Heraclitus, a Greek philosopher, said you can never step in the same river twice.
The stock market is always changing. In the past few years, with interest rates exceptionally low and the economy in recovery mode, highly profitable companies with low debt haven’t stood out much. But I think they will in the next few years.
Annually, I compile a list of companies that display high profitability and low debt. Specifically, I require:
- Return on equity of 25% or more.
- Debt 10% or less of stockholders’ equity.
- Stock price no more than 20 times earnings.
Only 33 stocks traded in the U.S. currently meet these criteria. I want to recommend five of them today.
Argan
Barely covered on Wall Street is Argan Inc. (AGX, Financial), a small Rockville, Maryland company that builds energy plants. In additional to traditional plants that use natural gas, it builds plants that use biodiesel, ethanol, wind and solar energy.
Argan has been increasing its revenue at a 28% clip the past five years, and last year’s growth was even faster. The company has no debt, and earned 28% on stockholders’ equity last fiscal year.
Michael Kors
I recommended Michael Kors Holdings Ltd. (KORS, Financial) a year ago in this column with bad results. The stock fell 32% from June 21, 2016 through June 16, 2017.
The company, based in London, sells handbags, shoes, watches and other accessories. Consumers didn’t go for its new line of handbags, and they also stayed away in droves from department stores, where many of Kors’s goods are sold.
Why on earth would I recommend Kors again? Because for all its troubles, Kors still had a 30% return on stockholders’ equity in the past four quarters, and the stock sells for an alluring eight times earnings.
Sturm Ruger
Debt free and sporting a 37% return on equity is Sturm Ruger & Co. (RGR, Financial). The Southport, Connecticut company is one of the three biggest U.S. firearms manufacturers, and the largest
by several measures.
My personal position is that more government control of pistols and handguns is desirable. But my opinion as a financial analyst is that Ruger is a highly profitable juggernaut. The stock sells for 15 to 16 times earnings.
T. Rowe Price
The only large-cap stock to meet my criteria is T. Rowe Price Group Inc. (TROW, Financial). Based in Baltimore, Maryland, the company manages about 100 stock and bond mutual funds.
My firm owns this stock for most clients, thanks to my colleague Tom Macpherson, for whom high profitability and low debt are paramount factors. (For me, cheapness generally comes first.)
Despite the trend to passive investing, T. Rowe Price has kept up a good growth pace in recent years. Revenue growth last year was about 8%. The return on equity was just over 25% and the company is debt-free.
United Therapeutics
United Therapeutics Corp. (UTHR, Financial), based in Silver Spring, Maryland, makes drugs, primarily for treatment of pulmonary hypertension and other vascular diseases. It posted a 34% return on equity in the past four quarters, and is debt free. Yet the stock sells for a mere nine times earnings.
Why the amazing bargain? Analysts expect earnings to fall in the next two years, as the company faces increasing competition, mainly from Johnson & Johnson and generic drug manufacturers. Out of 14 analysts who follow the company, only two recommend the stock. I’m with the minority.
Track Record
This is the 13th column I’ve written on high-profit, low-debt stocks. Seven of the first eight columns were profitable and the same number beat the Standard & Poor’s 500 Index.
But beginning in 2013 this approach has been on a four-year losing streak. Last year’s picks fell 4.35% while the index rose 18.92% from June 21, 2016 through June 16, 2017.
As I said at the start of this column, I think the financial environment in the past four years was anomalous and the next few years will be kinder to these high-quality stocks.
My best pick last year was Ituran Location and Control Ltd. (ITRN, Financial), up 46%. My worst pick was Michael Kors, as detailed above.
For the full 12 years I’ve written on this subject, my recommendations have averaged a 10.6% return, versus 7.9% for the S&P 500. That good but not stellar.
Bear in mind that my column recommendations are theoretical and don’t reflect actual trades, trading costs or taxes. Their results shouldn’t be confused with the performance of portfolios I manage for clients. And past performance doesn’t predict future results.
Disclosure: Many of my clients own T Rowe Price shares; one owns Sturm Ruger.
John Dorfman is chairman of Dorfman Value Investments LLC in Newton Upper Falls, Massachusetts, and a syndicated columnist. His firm or clients may own or trade securities discussed in this column. He can be reached at [email protected].
