Meet the Margin Hogs

Companies that earn attractive returns on invested capital (ROIC) make for sound long-term investments. After all, one of the best ways to generate wealth in the stock market is to invest in companies that create it.

So far, I've profiled two types of companies able to generate high ROIC: companies living La Vida Loca, and Speed Demons. Now it's time for one more.

Those margins are huge
Whereas Speed Demons generate tons of sales with low margins, and La Vida Loca stocks generate good sales with good margins, Margin Hogs have very high margins but low sales-to-capital ratios. Think of a Margin Hog as a weightlifter; he may look fat, and he may not be fast, but he's very powerful in his own right.

Here are some Margin Hogs with low capital velocity but nice, fat margins:

Company

NOPAT/ Sales

Sales/ Capital

ROIC

10-Year Return

FactSet (NYSE: FDS  )

32%

1.0

32%

778%

Paychex (Nasdaq: PAYX  )

25%

1.3

31%

408%

Medtronic (NYSE: MDT  )

24%

0.9

21%

291%

Genentech (NYSE: DNA  )

19%

0.8

16%

431%

Data provided by Capital IQ.

As you can see from the table above, Margin Hogs come in all shapes and sizes.

It's all about the price
FactSet sells financial database subscriptions. Paychex provides back-office business-support services. Medtronic makes medical devices, and Genentech sells specialty biotechnology drugs. But while they sell a variety of different products, they have one thing in common: Customers are willing to pay higher prices for their great goods.

Pricing power is very important for Margin Hogs, because their margins come after operating costs. Each sale has to pay for the production costs and sales expenses, fund R&D investments, and pay for all of the required support costs. Those margins do more than just create value; they also sustain the businesses.

Like bees to honey
Unfortunately, those big margins attract lots of competitors, which can make it tough to be a Margin Hog. FactSet must contend with companies like Morningstar (Nasdaq: MORN  ) and Capital IQ, which is owned by McGraw-Hill (NYSE: MHP  ) . Paychex has to deal with Automatic Data Processing (NYSE: ADP  ) , a huge competitor. And Medtronic must contend with Guidant, St. Jude, and Johnson & Johnson every day, much as Genentech has to worry about competitors in both biotechnology and pharmaceuticals.

The Foolish bottom line
Despite the challenges, Margin Hogs are one of my favorite types of business. I much prefer to bet on companies that have more control of their destiny. Wouldn't you? Unlike Speed Demons, which tend to have little pricing power, it's easier for Margin Hogs to create value because they can raise prices while minimizing costs. Last I checked, a Speed Demon like Wal-Mart is all about lowering prices.

The Fool's value guru, Motley Fool Inside Value advisor/analyst Philip Durell, loves Margin Hogs that lead him to great returns. You can read up on every recommendation Philip has made with a free 30-day guest pass. Check it out and join us in the search for fatter returns.

Up next: Value Destroyers
If a company does not earn its cost of capital, investors lose.

Fool editor David Meier does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.


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