Bulk up portfolios by targeting fat profit margins
It's been a while since I've heard the phrase “obscene profits” bandied about. It's a pejorative, of course. But maybe investors should look at fat profit margins as a good thing.
The profit margin is simply a company's profit (either pretax or after tax) as a percentage of its revenue. Fat margins can be a sign that a company has an extraordinarily good product or service, that it has little competition, or that it has its competition on the run.
All of that can, of course change. But finding a company with a competitive edge is half the battle in investing. (The rest is not paying too much.) This week, I call to your attention five companies that can boast fat and widening margins.
Johnson & Johnson
I've always admired the coherent yet decentralized approach Johnson & Johnson uses for its health care empire. Each of its approximately 250 subsidiaries is a separate profit center and enjoys some independence. Yet collectively, the company covers almost every niche in health care.
J&J's pretax margin was 29 percent last year and its net margin (after tax) was 23 percent. Both figures have been on the rise in the past few years.
Based in Santa Clara, California, Applied Materials Inc. (AMAT) makes a wide variety of equipment used to manufacture semiconductor chips. The company's sales, earnings, and profit margin have been erratic over the past decade, but have strengthened a lot lately.
In the 12 months through July, revenue is up 31 percent compared to the fiscal 2016 level, profits are up 82 percent, and the net profit margin has widened to 22 percent. At 15 times earnings, the stock seems to me reasonably priced compared to most technology stocks.
An outstanding dividend play is Getty Realty Corp. (GTY) of Jericho, New York. It owns the land and buildings for about 1,000 gas stations, many with associated convenience stores, and about three-quarters of them Getty stations.
As a real estate investment trust, Getty Realty must pay out at least 90 percent of its earnings in the form of dividends. It current affords a yield just under 4 percent. It net profit margin in the past four quarters was 36 percent.
A year ago, I recommended Amerisafe Inc. (AMSF) in this space, and it has declined about 1 percent since then. But its profit margins remain unusually high, recently about 25 percent pretax and 17 percent after tax.
The company, based in Deridder, Louisiana, sells workers compensation insurance to small and medium-sized companies in hazardous industries such as logging, trucking and construction. It is having a disappointing year this year, which is why the stock sells for 16 times earnings in a market that averages 21.
Chase Corp., based in Bridgewater, Mass., manufactures protective coatings and various kinds of tape. Over the years, its profitability hasn't been extraordinary, but it has accelerated recently. Net margins were about 17 percent in the four fiscal quarters through May, and 18 percent in the May quarter.
Granted, I'm a sucker for companies in unglamorous industries. But I think this one may be timely.
To be considered for this week's column, a company had to pass some tough tests: A pretax profit margin of 20 percent or better.
An after-tax margin of 15 percent or better. That is, 15 cents out of every dollar of sales flow to the bottom line as profit.
Margins are not only fat, but widening, having grown at a 10 percent clip or better the past five years.
Debt is no more than 75 percent of stockholders' equity.
Of the more-than 4,000 U.S.-traded stocks with a market value of $250 million or more, only 59 stocks passed these tests.
This is the seventh column I've written on companies with fat and widening profit margins. The average 12-month total return from the first six columns has been 22.5 percent, compared to 15.6 percent for the Standard & Poor's 500 Index.
My recommendations were profitable in six of the seven years. However, they beat the S&P 500 only two times out of seven. The strong average return owed a lot to one great year in 2014-15.
Last year's picks gained 13.2 percent, two strides behind the S&P 500 at 15.6 percent. Electronic Arts Inc. (EA) and Reynolds American Inc. (RAI) each gained more than 30 percent. But small losses in Mondelez International Inc. (MDLZ) and Amerisafe Inc. (AMSF) pulled down my average.
Disclosure: Almost all of my clients own Applied Materials, and I own it personally. A few clients own Johnson & Johnson.
John Dorfman is chairman of Dorfman Value Investments LLC in Newton Upper Falls, Massachusetts, and a syndicated columnist. His firm or clients may own or trade securities discussed in this column. He can be reached at firstname.lastname@example.org.