Over the past five years, the stock market has basically done nothing. The broad market, as measured by the Vanguard Total Stock Market ETF
Total Return Price Chart by YCharts
Two of the best-performing stocks represent the purest plays for the thesis -- Deere
Deere & Company Revenues TTM Chart by YCharts
Joy Global is the clear winner on sales, benefiting from the strong demand for things like coal, iron ore, and copper. AGCO
You might expect Caterpillar
Deere & Company Operating Margin TTM Chart by YCharts
Revenue isn't everything, though, if a company has tight margins. The crown again goes to Joy Global, whose operating margins have consistently been nearly twice that of others.
However, they haven't really improved much over the last few years. Steady, high margins are great, but margin improvement can greatly leverage revenue growth, and it's been Deere and AGCO that have shown the most improvement. By widening its margins from 1.3% in 2006 to 6.6% in the trailing 12 months, AGCO has leveraged modest revenue growth to massive net income growth.
Deere & Company Net Income TTM Chart by YCharts
CNH Global
Deere & Company Free Cash Flow TTM Chart by YCharts
In the end, though, it's free cash flow that matters to most investors, and it's especially important in a capital-intensive business like this. The unlikely winner by a wide margin is Deere, trailed by Joy Global and CNH Global, but for very different reasons.
Deere leveraged modest revenue growth with operating-margin expansion and declining capital expenditures to grow free cash flow substantially. CNH did basically the same thing, but with accounting gimmicks rather than any impressive business improvement.
Joy Global really operated the best business, with substantial enough revenue growth to increase profits without needing wider margins than they already had. Capital expenditures were a drag on free cash flow, but they were necessary to grow the business and open more production capacity. Free cash flow is great because it means more profits are available for shareholders, but in some cases, you'd rather the company reinvest it for you, and Joy Global is one of those cases -- the company has averaged a 32% return on invested capital over the past five years. It's no wonder my colleague Jason Moser has tapped the stock for his Rising Star portfolio.
The Foolish bottom line
It's important not to be wowed by profit margin growth if it's not coming from actual business improvement. Deere and AGCO win for improving their business, but Joy Global certainly deserves attention for already having the best business, making it somewhat of a tossup between the three. Add these companies to My Watchlist to keep track of them.
- Add Joy Global to My Watchlist.
- Add Deere to My Watchlist.
- Add AGCO to My Watchlist.