Concrete finishing at the Vale nickel smelter construction site, for which Fluor Corp. is providing EPCM services, in Long Harbour, Placentia Bay, Newfoundland.Greg Locke/The Globe and Mail
U.S. companies with the highest profit margins led the investing world in 2013, but it doesn't always go this way. Indeed, the potential for a more growth-oriented environment, one with corporate revenue accelerating, sets up the distinct possibility that lower-margin corporations will take the performance leadership reins in 2014.
High-margin companies were perfectly suited to a 2013 market where top-line sales growth was scarce. By definition, a big profit margin means companies can generate a lot of earnings growth from a small increase in sales.
So, unsurprisingly, the list of top-performing S&P 500 stocks is dominated by companies like Facebook Inc (gross profit margin of 73.2 per cent), Celgene Corp. (94.6), Priceline.com Inc. (77.6) and Biogen Idec Inc. (90.1).
The relationship between stock performance and profit margins is not cut and dried, however. If it were, investors could just invest in ten companies with the highest gross margin and outperform the market every year.
Rate of change or, as professional investors call it "the second derivative of growth," is the attribute markets reward most. It is often the stock with the most improved earnings growth, not the highest, that generates the biggest returns for investors.
Economists project U.S. GDP growth will accelerate to 2.6 per cent in 2014, almost a full percentage point higher than this year. If they are correct, next year's list of top-performing stocks will feature far more companies from industries which are sensitive to economic activity.
The biotechnology companies like Celgene and Biogen Idec that don't get an outsized bump from an improving economy are likely to underperform industrials and energy stocks.
It's my view that the U.S. economy will accelerate in 2014 as a result of rising wages, job creation, household credit growth and consumption. This won't be a clear-cut win for the equity markets, because wage costs – the biggest expense for most companies – are likely to cut into earnings growth.
Sales and revenue growth, however, should improve. The most recent U.S. earnings season saw anemic revenue growth of less than three per cent in year over year terms, so the bar is set pretty low. Stocks representing the biggest increases in top-line growth, not the best profit margins, are likely to lead the way in the next twelve months.
U.S. industrials is the area where I'm most optimistic for 2014 and General Electric Co. is the stock I want to own. The only reason I don't already is because I'm still a little squeamish about current valuation levels. Other industrials highly ranked by analysts include Ryder Systems Inc., Eaton Corp., Dover Corp., and Fluor Corp.
Scott Barlow