Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / How Gross Margin Trends Reveal Pricing Power in Stocks
Transcript
- Lucas: So the S&P 500 is sitting at 7,459, up about one-point-four percent in the last five days. But if you look under the hood, Apple surged eight-point-five percent in that same stretch — and that got me thinking about what actually drives that kind of stock performance. Luna: You're going to say gross margins, aren't you? Lucas: I am. Because Apple's gross margin has been quietly climbing. It's now around forty-four percent, up from the low forties a few years ago. And that's the kind of number that tells you a company has pricing power — they can raise prices or cut costs without losing customers. Luna: But isn't that just Apple being Apple? How do you apply that to other stocks? Lucas: Good question. Let's look at Microsoft. Their gross margin is around sixty-eight percent, and it's been remarkably stable. That stability itself is a signal — it means they're not getting squeezed by competition or input costs. When you see gross margin expanding over several quarters, that's often a leading indicator of earnings growth. Luna: So you're saying if I'm screening for stocks, I should start with gross margin trend rather than P/E ratio? Lucas: Not exactly start, but definitely add it to your filter. The price to earnings ratio can be distorted by one-time items or accounting changes. Gross margin is direct — it's revenue minus the cost of goods sold, divided by revenue. It tells you the core profitability of the product or service itself, before operating expenses. Luna: But what about a company like Amazon? Their retail gross margin is thin — around five percent on product sales. Yet they're incredibly profitable because of AWS, which has gross margins above sixty percent. Lucas: Right, that's the nuance. You have to look at segment-level gross margins, not just the consolidated number. Amazon's overall gross margin recently hit about forty-five percent because AWS is such a big piece now. But if you just saw that headline number, you'd miss that the low-margin retail business is actually improving its efficiency over time. Luna: So what are the red flags? When should a rising gross margin not be trusted? Lucas: Two things. First, if gross margin is rising because a company is cutting R&D or marketing — that's not sustainable. Second, if the improvement is purely due to input cost declines, like cheaper raw materials, that can reverse just as quickly. You want to see pricing power — the ability to raise prices without losing volume. Luna: Give me a real example of a stock where gross margin signaled trouble before the market caught on. Lucas: Think about the big retailers a few years ago. Many had gross margins that were flat or declining for two or three years before margins really compressed. Walmart, for instance, saw gross margin shrink from around 25 percent to 24 percent over several years as they invested in e-commerce. The market didn't panic, but it was a slow bleed that eventually pressured earnings. Luna: So gross margin is like a canary in the coal mine for competitive pressure. Lucas: Exactly. And the flip side is you can find stocks where gross margin is inflecting upward. That often happens after a restructuring or a shift in product mix. If you can catch that inflection early, you're ahead of most analysts. Luna: How do you calculate the inflection yourself? Is it just quarter-over-quarter? Lucas: I look at the trailing twelve-month gross margin, not just one quarter. A single quarter can be noisy — maybe there was a huge order with a different mix. But if the trailing twelve-month margin moves from 42 percent to 43 percent to 44 percent, that's a trend. I also compare to the same quarter last year to adjust for seasonality. Luna: And what about companies with negative gross margins? Is that ever okay? Lucas: Typically no, but some early-stage companies — especially in biotech or hardware — might have negative gross margins while they're scaling. You want to see a clear path to positive. If a company has been public for five years and still can't produce a positive gross margin, that's a red flag. Luna: Let me push back a little. Isn't gross margin less relevant for service companies? Like a consulting firm? Lucas: It's still relevant, but the cost of goods sold is mostly labor. So gross margin for a consulting firm is essentially utilization minus direct compensation. It's a measure of how efficiently they're billing out their people. A firm with rising gross margin is either raising rates or improving utilization — both good signs. Luna: Okay, so give me a quick checklist for using gross margin in a stock pick. Lucas: Sure. One: look at the trailing twelve-month trend — is it up, down, or flat? Two: compare to peers in the same industry — a company with expanding margin while peers are contracting usually has a competitive advantage. Three: check if the margin improvement is coming from price increases or cost cuts. Four: look at operating margin too — if gross margin is up but operating margin is down, maybe they're spending too much on SG&A. Luna: That's a solid framework. But I want to go back to Apple for a second. Their gross margin is 44 percent, but their operating margin is around 30 percent. That gap of 14 percentage points is mostly R&D and selling costs. Is that a concern? Lucas: Not for Apple, because they're investing heavily in new products and services. That R&D spend is what keeps their gross margin high in the future. The key is whether that spending is generating a return. Apple's revenue per R&D dollar is among the best in tech. Luna: So gross margin is a starting point, not the whole story. Lucas: Exactly. It's one lens. But it's a powerful one because it's harder to manipulate than earnings per share. A company can boost EPS by buying back shares, but gross margin reflects real economic value creation. Luna: Alright, I'm sold. I'm going to start screening for stocks with rising gross margins tonight. Lucas: If today's conversation actually helped you think about a stock differently — maybe saved you from a value trap or pointed you toward a company with real pricing power — that's exactly the kind of insight we try to deliver every episode. These conversations stay ad-free because of listener support, and if you found it useful, you can help keep it going at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that makes a big difference for us. We appreciate everyone who chips in. Lucas: So back to the practical side — one stock I'm watching right now is a mid-cap industrial that's seen gross margin expand from 28 to 32 percent over the last four quarters. I'll go through the details next episode. Luna: Looking forward to it. And for anyone building a concentrated portfolio, gross margin trends might be the edge you need.