Home > Market Commentary > Which S&P 500 Sectors Have the Highest Margins?

Which S&P 500 Sectors Have the Highest Margins?

David Sowerby of Loomis Sayles gave an interview on CNBC last Friday (12.16.11, video available here). Mr. Sowerby cited the following reason for being bullish on stocks:

. . . if you look at the continued improvement in cash flow margins, that are about 20% today for most companies, still below the 24% peak levels for 2007, I think too many investors are focused on net profit margins, not focused on the statement of cash flows, that’s what can get stock prices higher . . .

Twenty percent free cash flow margin sounded a little high to me, so I decided to take a closer look. I calculated the equally-weighted and capitalization-weighted gross, net, and unlevered free cash flow margins for the S&P 500 from 1994-2011. The graph below shows that the average gross margin expanded dramatically from 1994-2000, after which it levels off and drifts slightly higher. Cap-weighting makes a difference, as large-cap firms have higher gross margins. I found it interesting that gross margins were largely unaffected by the 2000-2001 and 2007-2009 recessions:

Health Care, Telecom and Information Technology have the highest cap-weighted gross margins. Health Care’s cap-weighted gross margin now exceeds 60%:

Average net margins are also trending upwards, although net margins display pronounced declines during the last two recessions. Cap-weighting once again makes a difference, as larger-cap companies earn higher net margins. Further note how the cap-weighted series shows less of a decline during recessions.

The Health Care and Information Technology sectors also have the highest cap-weighted net margins, along with — surprise — Financial stocks. Notice how, until their demise in 2007, Financials squeezed the highest net margins out of their revenues compared with the rest of the S&P 500:

I also calculated the equally-weighted and cap-weighted unlevered free cash flow margin for the S&P 500, depicted in the graph below.

Mr. Sayles definitely gets a few things right. Unlevered free cash flow margins have been in an 18-year uptrend, and the equally-weighted series does indeed peak in 2007. Cap-weighting makes more sense, however, as an equally-weighted series places disproportionate weight on the margins of smaller firms. The graph above shows that the mean cap-weighted free cash flow margin of the S&P 500 is at an 18-year high.

The sectors with the highest cap-weighted unlevered free cash flow margins are once again Health Care, Telecom and Information Technology, ranging between 13%-18%:

Conclusion: S&P 500 gross, net, and unlevered free cash flow margins trend upwards from 1994-2011. Health Care has the highest gross and unlevered free cash flow margin, followed by Telecom and Information Technology. Surprisingly, Financial stocks’ net margins have rebounded sharply.

The mean cap-weighted unlevered free cash flow margin for the S&P 500 is only 12.2%, however, much lower than Mr. Sowerby’s estimate of 20%. One possible explanation for the difference in our findings is that the Loomis Sayles calculations refer to levered free cash flow margin, which we would expect to be higher. I propose that cap-weighted unlevered free cash flow margin is a better measure, however. Levered FCF arbitrarily places more weight on the margins of firms that use more debt, instead of weighting by the more traditional market cap factor.

Datasource: Capital IQ.

Categories: Market Commentary
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