Wary of taking fliers on untested companies? A smarter -- and safer -- way to go is to find outfits with healthy profit margins year in and year out. Such companies have shown they can make money in good times and bad -- whether they have the latest technology or simply a lock on their industries or market niches that competitors can't touch.
You find such moneymakers in all sorts of businesses, from high tech to drugs. At BusinessWeek's request, Zacks Investment Research Inc. of Chicago ranked the top performers of the Standard & Poor's 500-stock index (MHP) by their net operating margin -- aftertax income, without unusual items, divided by sales. BW then culled the list to take out those that face humbling challenges, such as drugmaker Merck & Co. (MRK), which is reeling from the Vioxx fallout and uncertainty about management succession. We also nixed companies that, on a margin basis, are difficult to compare to others, such as banks. We were particularly interested in finding those that have shown their margin power over the past five years, a boom-and-bust time that would test any management's skills.
The result is a group of All- Stars that, though rarely cheap, are proven winners. Though many are fully priced today, these high performers are likely to continue to be big gainers over time.
Look at Linear Technology Corp. (LLTC). It's a small player in the giant chip business, with less than $1 billion in annual sales. But the 23-year-old Milpitas (Calif.) company churns out chips used in such hot areas as cell phones and notebook computers. Its products are so coveted that Linear Tech has averaged a better-than-40% net operating margin for the past five years, nearly twice that of its far bigger rival, Intel Corp. (INTC). "They make gobs of money," says David Wu, semiconductor analyst for Wedbush Morgan Securities in Los Angeles. "That's the most special thing about them."
Demand should be brisk through 2005 for many of the customers Linear Tech serves. That's why Wu believes the company will show 19% hikes in both net earnings and sales -- to $390 million and $963 million, respectively -- for the fiscal year ending in June. With Linear Tech's stock about $7 off its January, 2004, high of $45, such growth rates could spell a healthy gain for investors.
Adverse news -- especially when it hits a whole sector -- can be a positive for those seeking to invest in companies with profit power. Caught in the industrywide downdraft from Merck's problems with Vioxx, Pfizer Inc. (PFE) has lost about $11 a share so far this year and now trades at just $27. Pfizer markets a similar drug, Bextra, but the Food & Drug Administration has said it is satisfied that Bextra is safe when properly used. Pfizer sells a broad array of other products that nobody questions. So bulls on Pfizer insist the company's low valuation is ludicrous, especially given its impressive 30.4% operating margin. "Pfizer has continued to deliver," says Deutsche Bank Securities Inc. (DB) analyst Barbara A. Ryan. "The stock is exceptionally cheap."
Indeed, patient investors who stick with big-margin companies have seen healthy payoffs. Qualcomm Inc. (QCOM) has steadily climbed from below $15 a share in early 2003 to around $43 now. The company, thriving on shifts around the world to its CDMA type of cell-phone technology, has plenty of room to grow. Analysts at the National City Private Client Group, the wealth-management arm of the National City Corp. (NCC) banking company, figure the stock is worth at least an additional $5 a share -- and they've been bullish on it for years. The group's research director, Mary Jane Matts, says Qualcomm's technology offers a "significant competitive advantage."
Of course, high valuations can test any investor's mettle. Shares of mutual-fund company T. Rowe Price Group (TROW) have climbed from about $48 to over $60 a share this year. T. Rowe Price has sharply outperformed rivals, especially those tainted in market-timing and other scandals uncovered by New York Attorney General Eliot Spitzer and other investigators. In fact, some analysts think the $1.3 billion-a-year company has become too pricey, even if assets under management grow by an expected 17% next year. Still, Friedman Billings Ramsey & Co. analyst Matthew J. Snowling calls the company "among the most reliable," adding that it consistently turns in a "best-of-breed performance." That means there's still room for the fund company's shares to run.
Usually, companies that deliver the best results for shareholders are those that offer customers something unique or dominate their markets. Retaining dominance is tough, and it requires spending big money. Case in point: Oracle Corp., the world leader in corporate database products, plans to spend $10.3 billion to buy PeopleSoft, the No. 2 player in enterprise software. That will give Oracle, now No. 3 in enterprise software, more clout with its customers. "It was a long, protracted, and acrimonious battle," says S&P equity analyst Jonathan Rudy, referring to the 18 months Oracle spent trying to seal the deal. "It ended pretty well."
Wall Street, expecting Oracle to prevail, has bid up its stock from below $10 a share in September to above $14 now. Even so, says Rudy, there are more gains left as Oracle brings PeopleSoft into its fold.
Investors who opt for some high-margin producers may feel their patience tried because the stocks are already fully-priced. EBay Inc. (EBAY) has a net operating margin so far this year of more than 25%, well above its 18.6% five-year average. At about $114 a share now, the online auctioneer's stock has more than doubled in the past year, and further big gains in price could be at least 18 months to two years away. "The investor who buys eBay has to be willing to hold for the long term," says CIBC World Markets analyst Paul Keung.
While there's power in enduring profitability, high-margin producers aren't immune to market downturns, and nasty surprises can throw them off course -- and possibly into Wall Street's dog house. But for the most part, their solid track records show these companies are consistent performers with managers that know how to keep their engine humming. That's a sound investors love to hear.
By Joseph Weber