good chunk of your portfolio in them, and that exposure can leave your portfolio vulnerable.

Another viable strategy is to find narrower moats along with the wide-moat companies. This strategy helps you diversify while still participating in the gains of industry leaders.

Perhaps the least desirable strategy is investing in low-to-no moat companies. These are commodity-like businesses that compete only on price. None have competitive advantages in their industry and will usually offer low returns over the long run.

Morningstar.com used to provide moat information on companies for free. Now that information is hidden behind its paid service. There are ways to determine moats yourself, but it’s not simply looking for high profit margins in relation to a company’s peers. That’s a good starting point. But a better measure is to compare ROIC to costs of capital (WACC).

Nowadays, you can simply hit up your favorite LLM (ChatGPT, Claude, etc.) and ask if your target company has a wide moat. It will give you some insight into why it believes the company you specified has or does not have a wide moat. This interaction, done repeatedly, will help you learn about moats and get a feel for which companies fall into that category. It’s not perfect, though.

I created an article on my website that goes into more detail about profit margins and what makes a good margin. It is free for you to read right now.