Fat Profits At Thin Prices
Successful investing often hinges on finding the unusual, stocks with characteristics that separate them from the rest. Today we're looking for two strengths that don't always go together — high profitability and low valuations.
As of April 29, eight of the 10 sectors of the S&P 1500 Index traded at a premium to their five-year average price/earnings ratio. Seven of 10 had gross profitability ratios (trailing 12-month gross profit divided by average total assets) below their five-year average.
Many worry that corporate profit margins have risen to unsustainable levels. Pprofit margins, which measure profits as a percentage of sales, are higher than long-run averages. But gross profitability, which measures how much profit companies squeeze out of their assets, tells a different story.
Gross profitability trends suggest corporate America still has room for improvement. The S&P 1500 Index's gross profitability ratio was 13.1% for the year ended December, above the five-year average of 12.7% but down from the three-year average of 13.2% and the average of 13.6% since 1995. Fewer than half of S&P 1500 companies have higher gross profitability today than their five-year average.
We added gross profitability to our Quadrix system as a component of the Quality score because it provides a fresh viewpoint. Profit margins measure earnings relative to sales, which tend to be more volatile than assets. Quadrix also considers returns on assets (ROA), equity (ROE), and investment (ROI), which compare profits to balance-sheet metrics but use net income, not the cleaner gross profit number.
All else equal, we prefer companies with high and rising profitability along with valuations below historical and industry norms. Only 357 S&P 1500 Index stocks have a trailing 12-month gross profitability ratio above their five-year average and industry average, while only 375 trade at a discount to their five-year average P/E ratio as well as the industry average. When we cross-checked the stocks for those that satisfy all four criteria, we were left with just 72. Check them out at
The table below lists 11 A-rated stocks that compare favorably to their industries and their own history based on gross profitability and price/earnings ratio. Five intriguing selections are reviewed in the following paragraphs.
At 13 times expected 2014 earnings, DirecTV ($77; DTV) trades at a 30% discount to the median broadcaster in the S&P 1500. The satellite-TV provider's price/sales and price/operating cash flow ratios are also at least 34% below the peer group. Given the valuation ratios, DirecTV's Quadrix Value score of 91 should not surprise us. However, the stock also earns a Performance score of 82, helped by total returns of 11% so far this year and 34% over the last 12 months.
DirecTV's gross profitability ratio reached 71.6% in the last year, above the five-year average of 66.1% and nearly double the industry average of 38.0%. Analysts project per-share-profit gains of 16% this year and 14% next year, the type of growth that should keep gross profitability rising. DirecTV is a Focus List Buy and a Long-Term Buy.
The average diversified bank generates gross profits equal to 4.4% of total assets. In such a low-profitability environment, incremental gains can make a huge difference. U.S. Bancorp ($41; USB) managed a gross profitability ratio of 5.0% over the last four quarters, second-highest in the diversified-bank industry and above its own five-year average of 4.7%.
In the 12 months ended March, U.S. Bancorp returned 70% of its earnings to investors in the form of share buybacks and dividends, a trend likely to continue. The stock yields 2.3%, and its share count has fallen 2% over the last year and 5% over the last three. U.S. Bancorp trades at 13 times trailing earnings, 15% below both the median bank and its own five-year average P/E ratio. U.S. Bancorp is a Long-Term Buy.
When it comes to profitability, Wells Fargo ($49; WFC) stands out from the pack. The financial giant is the only diversified bank in the S&P 1500 with a higher gross profitability ratio (5.4%) than U.S. Bancorp. While Wells Fargo's gross profitability ratio is only marginally above its five-year average, its gross and operating profit margins and return on equity and assets are well above historical norms and trending higher.Â
Despite Wells Fargo's market leadership, profitability, and strong per-share-profit growth (10% over the last 12 months and 14% annualized over the last three year), the shares trade at less than 13 times trailing earnings, 4% below the median diversified bank and 21% below the median for the broader banking industry. The consensus calls for 5% profit growth this year and next year, and the company should be able to meet or exceed analyst targets. Wells Fargo, yielding 2.4%, is a Focus List Buy and a Long-Term Buy.
Two telecom giants — AT&T ($35; T) and Verizon Communications ($47; VZ) — satisfied our gross profitability and value screen. Neither makes our buy lists, but both earn A (above average) ratings on our Monitored List. The stocks' Quadrix Overall scores rose this year, powered in large part by massive one-time profit gains that boosted Momentum and Quality scores. In the 12 months ended March, AT&T's per-share profits nearly tripled, while Verizon's jumped more than fivefold. Such robust growth can't help but improve profitability measurements. In the year ended March, AT&T had a gross profitability ratio of 28.0% while Verizon managed 30.9%, both well above the average of 24.8% for integrated telecoms.
AT&T trades at 10 times trailing earnings, well below the industry average of 24 and its five-year average of 18. Verizon's trailing P/E of 16 also compares favorably to both the industry average and its own five-year norm of 28.
Since the big telecoms earn solid Quadrix scores and also satisfy our profitability and value screen, why don't we recommend them for purchase? Mostly because the future isn't clear. AT&T and Verizon face stiff competition from both traditional telecoms and broadcasters muscling into the field. Weak revenue growth and questionable pricing power reduce our confidence in the growth potential of the telecom sector as a whole, and AT&T and Verizon in particular.