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Thursday, Jul 7, 2022

John Dorfman—Profitable Firms Not Necessarily Good Investments

What are the most profitable companies in the U.S? They’re the ones in the “Fabulous Fifteen.”

I published a Fabulous Fifteen list in August 1998 and another in August 2000. Now, here is an updated roster of companies that show:

Return on equity of 40 percent or more in the latest fiscal year, gross profit margin of 25 percent or more, return on assets of 20 percent or more and market value of $750 million or more.

Four companies Bristol-Myers Squibb Co., Intimate Brands Inc., Plantronics Inc. and UST Inc. have made the list three times in a row.

Clearly, outsized profits can be made in almost any business, providing the business is run right. But are super-profitable stocks good investments? Not necessarily.

Profitability is only one of a number of important criteria in picking stocks. Among the other factors to consider are growth, balance-sheet strength, stock valuation, insider buying or selling and the quality of management.

The Fabulous Fifteen roster isn’t intended primarily as a buy list. It is primarily a way to salute companies with outstanding profitability.

But such companies haven’t necessarily racked up stock-market profits. The 1998 Fabulous Fifteen list achieved a two-year average total return of 38 percent. That sounds pretty good, but it trailed behind the Standard & Poor’s 500 Index by four percentage points.

Last year’s list was down 3.9 percent from Aug. 17, 2000 through Aug. 10, 2001. That beat the S & P; 500, which declined about 19 percent over the same period. Still, a loss is a loss.

Three in a row

Finally, take a gander at the past 12 months’ stock-market performance of the four companies that have made the roster three times in a row. UST is up a hearty 92 percent and Bristol-Myers is up 19 percent. But the return on Intimate Brands has been negative 9 percent, and Plantronics shares have fallen a sickening 63 percent.

Profitability alone, then, does not a good investment make. Many super-profitable companies are too expensive to buy, at least for a cheapskate investor like me. But I think there are some genuine bargains among this year’s Fabulous Fifteen.

One is Kemet, a manufacturer of capacitors, tiny electronic components that regulate the flow of electric energy. They are used in computers, communications equipment, cars and military electronics, among other places.

Among Kemet’s present or recent customers are Ford, General Motors, Compaq, IBM, Nokia and Solectron. The stock sells for six times recent earnings, 1.8 times book value (corporate net worth per share) and 1.3 times revenue. It is a major holding for many of my clients at Dorfman Investments.

Like much of the microelectronics industry, Kemet is being hurt by the current slump in computers and communications. Earnings are expected to drop to about 26 cents a share in the current fiscal year (ending March 2002) from $4 a share last fiscal year. But I think it looks like a fine investment for people who plan to hold onto it for three to five years.

Another Fabulous 15 member I like is Deluxe Corp., the leading U.S. check printer.

Deluxe stock offers a solid 4.6 percent dividend yield and sells for only 14 times the past four quarters’ earnings.

UST, the king of chewing tobacco, sells for about 11 times the past four quarters’ earnings and a little less than 11 times estimated earnings for this year. It is a major holding at Dreman Value Management.

As a tobacco stock, UST involves some litigation risk, but since its specialty is smokeless tobacco, the risk is less than with other tobacco producers.

Another Dreman small-cap holding is Delta & Pine Land Co., the largest U.S. producer of cottonseeds. At 23 times earnings, it is more expensive than most stocks we own at Dreman. But it was purchased at a considerably lower price, and we are holding onto it because of its exceptional profitability and because we believe it has takeover potential.

Three companies are back for a second appearance. They are CSG Systems International Inc., Eli Lilly & Co. and SEI Investments Co.

John Dorfman is a columnist with Bloomberg News.

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