Watsco: Gross Margin and Return Predictability

In Practise Analysis

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When we study mature companies, we first aim to understand the persistence of returns. We want to grasp the predictability of the company’s earnings power. After laying out the 20-year financials on excel, one variable we focus on is gross profit.

A stable gross profit margin suggests the company is consistently adding value in its industry over time. It’s a cleaner measure of the underlying business fundamentals, excluding overhead efficiency, management salaries, leverage, taxes, etc.

Low gross margin variability is one of the main reasons we’re interested in B2B distributors like Watsco, POOL, Fastenal, Addtech, etc.

Source: IPSource: IP

The table below shows the coefficient of variation, the variation of each year’s gross and ebit margin from the 20-year mean, for each distributor. The lower the variability, the greater the predictability of gross margins. A 3-4% variation in the gross margin is incredibly predictable for any industrial business.

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