Although Apple (Nasdaq: AAPL) is widely lauded for its ability to crank out great new products, its management team deserves a lot more credit than that.
Operating in the consumer electronics space, where cutthroat pricing leads to wafer-thin profits, Apple has shown a proven knack to convert a sizable amount of its sales into cash. Apple's profit margins, along with other key metrics, are simply remarkable.
These kinds of metrics are the hallmark of great companies, and more rare than you think. Of the 1,500 companies in the S&P 400, 500 and 600, only 12 of them are in the same league as Apple.
The question for investors: Can any of these great businesses be bought at a reasonable price? To assess that, we can view these stocks in terms of their price/earnings-to-growth (PEG) ratio.
It's unfair to solely focus on stocks with a PEG ratio below 1.0. Any companies with solid sustainable franchises can merit a larger PEG ratio. That was the case for steady growers such as Coca-Cola (NYSE: KO) over many decades.
The question is: Which of these companies have sustainable franchises with wide moats around them? After all, that's the key to high ROE and plus-sized profit margins. To my mind, the only stocks in this group that are likely to maintain a firm grip on their respective markets are AbbVie (Nasdaq: ABBV), C.R. Bard (NYSE: BCR), Moody's (NYSE: MCO), MasterCard (NYSE: MA), FactSet Research (NYSE: FDS) and CBOE Holdings (Nasdaq: CBOE).
Narrowing down that list to companies with a PEG of 1.25 and lower leaves us with two great stocks.
|1. MasterCard (NYSE: MA)|
|Though U.S. consumers have known this company for quite some time, it truly has established a globally dominant footprint in recent years. Back in 2005, MasterCard's revenues hadn't even reached $3 billion. By next year, they are likely to top $10 billion.
That rising base of sales has yielded impressive operating leverage, as more transactions are run through the company's automated network.
MasterCard's EBITDA Margins
Thanks an expected increase in the number of cashless transactions worldwide, analysts think MasterCard can boost sales at a low teens pace in each of the next few years. Growth will inevitably slow later in the decade as core markets become saturated, yet there's no reason to think that margins are cash flow will slump. Simply put, this company is fast-becoming one of the most powerful free cash flow generators in the world.
MasterCard's Free Cash Flow
MasterCard's management has historically been debt-averse, as solid financial stability was seen as a key virtue for its relationships with banks. But cash flow is now so strong and sustainable that management is looking to take on some debt.
Management realizes that a reasonable amount of leverage can support share buybacks: The company bought back more than $4 billion in stock over the past 24 months, and has a fresh $2 billion buyback plan in place. Those moves come in tandem with a recent hike in the dividend up to $0.60 a share (more than double the 2013 payout).
|2. Moody's (NYSE: MCO)|
|This debt-ratings agency sure took a lot of flak during the debt crisis of 2008. Regulators and investors angrily expressed concern that the company was simply asleep at the wheel, perhaps too close to the companies it was tasked with rating.
That controversy didn't have much impact on business, simply because Moody's has a wide moat and steady market share. Sales, which stood at $1.8 billion in 2008, hit almost $3 billion last year. Equally impressive: Profit margins are sky-high.
Like MasterCard, much of Moody's recent growth has come from its international operations, where bond issuance has been stronger. Though revenue growth is likely to only be in the upper single digits in coming years, that should still be enough to help generate ever-rising cash flow, which should fuel a rising dividend. Goldman Sachs' expects the dividend, which stood at $0.90 a share last year, to approach $1.60 a share by 2016.
Risks to Consider: The companies named in the chart above all have considerable pricing power, which is aided by a growing economy. Many of them have also wisely pursued an international expansion strategy, but that could turn into a negative if China slumps badly, dragging down growth in other emerging markets.
Action to Take --> Strong profit margins are leading to rising free cash flow for these companies. Considering that many of them have wide moats around their businesses, such returns are likely to be sustained for years to come, making these true buy-and-hold investments.