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America's Most Profitable Companies Share This 1 Key Trait

Monday, December 02, 2013 2:30 PM

What do Ray Kroc and Jack Welch have in common? Both of these men ran very different businesses, McDonalds (NYSE: MCD) and General Electric (NYSE: GE), respectively, yet they repeatedly hammered home the most important lesson for their management teams.

"Market share is everything."

It holds the key to great financial results, which can provide the capital for yet more growth. Or as Jack Welch once put it, if you aren't going to dominate your niche, then don't even bother.

He was likely inspired by a 1975 study in the Harvard Business Review that found that "as market share increases, a business is likely to have a higher profit margin, a declining purchases-to-sales ratio, a decline in marketing costs as a percentage of sales, higher quality, and higher-priced products."

Need proof? Simply look at the hamburger chains. According to QSR (quick-service restaurant) magazine, McDonald's had as much domestic market share in 2010 as Burger King (NYSE: BKW), Wendy's (Nasdaq: WEN), Sonic (Nasdaq: SONC), Jack in the Box (Nasdaq: JACK), and the next seven burger sellers -- combined.

And look at what that meant for Mickey D's profit margins in 2012.

And great margins invariably translate into prodigious free cash flow. Mickey D's typically generates around $4 billion in free cash flow every year, and consensus forecasts see that hitting $5 billion by 2015.

Perhaps the most ruthless pursuer of market share in the past decade has been Starbucks (Nasdaq: SBUX), which was the subject of a recent profile by my colleague Marshall Hargrave. Marshall lays out the coffee purveyor's current moves that will help maintain global market share -- and profit margins -- and set the stage for ever-higher profits.

Of course you can't simply focus on market share while ignoring the market itself. For example, Intel (Nasdaq: INTC) has an overwhelmingly dominant share of the microprocessor market, but that market has stopped growing in recent years.

So Intel is set to roll out a new chip called Quark. The chip is one-fifth the size of Intel's current smallest chip, the Atom, and uses one-tenth of the power. That could help Intel to establish dominance in the market for smaller chips, which has been under the grip of industry upstart ARM Holdings (Nasdaq: ARMH). Simply put, if Intel eventually establishes market dominance in the market for small chips used in mobile devices, then its stock will soar.

Other companies with established market dominance:

1. Adobe (Nasdaq: ADBE)​
You likely use this company's products every day: when you download a PDF (Acrobat) or watch a Web-based video or visit a website with flashy graphics (Flash). And many tech designers use Adobe's suites of software products. Other companies have tried to steal Adobe's market share, without success. "Strong user loyalty and product upgrades position ADBE well to command a large share in its end markets," note analysts at Merrill Lynch.

Adobe's operating margins routinely exceed 25%, which has led to steadily rising free cash flow. Merrill Lynch sees that metric reaching a record $1.5 billion by 2015.​

2. Schlumberger (NYSE: SLB)​
You can really see the relationship between market share and profit margins in the oil services industry. Industry leader Schlumberger has been able to cobble together the deepest and most well-respected set of products and services for its oil and gas driller client base, enabling it to generate firm pricing and solid economies of scale. Indeed the smaller you get in this industry, the worse the financial profile.


I've heard several fund managers say that if you are bullish on oil services, you may as well own Schlumberger. There's no reason to go with second-best in this industry.​

3. Applied Materials (Nasdaq: AMAT)​
Thanks to a combination of organic growth and savvy acquisitions, this chip equipment giant is simply pulling away from the field. Its $9 billion to $10 billion sales base is larger than that of its two closest rivals, Lam Research (Nasdaq: LRCX) and KLA-Tencor (Nasdaq: KLAC), put together. And it's no coincidence that Applied Materials' $4.2 billion in cumulative free cash flow generation over the past three years also puts its rivals to shame.

Yet you can still identify niches within industries where market leadership can be established. I recently noted that Axcelis Technologies (Nasdaq: ACLS), which toils in the shadows of Applied Materials and its bigger rivals, is hoping to take major market share in the ion implant market. It's a niche, but potentially a profitable one, proving that even when looking at entire industries, you should look for opportunities in subsets of those industries.

Risks to Consider: Companies that lack market share dominance are often forced to slash prices, which can reduce pricing power as well for the industry's dominators.

Action to Take --> As you size up companies in a specific industry, check out their market share, profit margins, and free cash flow strength. If a pair of stocks are comparably valued, but one company stacks up better by these measures, then you should buy it.

P.S. We recently identified more of the market's most dominant companies in a recent report, "The Top 10 Stocks For 2014." One stock has raised its dividend 36 times since 2004, while another has boosted its dividend a whopping 183% since 2011. And that's just the beginning... These 10 stocks have nearly tripled the market's return over the past five years. To get more information -- including names and ticker symbols -- click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.