The financially sound companies whose attractively priced stocks make up the Barron’s 400 Index have larger profit margins by company size than those in the Standard & Poor’s 500.
This is the third and final Diary entry on profit margins. The first (B400 Companies Have Larger Profit Margins Than Those in S&P 500) looked at the overall indexes and found that the Barron’s 400 companies’ margins were about 20% fatter than those in the S&P 500. The second (B400 Companies Dominate Sector Profit Margin Performance) showed that the Barron’s 400 companies boasted plumper profit margins in all but one of 10 sectors. Thus—no spoiler alert needed!—it is to be expected that the same pattern prevails according to component companies’ market capitalization. However, there are some characteristics below the surface that merit attention.
Profit margins are measures of how well companies convert top-line revenue into bottom-line earnings. It’s calculated simply by dividing income by revenue. Income is measured in two ways, which means there are two sets of profit margin data for each company. The first uses net operating income, which is revenue minus all expenses except interest charges and income taxes. The second uses net income, which is operating income with interest charges and income taxes deducted.
Data from 11 years, 2006 through 2016, were calculated by dividing aggregate trailing 12-month income by aggregate trailing 12-month revenue of both indexes’ component stocks as of each year-end. That means some companies in both indexes were omitted from the calculations because their stocks didn’t happen to be components on Dec. 31. For the Barron’s 400, which is reconstituted semi-annually, that includes many companies added in March of each year but dropped six months later, in September. Other companies were passed over because their year-end data didn’t stretch back a full 12 months, usually because of acquisitions, mergers and spin-offs.
Here are the results of these calculations by company size:
|Median Profit Margins 2006-2016|
|Operating (%)||Net (%)|
|B400||S&P 500||B400||S&P 500|
|Mega Cap (>$10 billion)||20.44||16.11||13.54||10.64|
|Large Cap ($3 bln-$10 bln)||17.96||13.16||11.65||8.06|
|Mid Cap ($1 bln-$3 bln)||18.00||N/A||11.58||N/A|
|Small Cap ($500m-$1 bln)||16.59||N/A||12.00||N/A|
|Micro Cap (< $500 mln)||14.91||N/A||9.74||N/A|
The Barron’s 400 advantage over 11 years is roughly four percentage points (400 basis points) in operating margins and three percentage points in net margins. That may not seem like much, but it’s enough to give the Barron’s 400 companies a distinct edge in producing superior financial results each quarter.
The S&P 500 consists essentially of two size segments, mega cap and large cap. Standard & Poor’s has other indexes to track mid-cap and small-cap stocks. Nonetheless, the 500 is considered by many to be a proxy for the U.S. stock market. It is that, but only with market capitalization weighting. The S&P 500 accounts for 75% to 80% of the total market cap of the U.S. market, and thus reflects the vast majority of the market’s moves. By contrast, the Barron’s 400 is an equally weighted index with components in five size segments. The smallest stock counts just as much in the index’s performance as Apple Inc. In terms of profit margins, the contributions of the mid-, small- and micro-cap segments raised the Barron’s 400’s 11-year operating margin to 20.4% from a combined mega- and large-cap average of 19.2%—one fourth of the four-percentage-point advantage.
Still, it’s only fair to compare the two indexes in just the two largest size segments. (Actually, the S&P 500 sometimes has stocks in the mid-cap and even small-cap ranges, especially during market declines such as in 2008-09. Falling prices reduce these companies’ market caps to lower segment definitions. For purposes of this study, however, companies in the S&P 500 with market caps below $10 billion are classified as large.) Here are the median profit margins in those segments of the two indexes, by year:
|Median Profit Margins by Year, 2006-2016|
|Operating (%)||Net (%)|
|2006||B400||S&P 500||B400||S&P 500|
|Mega Cap (>$10 billion)||21.80||14.88||16.01||9.84|
|Large Cap ($3 bln-$10 bln)||18.18||12.44||12.97||7.96|
|Mega Cap (>$10 billion)||20.90||13.82||13.96||10.71|
|Large Cap ($3 bln-$10 bln)||18.25||8.78||12.49||8.49|
|Mega Cap (>$10 billion)||19.23||17.39||11.85||10.60|
|Large Cap ($3 bln-$10 bln)||18.50||13.28||10.51||8.22|
|Mega Cap (>$10 billion)||18.04||16.20||13.60||9.41|
|Large Cap ($3 bln-$10 bln)||19.10||11.60||11.55||6.27|
|Mega Cap (>$10 billion)||22.46||16.25||15.31||10.66|
|Large Cap ($3 bln-$10 bln)||18.48||14.81||12.19||8.10|
|Mega Cap (>$10 billion)||20.29||16.56||13.68||10.63|
|Large Cap ($3 bln-$10 bln)||17.95||15.03||11.93||8.58|
|Mega Cap (>$10 billion)||17.93||16.90||12.67||10.37|
|Large Cap ($3 bln-$10 bln)||16.15||13.83||10.44||8.51|
|Mega Cap (>$10 billion)||21.49||13.90||14.54||10.86|
