The Street's Smooth Operators

In a recent article, I wrote about how improving margins can lead to big wins for businesses. I talked about the way stalwarts like Home Depot and Wal-Mart have continued to build strong profits by finding ways to increase their margins.

Of course, Wal-Mart and Home Depot are sort of textbook cases for advantages in scale, so I decided to do a little more digging, to see what I could learn from other businesses that have made continual margin improvements over the past half-decade.

What's it mean, man?
For this particular project, I focused on medium- and large-cap companies only, and looked at margins from continuing operations. I wanted to leave out the vagaries that come from taxes, interest income and payments, and other charges and credits that can blur the picture. Finally, because I'm a deal hunter, I also looked for companies trading at a 15% discount to their 52-week highs.

By my screen, the market's top 47 (recently discounted) smooth operators included big tech names like Yahoo! and eBay. That's entirely logical, since these Internet leaders were just emerging victorious from the tech bubble's slaughter and picking up the winners' spoils. The five-year margin improvement in the top group was nothing short of amazing, ranging from seven percentage points at the low end to nearly 13 at eBay and 30 at Yahoo!. But the list also included plenty of boring, old-school firms like Johnson & Johnson and Hershey.

To give you an idea of the wide range of companies that made it, here are a select 10, ranked by margin improvement, along with their dividend-adjusted returns for investors over the same period.

Of course, this isn't a proper statistical study, but I do find the summary results interesting. Of the 47 companies that made it through the screen, the average compound annual return was a very impressive 18.9%. Keep in mind that some pretty nice margin improvement at Tiffany and J&J didn't exactly add up to fireworks for stockholders, though both did manage to beat the S&P 500's 2.2% return over the same period.

The worst return was -12.9% annually from Clear Channel Communications, but of the full 47, 81% beat the (admittedly low) bar of the market. Of that group, 70% gained more than 5% each year.

Use it or lose it?
An 81% success rate? Annual returns of 19%? Sign you up? Well, hang on; the problem with using computerized screens to look backward like this is that we don't know if any of what we've found is predictive, or just a pile of pixilated nonsense. To try to find out if marginal improvement might be somewhat predictive, I took a look at the margin picture for this same 47 companies for the three years preceding their big gains. What I found was, well, kind of a mess.

Only 60% of these companies experienced operating-margin improvement during the three years prior to 2001, and success there didn't necessarily correlate with shareholder returns. Sure, Boyd Gaming tacked on nearly a three-percentage-point gain in operating margins from 1998 to 2001, and it followed up with a run that delivered 65.6% annual returns for investors, but that was a long way outside the norm. J&J had improved margins more than Boyd from 1998 to 2001, and continued to do well after that, but it only returned 4.8% per year thereafter. Apollo Group was worsening its margins during the three years prior to 2001, but it turned that around, and its shares subsequently returned 15.6% annually to investors.

Is it the growth?
Companies with incredible growth (like Yahoo! and eBay) did the best, but top-line increases alone weren't enough to predict good investment returns. Bed Bath & Beyond saw 23% annual top-line growth from 2001 to 2006, but only earned stockholders 8% per year. Why? It probably has a lot to do with 2001 investors' willingness to pay 47 times earnings (excluding nonrecurring items), whereas the company now gets less than half that. J&J provides a similar lesson. It commanded a P/E of 30 back in 1998, and only gets 20 now.

Maybe it's the price
Constellation Brands did just the opposite. By 2001, investors had discounted the firm to a slim 13 times earnings (excluding nonrecurring items). Between growth and the return to an earnings multiple closer to 20, we may have the explanation for its 27.2% annual appreciation. American Standard's 6% annual revenue growth was even sleepier, but since investors now pay 15 times earnings, versus 12 in 2001, the stock has earned its patient holders a solid 16% per year.

In fact, if I examine the results from the 12 companies that traded at P/Es of less than 20 back in 2001, the average annual gain to 2006 was 41.6%, and the worst of the lot earned 6.1% per year.

Foolish bottom line
Alas, investing stories are almost always too complex to compute. While increased operating margins seem to produce rewards for shareholders, finding these future stars isn't so easy. Past performance doesn't necessarily predict future prospects, but paying less than 20 times earnings for strong companies seems to be a pretty good place to start.

That's why, for me and my colleagues at Motley Fool Inside Value, price is primary. We'll take companies with improving margins, companies with deterioration, and everything in between. Each investment case is unique, but when you take the time to examine the facts, price the company according to expectations and risk, then pay less than you think it's worth, your odds of coming out ahead are better. If you'd like to learn how to wrestle with margins, predict future cash flows, price a company, or just see current stock recommendations -- such as Home Depot -- that already make the grade and beat the market, a 30-day guest pass is available.

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Seth Jayson is always looking for an easier way to spot a bargain. At the time of publication, he had shares of Home Depot, but no positions in any other company mentioned here. View his stock holdings and Fool profile here . Bed Bath & Beyond, Home Depot, and eBay are Motley Fool Stock Advisor recommendations. Fool rules arehere.