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Investment adviser's winning streak snapped at 7

| Tuesday, June 18, 2013, 12:01 a.m.

Well, seven out of eight isn't bad.

I like to look for companies with high profits and low debt. In my opinion, such companies are likely to do well both when the markets are sunny, and when they pelt investors with hail.

Eight times beginning in October 2000 I have written columns about high-profit, low-debt stocks. Based on 12-month total returns, my selections had seven consecutive wins over the Standard & Poor's 500 Index through last June.

That streak has now snapped. Last year's selections returned 17.5 percent (including reinvested dividends) from June 19, 2012, through June 14, 2013. The S&P 500 did better, up 22.5 percent.

For this series of articles, I look for companies with a return on stockholders' equity (profits as a percentage of corporate net worth) of 25 percent or better. This year, only 9 percent of U.S. companies with a market value of $250 million or more met that standard.

Profits are a key measure of corporate success, but I think many investors look at them through the wrong lens. They focus solely or mainly on the rate at which profits are growing. That's important, but in my opinion, it's equally important to look at how profitable a company is, as measured by profit margins and return on stockholders' equity.

Profitability tends to be more stable than the earnings growth rate, which can jump around wildly from year to year.

Low debt gives a company strategic flexibility. A low-debt company can acquire troubled competitors, can ride out hard times without selling off valuable assets in a fire sale, and can breathe easier than high-debt competitors if interest rates rise. In this series, I look for companies with debt less than 10 percent of stockholders' equity.

My best performer in this paradigm last year was Buckle Inc. (BKE), a maker of clothes, wallets and shoes, which was up more than 59 percent. That was a quicker up-move than I expected, and I wouldn't chase Buckle at the current price of $54.

Power-One Inc. (PWER), which makes devices to convert solar power from direct current to alternating current, returned 38 percent.

The largest of the four stocks I chose, Exxon Mobil Corp. (XOM), had a mediocre return, 10 percent.

Dragging down the results, Spectrum Pharmaceuticals Inc. (SPPI) fell 38 percent. Its main drug, a cancer medication called Fusilev, isnt selling as expected. I think Spectrum will do okay, but it no longer meets the selection criteria for this series. In eight outings, my high-profit, low-debt recommendations have achieved an average 12-month total return (including reinvested dividends) of 21.8 percent, against 5.6 percent for the S&P 500.

I apologize that in writing about this topic last year, I inadvertently omitted the results from a 2004 column. Those results, which are now included, don't materially change the picture.

The high-profit, low-debt picks have been profitable seven years out of eight. The 2001 selections lost money, but their loss was less severe than that of the S&P.

Bear in mind that column recommendations shouldn't be confused with the performance of actual portfolios I run for clients. Results for column selections are theoretical and don't reflect trading costs or taxes. And past performance doesn't predict future results.

Here are four new stocks I like from this paradigm.

Cirrus Logic Inc. (CRUS), a chip maker that is the largest supplier of audio chips to Apple Inc., posted a return on equity of 27 percent last fiscal year, and has no debt. People are worried that sales of Apple products may be slowing down. But with Cirrus stock at nine times earnings, I think the odds favor the investor.

Terra Nitrogen Co. LP (TNH), based in Deerfield, Ill., makes fertilizer. It is 75 percent controlled by CF Industries Holdings Inc., one of the world's largest fertilizer companies.

Terra Nitrogen has been profitable nine years in a row, with record profits last year.

Leapfrog Enterprises Inc. (LF), from Emeryville, Calif., makes educational software, including educational games. It sustained five losses in six years from 2004 to 2009, but has been profitable since then.

It is debt-free and posted a 33 percent return on equity last year. This year will not be as good, but at 10 times earnings it looks attractive to me.

I'll close by re-recommending Exxon Mobil Corp. (XOM). The largest U.S. oil company trailed the market in the past 12 months but seems to me a solid value. I used to own it for most of my clients, but currently own it only in the more conservative accounts.

John Dorfman is chairman of Thunderstorm Capital LLC in Boston. He can be reached at jdorfman@thunderstormcapital.com.

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