Stock Market Rewards Efficiency
Suppose your friend visits a new restaurant. If you ask her about the meal, she may regale you with tales of coq au vin and bananas Foster. But to learn whether the meal came with green beans rather than asparagus, you may have to dig a little, because veggies often fail to capture our attention.
On investors' analysis menu, efficiency metrics are the vegetables. And at least over the last year, the stock market has paid investors to eat their veggies.
Growth is the meat, the centerpiece of the plate. Most investors pay attention to growth because it affects a stock's operating strength. Value is more like the dessert, determining whether the price is sweet enough. But if you want to determine whether the meal is good for you, check the efficiency statistics.
Taken by themselves, efficiency metrics haven't historically been effective at identifying stocks that outperform. In 12-month periods since the end of 1992, only one stat, asset turnover trend, has seen top scorers in Quadrix outperform the average stock by an average of more than 1%.
But when we focused on the last dozen rolling 12-month periods, the picture changed. The top one-fifth of stocks based on cash conversion trend and returns on investment, assets, and equity all outperformed the average stock in the index by at least 1.7%.
Gross profitability (trailing 12-month gross profit divided by average total assets) did even better, though we aren't as confident in its 4.1% outperformance because we just started using the metric in November 2013 and only have nine data points for 12-month returns.
We don't advise readers to purchase a stock simply because a company operates efficiently. Plenty of companies with little growth operate efficiently yet make for horrid investments. Growth and value are still crucial. But before you dig into that savory entrÃ©e or scrumptious dessert, take time to check out the vegetables. They'll do your portfolio good.
Higher margins not always encouraging
Over the last five years, the S&P 500 Index's gross and operating profit margins have ebbed and flowed in a fairly tight range, as shown above. Profitability topped that from the previous five years, a period that featured more recession-driven volatility.
Margins posted a sharp rebound from recessional troughs, a trend typical after such periods, as profits tend to rise or fall more abruptly than sales.
The index's operating margins peaked in 2006, while gross margins reached 39.7% back in 1994 (our data only goes back to 1993). Operating profits have pulled back from midyear 2014 levels while gross margins have remained steady, but both remain well below historical highs.
Trends from the last few years suggest it will probably take a shift in the business climate or widespread technological change to drive sustainable margin growth going forward.
With all this in mind, the table below lists 11 A-rated stocks with solid growth or value (as measured by Quadrix Momentum and Value scores) and ranks above 60 in at least six of the seven efficiency metrics that have worked best in recent months. Three are reviewed below:
In the 12 months ended June, Goodyear Tire & Rubber ($31; GT) earned a 26.7% return on investment, up from 6.3% a year earlier. For the same period, operating profit margins rose to 13.7% from 11.7%. Other variants of returns and profit margins saw similar improvement, and Goodyear earns the highest return on assets, investment, and equity of any auto-components stock in the S&P 1500 Index.
Declines in the price of rubber and other raw materials deserve credit for much of the surge in profitability. However, Goodyear has also helped itself via aggressive cost controls. Shifting more of its manufacturing to low-cost Asian markets should also enhance Goodyear's margins and returns. While raw-materials prices could rising going forward, analysts expect profitability to keep improving; the 2016 consensus projects per-share-profit growth of 23% on just 1% higher sales. Goodyear is a Long-Term Buy.
Skyworks Solutions ($90; SWKS) has increased its efficiency the old-fashioned way — growing so fast that it creates its own economies of scale. Over the last year, Skyworks' sales rose 51% and per-share profits 102%. Over the last three years, sales rose at an annualized rate of 26%, while profits expanded at a 49% annual clip. During the 12 months ended June, Skyworks posted returns of 23.7% on assets and 27.5% on equity, up from 15.0% and 16.7% respectively in the year-earlier period.
The semiconductor maker sells smartphone components to Apple ($115; AAPL) but also supplies a host of products designed to wirelessly connect devices ranging from automobiles to medical equipment to defense systems. Skyworks shares have fallen in recent days, most likely hurt by the connection to Apple, which is reportedly losing smartphone market share in China. However, profit estimates rose in the wake of strong June-quarter results, and the consensus projects per-share-profit growth of 35% in the September quarter and 18% in the year ending September 2016. Skyworks, which doubled its dividend in June and now yields 1.2%, is a Buy and a Long-Term Buy.
As investors, we must understand that there are many ways to measure efficiency. Sure, Southwest Airlines ($39; LUV) earns Quadrix scores above 80 in return on assets, investment, and equity. Both returns and profit margins have climbed steadily over the last two years. But a more granular look at the airline reveals other signs of efficiency.
Airline capacity (available seat miles) is jumping industrywide, and while traffic is also on the rise, load factors (revenue passenger miles as a percentage of available seat miles) have been falling. However, while Southwest boosted its capacity 7.0% in July, traffic rose 8.2%. The airline's load factor rose to a record 87.7%. Year-to-date, Southwest's load factor rose to 83.3% from 82.5% in the same period a year earlier, one of only two airlines in the S&P 1500 to grow traffic more than capacity this year. Southwest is a Buy and a Long-Term Buy.