This week's calendar of economic data has been thin but the highlights - jobs claims and wholesale inventories on Thursday, productivity a day earlier and a strong reading on the services sector to kick off the week -- have pointed to a relatively healthy economy. The productivity figures were particularly surprising, rising 3 percent in the fourth quarter. But the numbers also raised some questions and sent us looking for companies with superior profit margins.
In a typical "nothing is ever as good as it sounds" scenario, the productivity rise in the fourth quarter marked a reversal from the third quarter's deterioration, but the 2.1 percent gain for all of 2006 was still the smallest improvement since 1997. Further, there is concern that the latest productivity figures will be revised lower down the road, as a result of higher employment growth.
The key aspect of improved productivity is workers' ability to make relatively more with fewer resources. From a corporate perspective, enhanced productivity should widen profit margins, and allow more revenue to turn into income. That said, potential downward revision in productivity suggests that companies might have faced a more difficult time widening their profit margins recently than first thought given the tepid gain in 2006. In our search to identify companies that have fared relatively well given these macro factors, our search criteria focused on profit margins and earnings growth.
We started off with the list of 499 stocks that recently registered on at least one Reuters Select stock screen. We then looked for companies with operating, pre-tax and net profit margins that were at least 10 percent better than the averages for their respective industries over both the trailing 12 months [TTM] and last five years. This dropped the list down to 121 companies. (Click here for an Excel sheet comparing these 499 companies.)
It is not enough for a company to have superior margins; the company should also be improving over time, regardless of what the broader industry-wide trend might be. As such, we also filtered for companies where the TTM margins are at least 10 percent better than their own five-year averages. This left us with 78 companies.
We then turned our attention to earnings growth. We filtered for companies where earnings per share [EPS] growth surpassed the industry average by at least 25 percent over the TTM and five-year periods. At this point, we were left with 23 names.
Given the significant improvement in productivity recently, we also looked at EPS growth in the most recent quarter and required that a company must outpace the industry norm, also by at least 25 percent. Seventeen companies remained.
Here, too, we want to see some improvement over time. So, we filtered for companies where the TTM EPS growth rate surpassed the company's own five-year rate by at least 25 percent. We then zeroed in on the companies where the EPS growth rate in the most recent quarter was at least 25 percent faster than their TTM pace. This left us with four companies.
Yet, we don't want companies where non-recurring events might push margins to extraordinarily high levels, so we omitted any company with operating margins in excess of 100 percent. This dropped the list down to three: Consolidated Graphics, Inc. (NYSE:CGX), Lan Airlines, S.A. (NYSE:LFL), and Philadelphia Consolidated Holding Corp. (PHLY).
Given that the Reuters Select Strong Operating Margins stock screen is designed to find companies with superior profit margins, it is not surprising to find that these three companies on our list also landed on this screen. However, one company, Consolidated Graphics, Inc. (CGX) also appeared on the screen for Favored Value Plays.
The Strong Operating Margins screen requires that company's have operating profit margins that are better than the averages for their respective industries over the TTM and five-year periods. It, too, requires improvement over time, highlighting companies with TTM operating margins that are at least 25 percent better than their own five-year averages.
This is a reasonable starting point for further research. Some investors might want to now turn to the balance sheet and inspect debt levels, while others might want to look at revenue growth. Others, yet, might want to focus on valuation. That is the direction we took.
It is not unusual for companies with industry-leading figures to also command premium valuations, and this is a key area that differentiates Consolidated Graphics from Lan Airlines and Philadelphia Consolidated. As indicated below, Consolidated Graphics is the only one of the three that has price to earnings [P/E] and P/Sales ratios that are below the averages for its industry
While its below-average price tag helped Consolidated Graphics score on the Favored Value Plays screen, it is only part of the story. This screen also requires that the analysts following a stock have grown more bullish on it recently.
Using an index where a buy recommendation receives a score of 1.00 and extends to a sell recommendation receiving a score of 5.00, the screen requires that a stock have an average score less than 2.00. Since we don't want to catch companies that are in the process of being downgraded, the screen also requires that the average rating must be less than or equal to where it stood four weeks ago. At present, Consolidated Graphics' mean score is 1.50, the same as it was a month back. By comparison, the average score on Lan Airlines is 2.00, also unchanged from a month ago. And Philadelphia Consolidated has an average rating of 2.83, which is also the same as its reading four weeks prior.
Disclosure: At the time of publication, Erik Dellith did not directly own shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
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