An iron rule of business is that returns regress to the mean. Thus, if a company enjoys excessive profits, the sector attracts more capital, rivals are established, and any exceptional surplus is competed away.
This cycle is the magic of capitalism in action. Price gouging of the customer is defeated by new entrepreneurs who offer the same — or perhaps better — for less, so the pioneer is forced to reduce prices and profits.
Of course, ownership of brands and intellectual property enshrined by patents and copyrights can generate above-average returns for as long as the legal protection holds, as can monopolies. These are the most valuable sorts of investment “moats”. But there are also certain product categories that appear to defy gravity without such legal shields.
I am referring to the handful of amazing goods that enjoy consistently super margins. If you identify and exploit such a segment, you are very clever or very lucky.
I was the latter when, aged 29, I stumbled across pizza. At heart it is a simple food: flour, water, yeast, tomato and cheese. Many restaurants charge £7 or more for the classic margherita. The ingredients should cost no more than 50p; even after VAT an operator can make an 85% gross margin. I have never come across a more profitable dish with such wide appeal.
Coffee shops are opening everywhere because caffeine is addictive, legal — and very lucrative. The sector has enjoyed 16 consecutive years of growth. An espresso bar can take two-thirds of the revenue of a pub near by and still have a better bottom line because the margin on coffee is so much greater than that on beer, wine and spirits. Hot drinks, such as tea and coffee, as well as carbonated soft drinks, can yield gross margins of 90%.
Another highly profitable niche is the greetings card industry. Generally, cards command gross margins of at least 85%.
They are occasional, spontaneous, small-ticket purchases, invariably gifts for others — and the giver doesn’t want to be seen to penny pinch, so what’s an extra 50p? But when the production cost is a few pence, even including amortisation of the origination cost, it is obviously a highly profitable business.
No wonder one in six retailers stocks greetings cards, according to the Greeting Card Association. Britain has a long tradition of giving cards, and the industry grew in value by 5% to £1.7bn last year despite the growth of digital substitutes.
When it comes to clothing, lingerie offers the best margins. Women seem prepared to pay relatively more for bras and briefs than other items.
Victoria’s Secret, easily the market leader, enjoys operating margins of 17%, triple the average in the clothing industry. The company was founded in 1977 in Palo Alto by 30-year-old Roy Raymond. It caught on quickly with shoppers but failed to generate a profit, and he sold out to retail genius Leslie Wexner a few years later for just $1m. Wexner went on to build the business to revenues of more than $6bn (£5bn). Tragically, Raymond committed suicide by jumping from the Golden Gate Bridge in 1993 following bankruptcy and divorce.
Making and selling spectacles can be a spectacularly profitable trade.
The world leader in eyewear is Luxottica, which achieves gross margins of almost 70% on $10bn of annual revenue.
It owns lots of brands, including Ray-Ban, Oakley and Sunglass Hut, and licenses dozens of others.
Meanwhile, Specsavers is one of Britain’s most profitable private companies, run by Dame Mary Perkins and her husband Doug: their family wealth is calculated at £1.55bn by The Sunday Times Rich List. Prescription frames can enjoy mark-ups of 5 to 10 times, since even quality frames should cost no more than £10 wholesale and can retail for £100 or more. Of course, opticians have rent, staffing and other costs — and frequently throw in a free eye test as part of the package.
Another product that yields enormous returns is software, where the cost of goods sold is in effect nil once development costs are expensed. It should, therefore, be no surprise that Bill Gates is regularly named the world’s richest man, and Microsoft is one of the world’s most valuable companies.
High-end jewellery, which has the added advantage that the per item price can be very high, is extremely profitable. Tiffany enjoys gross margins of more than 60%.
Likewise, beauty items such as perfume and cosmetics have a high mark-up. I wonder if it is a coincidence that female luxuries such as lingerie, perfume, cosmetics and jewellery are so profitable. All these markets are pretty competitive, but somehow operators are able to maintain high prices. I suppose they are selling dreams.
Many makers of capital goods — such as vehicle, aircraft or machine manufacturers — generate modest margins on their main products, but enormous margins on spare parts. This business model enables them to sell more original equipment, then make returns over time from their installed base of users in the aftermarket.
High gross margins enable companies to survive tough times, but they can also make management complacent. As every entrepreneur should know, nothing lasts for ever.