3 Companies With Rising Profitability

For companies, high profit margins are a hallmark of operational excellence. So, stock investors should favor companies with the fattest margins, right?

Nope. The problem with margins is that they tend to gradually revert to industry averages. In a 2000 study in the Journal of Business, professors Eugene Fama and Kenneth French showed that the further above or below average a company’s profit margin is, the faster it tends to come back. Capitalism, you might say, is all but based on that tendency. Where margins are high, entrepreneurs set up shop and drive them lower, and where margins are low, some companies close and surviving ones improve.

Odd as it seems, then, the best predictor of a rising profit margin might be a low one. The companies below all recently increased their operating margins and have room for more improvement based on industry averages.

Operating margin: 4.1%
Industry average: 7.5%

Smart Balance (SMBL) is best known for its popular line of spreads, which have less saturated fat than butter and no trans fat unlike spreads made with partially hydrogenated oil. Spreads bring in 70% of the company’s sales, but the company also makes peanut butter, popcorn, cheese and cooking sprays and is expanding into huge dairy categories, like sour cream and milk. Last year, sales for the company doubled. This year, it turned its first quarterly profit. While margins are below the industry average, they might shoot much higher once Smart Balance reaches critical mass considering the company’s lean operating model. It has only several dozen employees mostly for product development and outsources costly activities like manufacturing and distribution.

Operating margin: 5.5%
Industry average: 7.5%

Budget cheese and crackers have never looked tastier. While the S&P 500 index has lost 20% over the past year, shares of snack maker Lance (LNCE) have gained 18%. As workers forsake restaurant lunches for packed ones, the company’s namesake crackers and nuts, Cape Cod potato chips and Archway cookies (it bought Archway in Dec. 2008) are getting a boost. And while Lance doesn’t enjoy the name recognition of brands like Nabisco or Keebler, it’s perhaps moving up in the snack world. Management recently began running the company’s first television commercials. Sales are expected to climb 8% compared to last year. Earnings per share are expected to more than double.

Operating Margin: 10%
Industry average: 20%

Scotts Miracle Gro (SMG) products nourish lawns, flower patches, vegetable gardens and shrubs and eliminate weeds. The company’s shares have sprouted 39% higher over the past year. That’s partly because while America’s recent real estate bubble has popped and the houses it produced are changing hands at lower prices, the lawns haven’t gone anywhere. Most are being tended to with the same loving attention as before, and perhaps more, since spending on travel is down, and vacations spent at home are up. Scotts is on pace to grow its sales by 5% during its fiscal year ending Sept. 30. Earnings per share are expected to climb 20%.