The news has done a good job of highlighting the point that corporate profit margins are quite wide. Yet, the general uptrend in commodity prices caused many people to consider that margins would only narrow in coming quarters. While the recent pull-back in commodity prices should help ease those concerns, there remains much to the idea that margins will narrow, particularly if revenue slips from a reduction in consumer activity. Such a situation could also wreak havoc on stocks. One way to assume a defensive position in such a market is to focus on names that have plenty of cushion.
The great thing about profit margin improvement is that it allows for more top-line growth to enhance bottom-line performance. Through the financial crisis and recovery, companies slashed costs, and this has worked well to enhance margins, particularly as sales have edged higher. There are concerns that the US consumer may take a breather in coming months – take a look at the weakness in retail stocks on Friday.
In the event that maybe the US consumer does ease up a bit, and concern over the recovery adds more volatility to the market, there are several ways to defensively position your portfolio. One way is to look for companies that have plenty of cushion or wiggle room.
The concern here is profit margin narrowing, leading to stock-price deterioration. The first step, then, could be to focus on companies where profit margins have widened in recent years. Companies with wider profit margins have more wiggle room than companies with razor-thin profit margins. If, all else being equal, production costs increase, the company with the wider profit margins can take the hit better than the other.
To identify such a company, we can write a screen or filter to identify companies that have improved their profit margins in each of the last three years. Further, we want to make sure that the increase is relatively substantive, so we can focus on companies with gains of at least 10% in each of the last two years.
In this article Mr. Karsan pointed out the distortions that can be created by accounting differences across industries. For this reason, it is important to compare apples with apples. With that in mind, we are not going to compare operating margins across different industries. Instead, we will compare margins within the same industry. More precisely, we want companies that have an operating margin better than the industry median.
Next, we can shift gears a bit and look for companies that are already trading at attractive valuations. The idea here is that, if a stock is already a value play, then it shouldn’t fall as far as a stock that is overly valued if the markets get a bit jittery. Also, such companies arguably have more room to rise than their over-priced peers.
I am less concerned with what has already happened than I am with what will happen in the future. I want to see that the company will continue to generate earnings, so we can focus on companies where next year’s expected earnings are higher than this year’s expected earnings.
There are some caveats here. First, no one has a perfect crystal ball. The best thing we have is the best guess from the analysts who cover the companies. Also, equity analysts are often accused of looking at the world through rose-colored glasses. The reality may not necessarily live up to the expectation. Still, those analysts get paid to follow those companies, so they are going to know more about them than I will. In other words, their guess is probably better than mine, so I’m going to use their expectations for the future.
Next, we can use those earnings to calculate valuation ratios. Specifically, we look at the price to earnings (P/E) ratio based on this year’s earnings, and the P/E based on next year’s earnings. In both cases, we want P/E ratios that are less than the industry median.
Finally, we want to take into consideration analyst estimates for longer-term growth. Here we use a PEG ratio, which is the forward P/E ratio divided by the long-term growth rate.
Aren’t we already looking at forward P/E ratios? Yes. Aren’t we making sure that those forward P/E ratios are below the industry? Yes. But if the industry is significantly over-valued, we could have a stock that is trading just a touch lower than the industry, which means that it, too, could be over-valued.
There is nothing magical about the number that we assign. There are rules of thumb that one can follow (a number below 1.00 suggests a deep value play, a number above 2.00 indicates that a stock is a bit pricey, etc.). In this case, we split the difference and filter for companies with PEG ratios less than 1.50. If we wanted to be more conservative with valuation, we could choose a lower number; if we wanted to be more aggressive, we could go higher.
While this process does not make any guarantees about the future performance of these stocks, it does help me identify companies with the characteristics that, at this point, might be desirable if certain less-than-favorable conditions prevail in coming months, namely profit-margin compression. As always, it is important to do more research to make sure that any stock fits the risk-reward criteria of your portfolio.
When I ran this screen on Saturday night, it gave me a list of 24 companies. Here they are:
|#||Company (Ticker)||Last||Mkt Cap||PEG|
|1||Chinanet Online Holdings Inc. (CNET)||2.18||38.28||0.15|
|2||Continucare Corp (CNU)||4.54||275.26||0.96|
|3||America's Car-Mart, Inc. (CRMT)||24.07||255.22||0.67|
|4||Cirrus Logic, Inc. (CRUS)||15.95||1079.45||0.52|
|5||Dollar General Corp. (DG)||33.63||11485.38||0.82|
|6||Endeavour Silver Corp. (EXK)||8.83||732.49||0.04|
|7||The Finish Line, Inc.(FINL)||22.29||1202.18||0.90|
|8||Fortegra Financial Corp. (FRF)||9.70||198.95||0.72|
|9||iGATE Corporation (IGTE)||18.45||1041.54||1.06|
|10||Metropolitan Health Networks, Inc. (MDF)||4.67||191.94||0.72|
|11||Medidata Solutions, Inc. (MDSO)||23.00||558.11||1.07|
|12||Marvell Technology Group Ltd. (MRYL)||14.34||8766.3||0.58|
|13||The Pep Boys (PBY)||13.22||696.07||0.60|
|14||PSS World Medical, Inc. (PSSI)||28.93||1601.06||1.06|
|15||SciClone Pharmaceuticals, Inc. (SCLN)||5.73||324.16||0.43|
|16||Sirona Dental Systems, Inc. (SIRO)||53.86||3003.29||1.44|
|17||SLM Corp. (SLM)||16.34||8618.05||0.95|
|18||Constellation Brands, Inc. (STZ)||21.85||4656.91||0.96|
|19||Schweitzer-Mauduit International, Inc. (SWM)||49.41||866.69||0.56|
|20||The Timberland Company (TBL)||31.94||1653.51||1.16|
|21||Tech Data Corporation (TECD)||53.57||2494.61||0.96|
|22||TriMas Corp. (TRS)||21.35||731.4||0.79|
|23||Tupperware Brands Corp. (TUP)||62.47||3898.52||1.00|
|24||WMS Industries Inc. (WMS)||32.28||1848.15||1.06|
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.