There's More Than One Way to Turn a Buck

Business is remarkably simple, considering there are only three ways to magnify returns: (1) increase margins, (2) increase asset turnover, and (3) leverage one and two. (I suppose I could add cheaper leverage and fewer taxes to the mix, but those variables are often outside management's control.)

Margins -- gross, operating, and net -- are often the first measure to grab an investor's attention, which is understandable: They're simple to calculate when they're not already calculated for you.

Wider margins, but more competition
With margins, it's the wider, the better. Margin enthusiasts provide ample arguments for seeking companies where margins are expanding: Margins are the primary determinant of business moats. They provide flexibility, enabling companies to direct cash flows to develop and market better products. They provide a safety buffer for when you-know-what eventually hits the fan.

Wide margins are the province of low fixed-cost businesses -- those insulated from the vagaries of commodity and energy prices and the cost of implementing new production processes. It's no coincidence that software firms sport some of the widest margins. After all, once a product is developed and the first unit is produced, the marginal cost to produce and deliver each marginal unit is infinitesimal in comparison. (Think of the cost of developing and shipping the first unit of Microsoft's (NASDAQ:MSFT) Windows 7. Now think of the cost of developing and shipping each subsequent unit of Windows 7.)

There is a downside, though. Wide margins attract a lot of attention, from both competitors and investors, which means margins can rapidly deteriorate if competition becomes particularly fierce, while returns can rapidly deteriorate when stock prices are bid too high. More than one investor has been reeled in by high margins only to be fried when the competition proved they were ephemeral.

Lower margins, but still profitable
Fortunately, you don't have to focus on margins to find durable, profitable companies; you can focus on asset turnover instead. Indeed, many profitable companies sport low margins but compensate with higher asset turnover ratios (and they're not all retailers, either.)

I like the asset turnover ratio for three immediate reasons: First, investors scrutinize it less than margins. Second, asset turnover is a direct measure of management efficiency. Third, changes in total asset turnover signify greater productivity from the asset base, which can arise from more efficient operations (fewer assets generating the same levels of sales) or an increase in sales (which could indicate improved market conditions for the firm's products).

In short, the asset turnover ratio reveals a firm's efficiency in deploying capital.

Comparative advantage
As in any measure, apples-to-apples comparison is required. The asset turnover ratio, like margins, vary greatly among industries. In capital-intensive industries -- steel, autos, and heavy manufacturing -- total asset turnover tends to be low compared to information-based and distributive industries.

Turning over assets in a significant multiple is difficult. In fact, my screens produced few companies that turned over their total assets more than five times in one year, and those that did I considered speculative.

When screening, I prefer companies with above-average returns on equity and below-average long-term debt; I prefer return on equity based on management performance, not financial leverage. (2008 revealed what can happen when investors rely too much on the latter and not enough on the former.)

My asset-turnover screen produced the following companies, which have OK-to-piddling margins, yet they post a superior ROE compared to their respective peers based on data from their latest 10-K. What's more, they posted their superior ROE sans the aid of long-term debt.

DuPont analysis, which dissects ROE into its three principal components: margins, asset turnover, and leverage, also reveals what each ROE component is contributing to the total. What's more, it's easy to calculate, simply multiple the net profit margin, the asset turnover ratio, and the leverage factor (total assets divided by shareholders' equity).

But even without DuPont analysis, intuition suggests that a company generating superior ROE with no long-term debt and above-average asset turnover is likely to be better managed than one that isn't.