Fat Profit Margins can be Sign of Great Stock
Posted: September 06, 2016
How good is a company’s profit margin? And is it growing or shrinking?
Many investors don’t pay much attention to profit margins. They are obsessed with how fast earnings are growing, or whether a company is in a trendy business.
Yet fat and widening margins can be a sign of a great stock. This weekend I combed through the Ned David Research database for U.S. stocks that met four criteria:
• A pretax profit margin of 20 percent or better in the past four quarters.
• A net (after-tax) profit margin of 15 percent or better.
• A five-year average of 10 percent or more on the net profit margin.
• Debt no more than 75 percent of stockholders’ equity.
Fewer than three dozen stocks met those tough criteria. I’ve selected five to recommend here.
Mondelez International
Mondelez International Inc. (MDLZ), formerly known as Kraft Foods, spun off many of Kraft’s operations in 2012. What remains is a powerhouse in candy, snack foods and beverages. Brands include Nabisco, Cadbury and Oreo. Sales run about $26 billion a year.
Since the spinoff, Mondelez has been highly profitable. Its net margin was about 28 percent in the past four quarters.
The company failed in its recent efforts to acquire Hershey Co., which would have been quite a coup. But even without Hershey, it looks to me like a company likely to show continued success.
Reynolds American
If you don’t have ethical objections to tobacco stocks, Reynolds American Inc. (RAI) deserves a look. It has shown a profit for 12 years in a row, and despite high taxes on cigarettes, its profits have been increasing. Its net margin last year was 30 percent, and it has been above 12 percent ever since 2005.
Reynolds has about a third of the U.S. cigarette market, with brands including Camel, Newport and Pall Mall. In a time when bank accounts and bonds have skimpy yields, this stock yields about 3 percent.
Amerisafe
Based in DeRidder, La., Amerisafe Inc. (AMSF) writes workers compensation insurance policies. It specializes in hazardous occupations such as construction and logging.
Although it has been around for three decades, Amerisafe attracts little press coverage and is covered by only four Wall Street analysts, none of them from big well-known firms. Its net profit margin waxes and wanes, but has been waxing since 2011 and passed 20 percent in the past 12 months.
Baidu
Baidu Inc. of Beijing (traded as BIDU in the United States) is an Internet search company. Its revenue has grown from $40 million a decade ago to well over $10 billion today.
Its net profit margin has been more than 30 percent ever since 2006 and was running about 45 percent recently. From 2008 to late 2014, the stock increased 20-fold to about $250. Today it’s at $177 — not cheap but worthy of consideration.
Electronic Arts
If the following games are not familiar to you, check with your kids: Battlefield, Dragon Age, FIFA, Madden NFL, Mass Effect, Need for Speed, Plants vs. Zombies, Star Wars, the Sims and Titanfall.
The maker of all these games is Electronic Arts Inc. (EA) of Redwood City, Calif. Yes, it’s an industry prone to fads. But Electronic Arts has been an industry leader for years now and has achieved an impressive net profit margin in its past two fiscal years. Recently, the margin was about 26 percent.
For the record
The column you’re reading is the seventh I’ve written on stocks with fat profit margins. The average 12-month gain on the previous six columns was 24.1 percent. That compares nicely with 15.6 percent on the Standard & Poor’s 500 Index.
But my record is not quite as good as it looks. The big gains came mostly in one year, 2014-15. And the great performance that year was mostly because of one stock, Anacor Pharmaceuticals Inc. (ANAC), which rose 481 percent.
My recommendations have been profitable five years out of six but have beaten the S&P 500 only two years out of six. Last year they scored a 14.3 percent total return, while the S&P 500 returned 16.0 percent including dividends.
My best pick was Corning Inc. (GLW), up 39.6 percent. BlackRock Inc. (BLK) also did well, returning 29.7 percent. Chemtura Corp. and PacWest Bancorp were up, but less than the index.
My worst pick, which I owned for clients during part of the year, was Gilead Sciences Inc. (GILD), down 22.3 percent. I still like the company but don’t currently own the stock because I worry that biotechnology companies won’t be able to command the handsome prices for their drugs in the next few years that they did in the past few.
Disclosure: One of my family members owns shares in Electronic Arts.