Consider two companies . Dominant Widgets, the leader in its industry, turns 20 cents of each sales dollar into operating profit. Laggard Widgets, the No. 5 player, has an operating margin of just six cents on the dollar. Assuming you must buy and hold shares of one of them, which should you pick?

History says pick the laggard.

“There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries,” wrote Nobel economist George Stigler in 1963. In other words, the profitability of companies tends to revert toward industry averages over long time periods as the most successful companies attract imitators and the least successful companies either fail or are forced to improve. In a 2000 study using three decades of performance data for thousands of companies, economists Eugene Fama and Kenneth French tested that assumption and found a strong tendency for stars to fade and stinkers to get better.

Underperformance alone is no reason to buy a stock, of course. Underperformers that are improving, however, make promising candidates. The three companies below have profit margins that lag behind industry averages but have done so by diminishing amounts in recent quarters.

Ann Taylor
Operating margin: 6.1%
Five-year average: 1.0%
Industry average: 14.2%

When sales of women’s clothing plunged during the recent recession, Ann Taylor ( ANN ) struggled more than most stores. Part of the reason is that it specializes in work wear, and jobs have been scarce. In February, the unemployment rate improved in three-quarters of U.S. cities, the Labor Department said Wednesday. It seems little coincidence that sales at longstanding Ann Taylor stores, including Loft stores, jumped 11% during the fourth quarter ended Jan. 29 versus a year earlier, and that management projected a “mid-single digit” increase for this year. Soaring cotton prices could crimp margins for clothing chains this year, but analysts say Ann Taylor bought its cotton earlier than most and has re-engineered some of its clothing to use less cotton, giving it a key pricing advantage. Shares sell for 17 times earnings.

Constellation Brands
Operating margin: 10.5%
Five-year average: 6.6%
Industry average: 20.6%

After years of swallowing premium wine brands and accumulating debt, Constellation Brands ( STZ ) is newly focused on pruning non-core businesses and increasing free cash flow. That’s a good thing for investors. As the recent recession showed, the long-held view that booze sales are little affected by recession is outdated. Distributors have been so effective at branding wine and spirits as posh drinks deserving premium prices that when money gets tight, drinkers can save more than ever by switching to the cheap stuff. Analysts say the trading-down trend that has challenged the industry in recent years is now starting to reverse. That and Constellation’s improvements — management says debt reduction over the past three quarters will save $64 million a year in interest — could give shares a lift. They sell now for 11 times earnings, a discount of more than one-quarter to the broad stock market. Constellation reports results for its fourth fiscal quarter Thursday before the market opens.

ConocoPhillips

ConocoPhillips ( COP ) is in the middle of a multi-year restructuring program that involves unloading underperforming energy deposits and using the cash to reduce debt and grow production at remaining deposits. Debt as a percentage of capital has shrank by half in two years. The company boosted its dividend payment by 13% last year and has spent freely on its shares. Refining profits remain weak for most companies, including ConocoPhillips. When the business improves, analysts expect the company to begin trimming refining holdings, too, and to return more cash to stockholders. Shares trade at 11 times earnings and carry a 2.6% dividend yield.

Similar Posts:

Share