An Easy Way to Find Winning Stocks

It’s no secret that investors place a premium on lofty margins. If one business squeezes $0.15 in earnings from each dollar in sales and another manages just $0.10, the first company clearly has a big advantage.

But there’s one thing even better than a healthy profit margin — an expanding one. If the firm does manage to boost revenue as well, then earnings growth will be even more dramatic.

Hansen Natural (Nasdaq: HANS) is a prime example. Powerful margin expansion enabled the drink maker to turn a 10-fold increase in sales into a jaw-dropping +4,000% surge in net income. There’s a similar story with Blackberry manufacturer Research In Motion (Nasdaq: RIMM), whose operating income has consistently climbed about +90% per year during the past decade.

These companies have created tremendous wealth for their shareholders, with Hansen returning +1,075% during the past five years while RIMM has returned a modest, but respectable +170%.

For a more recent example of what rising margins can do to a firm’s earnings, let’s peek inside the recent year-end results from consumer products maker Clorox (NYSE: CLX).

  Fiscal 2008 % of Sales Fiscal 2009 % of Sales
Net Sales $5,273 100% $5,450 100%
Cost of Goods Sold $3,098 58.8% $3,104 57.0%
Gross Profit $2,157 41.2% $2,346 43.0%
Administrative Expense $690 13.1% $715 13.1%
Advertising $486 9.2% $499 9.2%
R&D $111 2.1% $114 2.1%
Other $195 3.7% $207 3.8%
Operating Income $693 13.1% $811 14.9%
Income Taxes $232 4.4% $274 5.0%
Net Income $461 8.7% $537 9.9%

Thanks to an impressive 180 basis point increase in gross profit margins (from 41.2% to 43.0%), it only took a modest +3.3% uptick on the top-line to produce a much stronger +16.5% increase on the bottom.

In this case, rising prices for Clorox’s products at the retail level deserve most of the credit. While this can provide a nice bump (and is reflective of powerful brands), prices can only be hiked so far before scaring away customers and pinching volume.

#-ad_banner-#You can also find cost-cutting initiatives (whose impact can be seen lower down on the income statement) to be another common path toward margin expansion. But again, while certainly welcome, cost cutting can only run so deep before there’s no fat left to trim.

That’s why my staff and I typically look for the rarest breed of margin expansion — the type built into the business model itself.

If a widget maker gets $1.00 for a product that costs $0.90 to get out the door, it will always have a profit margin of 10% — regardless of whether it sells 1 unit, 1,000 units, or 1 million units.

On the other hand, there are companies with high fixed expenses, but minimal variable costs — a structure that allows margins to rise along with sales. Think of a video game company that spends $1 million in upfront costs to develop a new game. That initial outlay for the first copy may be high, but the expenses to produce additional copies are negligible (maybe a few pennies for a blank DVD and packaging).

If the game retails for $50, then it will take about 20,000 units to reach the breakeven point. But from then on, the next sale represents almost pure profit — and the one after that, and the one after that…

So if the company sells 30,000 units, its gross margins rise to 33%. And if it manages to sell 40,000, then margins expand to 50%. In other words, each incremental dollar in sales is more profitable than the one preceding it. Said another way, the higher the revenues, the stronger the margin — a stark contrast to the widget maker.

Some of the most profitable investments of all time have fallen into this category — firms like Microsoft (Nasdaq: MSFT), Moody’s (NYSE: MCO), and Gilead Sciences (Nasdaq: GILD).

My staff and I have looked for the companies with the largest growth in net income, operating income, and profit margins. Here’s what we found:
Company (Ticker) 1-Year Net Income Growth 1-Year Operating Income Growth Profit Margin
Discover Financial (NYSE: DFS) +220.7% +70.8% 34.4%
Genzyme Corp. (Nasdaq: GENZ) +169.6% +189.9% 15.3%
Goldman Sachs (NYSE: GS) +64.6% +77.6% 22.6%
Apollo Group (Nasdaq: APOL) +44.6% +50.6% 19.1%
Red Hat (NYSE: RHT) +36.9% +28.7% 15.8%

P.S. Expanding profit margins are just one of the catalysts we look for in a stock. Of course, sometimes we find stocks with several strong catalysts. Those are the stocks you want to buy. In fact, we’ve just found five stocks we think could double your money by 2012.