|Large Cap ($3 bln-$10 bln)||18.40||13.90||11.55||8.63|
|Mega Cap (>$10 billion)||20.90||16.59||12.68||10.80|
|Large Cap ($3 bln-$10 bln)||16.41||14.49||10.73||8.07|
|Mega Cap (>$10 billion)||17.67||16.11||11.65||10.91|
|Large Cap ($3 bln-$10 bln)||17.75||12.65||11.35||8.07|
|Mega Cap (>$10 billion)||22.82||16.21||16.36||11.14|
|Large Cap ($3 bln-$10 bln)||19.68||11.94||12.16||7.01|
Contrasting the year-to-year margin performance against the each index’s median for the full 11 years reveals a couple of interesting points. Here are two charts showing operating and net margins for mega caps:
Yearly Mega-Cap Median Operating Margins vs. Medians for Full Period (%)
Yearly Mega-Cap Median Net Margins vs. Medians for Full Period (%)
The more important point is that the Barron’s 400 margins vary by a greater degree from year to year than those of the S&P 500. It is especially visible in the second chart on net margins. The likely reason is that the S&P 500 has significantly more mega-cap companies than the Barron’s 400; this topic is discussed further on in this Diary. Volatility (of stock prices or in this case profit margins) tends to increase with fewer components and decrease with more components.
The secondary point is that with this marked variation in margin volatility, the median margins of the two indexes occasionally move in opposite directions. One result is possibly accentuated differences in profitability showing up in certain reporting periods. It’s something to keep in mind because these accentuations usually don’t last long.
Margin volatility looks a little different in the large-cap segment, as these charts show:
Yearly Large-Cap Median Operating Margins vs. Medians for Full Period (%)
Yearly Large-Cap Median Net Margins vs. Medians for Full Period (%)
The first thing to notice is that in the large-cap segment it’s the S&P 500 that is more volatile, at least for operating margins. The two indexes are roughly equivalent in net margin volatility. However, there are diametrically opposite net-margin moves in 2009 and 2016, and a sharp vs. muted move in 2012—that accentuating effect mentioned above. The second thing to nota bene is that both operating and net margins diverge rather sharply in 2016 without the extenuating circumstance of a Great Recession as there was in 2009. An adequate explanation requires further research, which is beyond our mission here, but it’s worth follow-up to determine if the trend continues or reverses.
As noted above, indexes’ component counts can affect the volatility of median operating and net margins from year to year. In this 11-year period, the numbers of stocks seem to matter in the mega-cap segment and less so in large-cap. The S&P 500 has more mega-cap stocks but fewer large caps than the Barron’s 400, which has 100 fewer stocks overall and those are divided into five size segments rather than two. Below is a chart depicting the portion of total components that are in the mega- and large-cap segments of the two indexes.
Portion of Total Index Components in Mega- and Large-Cap Segments
Over the 11 years, the S&P 500 mega-cap segment has ballooned from 50% to 80% of total components. Its large-cap segment, meanwhile, has shrunk from a high of 45% since the 2008-09 bear market ended to 20%. These changes are consistent with a rising market, which has prevailed since 2009. The Barron’s 400 has reduced its mega-cap exposure in recent years from 30% in 2013 to 18% while expanding the large-cap segment to 32%—bigger than its S&P 500 counterpart in both proportion and component count. However, the Barron’s 400 remains essentially a mid-cap index, both because smaller size segments partially counter-balance the larger size segments and because its mid-cap segment is its largest; at the end of 2016 it accounted for 35% of index components.
There is another important distinction between the two indexes. The S&P 500’s move toward being a mega-cap index is to some extent deliberate, in addition to the effects of a rising overall market and the recent rebound of the energy sector. That’s because S&P 500 stocks are chosen by a committee, which over the past 20 years has inclined toward picking larger stocks. So, the transformation of the S&P 500 into an overwhelmingly mega-cap index is probably permanent, insofar as the committee has a voice in the matter.
The Barron’s 400 components, on the other hand, are the highest scoring in a 24-factor assessment of financial strength by MarketGrader. Each company’s operational performance determines whether it is selected to be a component at every semi-annual rebalancing. Thus, the size-segment makeup of the Barron’s 400 is subject to change over time as the variables of financial strength fluctuate.
Plump profit margins are essential to superior financial performance, which in turn has a strong long-term influence on stock prices. The companies selected for the Barron’s 400 have these fatter margins as part of their armor of financial strength.