An investment strategy based on the efficiency level of a company is likely to lead to healthy returns across all market conditions. Efficiency is a measure of a company’s potential to convert its available input into output. Different studies have shown that there is a direct relationship between a company’s efficiency level and its price movement. So, investing in efficient companies may prove profitable.
Key Efficiency Ratios
Sometimes it becomes difficult to measure the efficiency level of a company. This is the reason why one must consider popular efficiency ratios to select potential stocks in order to build a profitable portfolio. These efficiency ratios are:
Inventory Turnover: The ratio of 12-month cost of goods sold (COGS) to a 4-quarter average inventory, is considered as one of the most popular efficiency ratios. It indicates a company’s ability to maintain a suitable inventory position. While a high value may indicate that the company has a relatively low level of inventory compared to COGS, a low value will indicate that the company is suffering from weak sales, which led to excess inventory.
Receivables Turnover: This is the ratio of 12-month sales to four-quarter average receivables. It shows a company’s potential to extend its credit and collect debt in terms of that credit. A high receivables turnover ratio or the “accounts receivable turnover ratio” or the “debtor’s turnover ratio” is desirable as it signals that the company is capable of collecting its accounts receivables or that it has quality customers.
Asset Utilization: This ratio indicates a company’s capability to convert its assets into output and is thus a widely known measure of efficiency level. It is calculated by dividing total sales over the past 12 months by the last 4-quarter average of total assets. Like the above two ratios, high asset utilization may also indicate that a company is efficient.
Operating Margin: This efficiency measure is the ratio of operating income over the past 12 months to sales over the same period. It measures a company’s ability to control its operating expenses. Hence, a high value of the ratio may indicate that the company manages its operating expenses more efficiently than its peers.
As efficiency level varies across different industries, it is best to select those stocks that have higher ratios compared to their industries. Along with higher ratios, we have considered only those stocks that have either a Zacks Rank #1 (Strong Buy) or a Zacks Rank #2 (Buy) in order to make the strategy more profitable.
Inventory Turnover, Receivables Turnover, Asset Utilization and Operating Margin greater than industry average: The values of these ratios higher than industry averages may indicate that the efficiency level of the company is higher than its peers.
Zacks Rank less than or equal to #2: Only Strong Buy and Buy rated stocks can get through.
The use of these very few criteria has narrowed down the universe of over 7,700stocks to only 19.
Here are five stocks from the 19 that made it through the screen:
Copart, Inc. (CPRT - Free Report) provides a full range of services to process and sell salvage vehicles through auctions, principally to licensed dismantlers, rebuilders and used vehicle dealers. Copart also has an average four-quarter positive earnings surprise of 9%.
Tallgrass Energy GP, LP is engaged in the transportation, storage and processing of natural gas, transportation of crude oil and provision of water business services. This Zacks Rank #1 company has an average four-quarter positive earnings surprise of 82.6%.
Vishay Intertechnology Inc. (VSH - Free Report) is a leading international manufacturer and supplier of discrete passive electronic components and discrete active electronic components. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 16%.
W.R. Grace & Co. (GRA - Free Report) produces specialty chemicals. It primarily operates through two business segments, namely Davison Chemicals and Performance Chemicals. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 6.7%.
SurModics, Inc. (SRDX - Free Report) is a leading provider of surface modification technologies to healthcare domain throughout the globe. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 95%.
While backtesting over a two-year timeframe (June 13, 2014 to June 10, 2016), considering a four-week holding period, a portfolio following this strategy provided a total return of 15% compared with the S&P 500’s return of 6.9%. Thus this strategy may prove to be profitable for investors seeking healthy returns.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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