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WANTED: Companies that have terrible margins and low price-to-sales ratios

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August 13, 2010 – Comments (6)

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.

1952-1959
ALL: 19.22%
High: 14.96%
Low: 20.85%

1960-1969
ALL: 11.09%
High: 11.99%
Low: 11.15%

1970-1979
ALL: 8.53
High: 5.82%
Low: 14.80%

1980-1989
ALL: 15.85%
High: -2.02%
Low: 20.43%

1990-1999
ALL: 14.75%
High: -2.46%
Low: 13.80%

2000-2003
ALL: 5.91%
High: -42.37%
Low: 19.91%

Here's a link to the source data: 

http://www.whatworksonwallstreet.com/annualData.as...

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?

Deej

6 Comments – Post Your Own

#1) On August 13, 2010 at 4:10 PM, ChrisGraley (29.67) wrote:

Blockbuster video?

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#2) On August 13, 2010 at 6:44 PM, rd80 (98.30) wrote:

Fool's screener inclues P/S.  It turned up 66 hits 0 < P/S <0.1

The list is heavy with financials and retailers.  A few that jumped out are AIG, RAD and YRWC.

There were a bunch with negative P/S values.  How the heck do you generate negative sales?  I can understand zero sales, but negative?!?

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#3) On August 14, 2010 at 5:27 AM, lorteungen (99.71) wrote:

I don't know about incompetent management, but the drug distributors like CAH, ABC and MKC all have massive revenues and very low margins. CAH has sales of about 100 billion and a marketcap of just 11 billion. Net margins are around 1%.

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#4) On August 14, 2010 at 9:03 AM, TMFDeej (99.43) wrote:

HA good one, Chris.  I deserved that.  I should have stipulated that the company cannot be in a dying industry.

I forgot that CAPS has a screener, RD80.  I'm going to have to take a look at that.  Thanks.

I suppose that truly value-destroying management that is firmly entrenched is indeed a huge negative lorteugen.  However, that's just the sort of company that someone should put on a watch list because if a legit management team is ever brought in the company could really turn things around.

The idea here is to find companies that have worse margins than other companies in their industry.  An entire industry with low margins isn't exactly what I was looking for, however interestingly I do currently own Cardinal Health both here in CAPS and in real life.

Deej 

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#5) On August 14, 2010 at 9:05 AM, TMFDeej (99.43) wrote:

Ah ha, I found exactly what I was looking for.  The Yahoo! stock screener has the ability to look at groups of companies by sector. One can just focus on profit margins and sort them from best to worst.  I'm going to have fun playing with this one later.  Here's a link:

http://screen.yahoo.com/stocks.html 

Deej 

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#6) On August 25, 2010 at 1:25 AM, walt373 (99.79) wrote:

What do you think about CHCG?

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