Ten of the highest profitability stocks in the FTSE 350

Hugely profitable companies have a habit of achieving cult-like status in the stock market.For those that catch them early, they can be life-changing. For many of the rest of us, they’re the ones that got away… because they just seemed too expensive at the time.

The appeal of these stocks is often very clear. Profitable companies are those that are likely to have the best chances of protecting themselves through the economic cycle. They often have robust brands and strong customer loyalty. And they are able to operate and grow very efficiently, which means they can drive and compound shareholder returns over the long term.

They’re the kind of stocks you imagine Warren Buffett taking a shine too. They’ve got those elusive moat-like qualities; profits driven by rock-solid competitive advantages that it’s hard to see anyone breaking own.

The price of these stocks, of course, can be extreme. Highly profitable companies are naturally popular in the market and that makes them appear expensive (especially in bull markets). These are the classic hallmarks of what we call at Stockopedia, High Flyers. Strong quality and blistering momentum can be a potent blend over long periods – but it can be a pricey party to attend for anyone arriving late.

A profitability checklist

With this in mind, here’s a quick-fire checklist of possible profitability measures (by no means exhaustive) for use in a strategy looking for financial firepower.

One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed – or ROCE. A high return on capital can be a signpost to stocks with strong and defensible brands and franchises that can be rolled out very profitably.

Another signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted. This is known as the operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.

Competitive advantage is also something that can be examined by looking at what’s known as return on equity. This is the technical term for comparing a company’s net income to all the cash that investors have put into it. It’s a popular way of comparing the profitability of companies in the same sector. ROE varies from industry-to-industry, but 15% is generally thought to be desirable.

A fourth check in the hunt for profitability is a ratio called free cash flow to sales. This handy comparison lifts the lid on the proportion of sales revenues that actually turn into cash after everything else has been paid. Companies are sometimes criticised for producing impressive-looking accounts yet fail to generate hard cash. This cash flow ratio should help you spot them.

With these measures in mind, here’s a screen built for the FTSE 350 using some of the key hallmarks of strong and consistent profitability (sorted by ROCE). To give you an idea about how the valuations of these kinds of stocks can swing to extremes, I’ve included the ValueRank – which proves to be a useful first filter to pinpoint a couple of interesting results… (you can find the full screen here).

Phil Oakley said it recently in his article for Investors Chronicle – but Rightmove, as the most profitable stock on this list, really has been a staggeringly impressive business (and investment) over several years. It’s been right up there as one of the better examples of a well-protected, moat-like business. Can it continue that way? Well, competitors are out there. But for now, the profitability stats remain very impressive.

At more normal (but still strong) levels, a number of the stocks here have been passing these screen rules for years. Companies like Hargreaves Lansdown, Games Workshop and Money Supermarket. Auto Trader, a more recent listing, has also consistently scored well.

Plus 500, the online trading business, has got itself caught up in all kinds of reporting issues this year, which have dragged down its share price. Another momentum loser is 888 Holdings, the gaming businesses. In both cases, the ValueRanks have shot up – to the polar opposite of what most of these stocks rank at. Numbers-wise, the two stocks look cheap on some measures (but perhaps not on others), but they are suffering operational (and possibly financial) challenges. It’s unknown how things will develop in those cases – but it’s a reminder that high profitability in not always a defence against disappointment.

But even with the disappointments, this particular group of stocks held in an equally weighted (simulated) portfolio would have achieved a return of nearly 12 percent over the past year – bouncing back from last year’s dip and easily outperforming the wider market.

So overall, strong profitability tends to be associated with some of the most respected names in the market – some of which we’d probably all like to own. While these stocks can become expensively priced, their strong competitive advantages can make them formidable businesses and very successful long-term investments.

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