WANTED: Companies that have terrible margins and low price-to-sales ratios
I am placing a call to arms in CAPS for suggestions of companies that have terrible margins. That's right, if you know about an inefficient beast of a company with incompetent management or better yet brand new management I want to know about it.
I have done pretty well so far by investing in a company that had terrible margins in American Water Works. AWK had some of the worse margins in the industry, and I loved it for that. As it improves its margins, its earnings are growing, its dividend is rising, and its stock price is climbing.
Companies that are well-run and have high margins are expensive. I'm looking for the unloved companies with crappy margins. These businesses don't even have to grow to increase their earnings. As we have seen as company after company misses revenue estimates in the current environment sales growth is hard to come buy in today's troubled economy. Companies with messed up margins don't have to grow to improve earnings. All they have to do is get leaner and meaner and fix their operations. I'd rather buy a company with bad margins that can fix itself and add juice to future EPS growth than one that has margins that are already as high as they are going to go.
Historically companies with low price-to-sales ratios have significantly outperformed companies with high ratios the market. Take a look at the following statistics from James P. O'Shaughnessy's great book What Works on Wall Street.
Here are the average annual returns for the total market, the 50 stocks with the highest P/S ratio, and the 50 stocks with the lowest P/S ratio for the past several decades.
Here's a link to the source data:
As you can see, while no strategy works all of the time, in the long run purchasing stocks with low price-to-sales ratios pays off. Screwed companies that eventually went out of business were not filtered out of these results, and with this subset crummy businesses I'm sure that there were some real dogs in there that did end up kicking the proverbial bucket. That just goes to show how strong the performance for the companies that survived was. They significantly outperform companies with high price-to-sales ratios and the total market even after averaging in a few big fat zeros. This means that the companies that survived were Rock Stars.
Over time margins tend to revert to the mean, yet many investors assume that recent trends will continue indefinitely. That's where opportunity is created. It is difficult for companies with amazing margins to maintain them for an extended period of time. High margin businesses attract competition that over time erodes profitability.
Likewise, eventually the management at companies that have terrible margins will usually of their own volition or as a result of pressure from investors take steps to improve their company's margins. Furthermore, low margin business are not attractive to outside investors and almost end up having a most by default.
So let's have it. Who are some of the worst operators in various industries? What companies have terrible margins?