The market is obsessed with fast-growing companies. And you can't blame it really.
All things equal, everyone would rather invest in a business that is thriving and expanding rather than one that is stagnant or deteriorating. Even if you're not a growth investor per se, you have to appreciate a company whose products or services are really catching on.
Because if sales are rising, then so are profits. At least, that's what's supposed to happen.
But it doesn't always work out that way.
Back in 2003, the company took in $239 million in sales, but fell just short of breakeven and lost $12 million. Flash forward to 2008 and revenues had climbed to $834 million. But net income that year was almost the same, actually a little worse, negative $13 million.
Revenues rose by $595 million (149%) over that five-year period. But remarkably, not a single dollar of the extra half-billion in sales made it to the bottom line.
How is that possible? Well, cost of goods sold increased from $213 million to $691 million. As a percentage of sales, that's a modest improvement from 89% to 83%. Still, it only left a gross profit of $143 million, not enough to cover $154 million in salaries, rent and other operating expenses.
This is a common tale. Many companies with thin margins and a variable cost structure just can't get ahead. The more they sell, the more they have to pay for inventory. If gross margins are 10%, then the business can never make more than a dime per dollar -- even if sales climb from $1 million to $100 million to $10 billion. And any leftovers often get eaten up by heavy advertising spending, costly research and development or other expenditures.
That's why I'm drawn to companies with large operating and profit margins -- with a higher proportion of fixed costs that can be spread over a larger revenue base. Operating leverage ensures that the bigger they grow, the greater the percentage of profits they squeeze out. That means each incremental dollar of sales is more profitable than the one before.
Picture a software developer that spends $1 million to create a new product. If it sells copies for $100 each, the company will need to sell 10,000 copies of the software to recoup its expense. But since the software can be replicated virtually for free, the 10,001st sale will generate pure profit. As will each one thereafter. So the bigger the company gets and the more it sells, the higher its profit margins rise.
This is a powerful 1-2 punch because not only is more revenue coming in the door, but the company is pocketing more from each dollar. These situations can be highly lucrative for investors.
With this in mind, I set out in search of companies whose operating margins have been on a sustainable upward path. I looked for companies whose current margins today are higher than they were a year ago, and those whose year ago margins showed expansion from the year before.
Of course, we focused our search on companies that also exhibited healthy profits and sported dividend yields of at least 4%. Here's what I found.
I'm not surprised to see Verizon, a former High-Yield Investing portfolio holding, on this list. Telecom is a capital intensive business, and Verizon has invested heavily to roll out its next generation wireless network. But now that infrastructure is in place, and the cost to connect a new phone user to it is negligible -- so each new subscriber addition can have a meaningful bottom-line impact.
Same with Six Flags. The company has sunk a lot of fixed costs to build, maintain and staff its theme parks. But it doesn't cost any more to host the 5,000th daily visitor than in does the 4,000th -- so the more people it moves through the turnstile, the higher its margins climb.
Put simply, companies with large and growing profit margins typically pay higher-than-average dividend yields and outperform the market for one main reason -- they have the greatest ability to return increasingly larger shares of profit directly back to their shareholders in the form of dividends, buybacks and debt reduction.