For a quick lesson in why investors want to follow industry leaders, consider Google (GOOG, news, msgs).
Google's share price has more than tripled (adjusted for splits) since its August 2004 initial public offering, when the company and chief rival Yahoo (YHOO, news, msgs) were in a virtual tie for market share.
Now Google has three times as much of the Internet search market as Yahoo, and Yahoo's stock price has been cut in half. That's a simple example of why you'll always do better by riding the winning horse.
But in an economy like this one, with so many companies beaten up, how do you do spot the future leaders?
Picking the best stocks in an industry isn't necessarily rocket science. Sometimes it can be as easy as looking at profit margins, specifically gross margins and operating margins.
For instance, here's what the gross margins for carmakers Ford (F, news, msgs), General Motors (GM, news, msgs) and Toyota Motor (TM, news, msgs) have looked like over the past few years:
| Year | Ford | GM | Toyota |
|---|---|---|---|
2008 | 6.5% | 2.3% | 18.1% |
2007 | 11.0% | 8.1% | 19.7% |
2006 | 1.5% | 9.3% | 19.5% |
2005 | 13.3% | 4.8% | 19.8% |
2004 | 16.3% | 16.0% | 19.8% |
You could look at that chart and see exactly where these three sit today.
Why margins matter
I'll give you the details on gross margins in a minute. But to use them, all you have to know is that higher is better. You won't need your calculator. MSN Money does the math for you and lists both gross and operating (pretax) margins in the Profit Margins section of its Key Ratios report.(You can also compute the gross margin by displaying the annual income statement for the stock in question. The gross margin is the gross income divided by the total revenue. That's what I did for the numbers in this column.)
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You can see from the table that Toyota's gross margins were much higher than the margins for Ford and General Motors, especially in recent years. Here's why those numbers are so significant.
Gross margin measures the profit a company makes on a product considering only the cost of production. It doesn't include overhead, marketing or the costs of research and development. Toyota's 18.1% margin for 2008 means that the Japanese automaker made $18.10 for every $100 of sales. That's cash that it could apply to research and development, advertising or administrative costs, or add to profits.
By contrast, in 2008, Ford had only $6.50 per $100 and General Motors only $2.30 left over for those things.
For another example, here are recent annual gross margins for microprocessor-chip makers Intel (INTC, news, msgs) and Advanced Micro Devices (AMD, news, msgs):
| Year | Intel | AMD |
|---|---|---|
2008 | 56% | 40% |
2007 | 52% | 37% |
2006 | 51% | 50% |
2005 | 59% | 41% |
2004 | 58% | 39% |
Advanced Micro's chips are arguably technically competitive with Intel's. Nevertheless, Advanced Micro -- the perennial No. 2 -- has to undercut Intel's prices to maintain market share. Once again, the numbers speak for themselves. Last year, for every $100 of sales, Intel had $56 compared with $40 for Advanced Micro for other expenses and for profits.
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Gross margins also tell you a lot about a manufacturing company's competitive position within its industry. The company with the highest gross margin has lower production costs or can sell its products at higher prices because customers are willing to pay more for quality that is perceived to be better (or both). Either way, for manufacturers, the highest-margin company is probably best of class.
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