10 great shares with profit margins to survive recession

Times are tough and hard-up consumers can make life very difficult for businesses. So stock screen expert Ben Hobson has identified the companies best placed to ride out a downturn and emerge healthy on the other side.

There are few things investors loathe more than a company profit warning - and the bad news is that we’ve seen a lot of them this year.

Inflation, rate hikes and recessionary forces have been piling the pressure on businesses across all sectors. But while some firms are vulnerable to a squeeze on profits, others can be much more resilient. 

In the search for shares that can withstand economic headwinds, it could pay to look closely at profit margins and just how efficient businesses really are at making a profit. These have always been important clues in the hunt for quality, and new research shows they can be surprisingly resilient over time.

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The misery of missed earnings

There were 86 recorded profit misses from UK-quoted firms between July and September, according to EY-Parthenon. That was up from 64 in the previous quarter and up from 51 in the third quarter of 2021.

In many ways this is no surprise. Inflation in the UK has been on an uptrend for 18 months and currently sits at just over 10%. When you mix in rising costs for energy, raw materials and staff plus a squeeze on consumer spending, many firms will feel the pressure on profits.

The latest profit warning data points to exactly that. Fifty-seven per cent of firms that missed expectations in the third quarter blamed rising costs. Another 23% blamed ‘labour market issues’, which includes rising staffing costs.

Finance textbooks will tell you that shares in defensive industry sectors do better in a downturn. That’s certainly proved to be true in many areas this year - but not everywhere.

Forty-four per cent of third-quarter profit warnings were in consumer-facing sectors such as retail, travel and leisure. But even food production, which tends to be more defensive because it’s always in demand, saw several profit misses. It’s a signal that firms across a range of sectors are struggling to juggle higher costs and weaker demand.

Prioritising profit margins

Faced with this barrage of economic punches, investors need to look for good quality companies that can defend themselves. And when it comes to good quality, few clues are more important than profitability.

Good quality profitability isn’t just about the bottom line. It’s about how efficient a company is at being a profit machine - and that is where profit margins come in.

A gross profit margin is calculated by taking a business’s revenue and deducting the cost of the goods sold to get it. Margins are measured in other ways too, depending on what costs you include. For instance, operating margins take into account some additional costs of running the business. Net margins are the same but include all the costs.

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High margins are important because they can point to companies with an advantage that gives them pricing power. It can mean their products are in demand or have sticky customer bases. It can also mean that the firm is good at minimising costs.

These high margins are a buffer against economic turmoil and can protect overall profitability from rising input prices.

Another way of looking at quality profitability is to think about how good the company is at sweating its balance sheet to get a return.

A useful measure here is the ‘return on assets’ which simply looks at how much profit the company makes from the assets at its disposal, such as equipment and intellectual property.

With profit margins and efficiency ratios like ‘return on assets’, it is best to compare companies in similar sectors in order to make a fair assessment. But you can also use them to get a good look at a company’s profitability over time - and it’s here that research has made some eye-opening findings.

Good quality profitability sticks around

A new study by asset management firm Verdad, has found that quality profitability measures such as profit margins and return on assets stay surprisingly consistent for firms over the medium term.

That means the past is potentially a more predictive guide to the future when you are using these kinds of ratios.

Verdad has studied the usefulness of a range of growth and profit indicators. It previously found that popular metrics such as earnings growth stop being useful very quickly. But when it comes to profitability, it seems that trends do persist.

At a time when companies are facing all kinds of pressure on profits, good quality profitability could be a useful starting point to finding shares that can manage their way through.

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With that in mind, this “Sticky Profitability” screen looks for shares with margins and return on assets of more than 15% currently and on average over both five and 10 years. It also shows the performance of those shares relative to the FTSE All-Share index in 2022.

By looking for values of more than 15% the screen rules are tilting towards what we might expect to be some of the higher profitability companies in the market. But these top results are far in excess of that figure in most cases. So what we’ve found are some of the most consistently highly profitable companies in the market over the past decade.

Another notable feature is that the top results are apparently market-cap agnostic. M Winkworth (LSE:WINK), the property agency, has a market cap of just £18.8 million, while Property Franchise (LSE:TPFG), Record (LSE:REC), Bioventix (LSE:BVXP) and Quartix Technologies (LSE:QTX)all have market-caps of sub-£200 million.

Meanwhile, Auto Trader (LSE:AUTO) and Games Workshop (LSE:GAW) have multi-billion pound valuations.

What is striking about this list is the consistency between last year’s gross margins and return on assets to their 10-year averages.

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You could argue that some of these companies have benefited from benign conditions over this period where consumer spending has been robust. Faced with a downturn, things might change. Some of these firms are in economically sensitive sectors where there have been profit warnings this year. Certainly, some of their share price performances in 2022 suggest the market is wary.

However, on the basis of these quality profitability indicators, these firms show signs of being fairly resilient. It doesn’t mean they won’t come under pressure, but it does suggest they are in good shape to navigate difficult conditions - but it’s essential to do your own research to be sure.

For investors, rising numbers of profit warnings and the looming prospect of recession are hardly encouraging. But the good news is that some companies are more than capable of riding out the conditions and emerging healthy on the other side. Whatever strategy you use, keeping an eye out for good quality profit margins could be well worth it.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.