We penalise companies whose net income margin is abnormally high or low relative to industry peers, or where it has materially deteriorated. We penalise companies with low and falling margins and it suggest poor and/or deteriorating business conditions. Companies with abnormally high net income margins are penalised as they might be in the “too good to be true” fraud category. Investors should conduct further investigation to make sure they are comfortable with the reasons behind such margin performance.
We assume that net income margins are primarily determined by the industry in which a company operates although financing structure and domicile will also have some bearing. As Figure 83 shows, asset heavy businesses, such as real estate development and REITs, generate the highest net income margins in order to compensate for low asset turnover. Thereafter it is software and pharmaceutical companies which are presumably being compensated for intellectual property.
Our accounting screen is set to trigger a red flag when the net income margin is in the lowest 20th percentile or the highest 80th percentile relative to GICS industry peers (i.e. it is either very low or very high), and/or when there is an abnormally large margin decrease relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the margin deterioration exceeds the 80th percentile relative to the change experienced by global peers between 2010 and 2015.
