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Fat profit margins put 5 stocks on 'buy' list

| Tuesday, Sept. 4, 2012, 12:16 a.m.

How do you know if a company has a “moat,” a formidable barrier against competitors? One way to tell is to look at the company's profit margins.

Fat margins are good. Fat and growing margins are even better.

Only 3 percent of U.S. companies can boast an operating profit margin of 20 percent or better and a five-year geometric growth rate in the operating profit margin of 10 percent or better. Operating profit is the profit from a company's normal business activities. It excludes interest, taxes and profits from selling subsidiaries or property. The operating profit margin is the operating profit as a percentage of the company's revenue.

Here are five companies that do meet that stringent test, and that I like as investments.

Pfizer Inc. (PFE), based in New York City, is the largest U.S. drug company by market value. I own it for a few clients, primarily those that want to emphasize dividend income. Its operating profit margin is 31 percent.

The litany of problems affecting big U.S. drug companies is well-known. It is getting harder to develop new drugs and get them approved. The public, insurance companies and the government are pressing for lower drug prices. Important patents are expiring – the so-called “patent cliff.” And hungry generic drug makers are trying to eat the majors' lunch.

Precisely because of those problems, the drug stocks sell for moderate prices, even though the companies are still quite profitable. Pfizer, for example, sells for about $24 a share, or 10 times earnings. At that price, it seems to me the stock is an appealing value.

Next, I repeat last year's recommendation of CF Industries Holdings Inc., a fertilizer manufacturer based in Deerfield, Ill. Though it is up 12 percent in the past year, it still sells for only eight times earnings. Its operating margin last year – admittedly a great year for fertilizer makers – was 45 percent.

Analysts expect 2012 to be even better than 2011, as farmers try to rebuild their crop yields after a drought-stricken summer. CF's record profit last year was $21.98 a share. This year, Wall Street expects $26.84.

NextEra Energy Inc. (NEE), which has its headquarters in Juno Beach, Florida, operates Florida Power & Light Co. and claims to be the largest producer of solar and wind energy in the United States. Its operating margin last year was more than 22 percent, and it has been increasing steadily for six years.

One thing I like about NextEra is that it views nuclear energy, along with solar and wind, as a “clean energy” source. I believe that people are so concerned about radiation and nuclear waste disposal that they underestimate the dangers associated with electricity generation from oil, natural gas and coal.

Fourth, I want to mention Intel Corp. (INTC), the largest U.S. semiconductor manufacturer. Based in Santa Clara, Calif., Intel achieved a 32 percent operating margin last year, and has raised its dividend every year beginning in 2003. Dividend increases are a sign that management believes earnings progress is sustainable.

I own Intel shares for almost all of my clients. They provide a 3.6 percent yield, and sell for 10 times earnings. In the past five years, defying a harsh environment, the company has shown 21 percent annual earnings growth.

Fifth and finally, I see value in Marathon Oil Corp. (MRO) of Houston, which boasts an operating margin of almost 31 percent. Marathon spun off its refining operations last year to Marathon Petroleum Corp. (MPC), which is based in Findlay, Ohio. The refining business was the larger part of Marathon, but the exploration and production business has better profit margins most years.

Marathon Oil explores for and produces oil and natural gas, primarily in the United States, Norway and Canada. It has been consistently profitable, but has struggled to find growth. In my opinion, the stock's current price of about $28 reflects the company's problems, while failing to fully reflect its potential. The shares sell for just 1.1 times book value (corporate net worth per share).

This column is the third I've done on the subject of stocks with fat and widening profit margins. The record to date is mixed. The September 2009 crop was successful, rising 35 percent compared with a gain of 9 percent for the S&P 500. Gains in Terra Industries Inc. (TRA, up 67 percent) and McDonald's Corp. (MCD, up 41 percent) propelled the performance.

The September 2011 recommendations, however, flopped. Collectively, they fell 5.7 percent while the S&P 500 rose 23 percent. Two stocks did particularly badly. Leucadia National Corp. (LUK), which I owned for clients, dropped 21 percent, and Marvell Technology Group Ltd. (MRVL) fell 20 percent.

John Dorfman is chairman of Thunderstorm Capital LLC in Boston. His firm or its clients may own or trade securities discussed in this column. He can be reached at jdorfman@thunderstormcapital.com or 617-542-8888.

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