Companies with favorable efficiency levels are poised to be on investors’ radar irrespective of market conditions as price performance is believed to be positively correlated with efficiency level. Efficiency is the measure of a company’s potential to convert its available input into output.
Key Ratios to Identify Efficiency
Sometimes it becomes difficult to measure the efficiency level of a company. This is the reason why one must consider popular efficiency ratios while selecting stocks 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 to be one of the most popular efficiency ratios. It indicates a company’s ability to maintain a suitable inventory position. While a high value indicates that the company has a relatively low level of inventory compared to COGS, a low value indicates that the company is suffering from weak sales, which resulted in 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 Zacks Rank #1 (Strong Buy) and Zacks Rank #2 (Buy) rated stocks can get through.
The use of these very few criteria has narrowed down the universe of over 7,700 stocks to only 21.
Here are five stocks from the 21 that made it through the screen:
Baxter International Inc. BAX engages in the worldwide development, manufacture and distribution of a diversified line of products, systems and services primarily in the healthcare domain. This Zacks Rank #1 company has an average four-quarter positive earnings surprise of 30.6%.
AO Smith Corp. AOS is one of the world's leading manufacturers and marketers of residential and commercial water heating equipment. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 6.3%.
Johnson & Johnson JNJ is engaged in the research and development, manufacture and sale of a range of products in the healthcare field. The company has an average four-quarter positive earnings surprise of 2.9%. It carries aZacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
BWX Technologies, Inc. BWXT supplies precision manufactured components and services to the commercial nuclear power industry. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 17.8%.
Lancaster Colony Corporation LANC manufactures and markets three families of products: Glassware and Candles, Specialty Foods, and Automotive. This Zacks Rank #2 company has an average four-quarter positive earnings surprise of 9.9%.
While backtesting over a two-year timeframe (Sep 5, 2014 to Sep 2, 2016), considering a four-week holding period, a portfolio following this strategy provided a total return of 13% compared with the S&P 500’s return of 7.1%. 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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