Five Stocks With Extraordinary Profitability

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Note: This article contains a revised table to address a previous inconsistency.

Return on equity - ROE - is one of the most important indicators to watch when looking for high quality investment opportunities. ROE measures the speed at which the company compounds shareholder´s capital, and it’s a reflection of competitive strength and management quality. The following companies offer big fat ROE ratios, combined with moderate valuations and strong businesses prospects over the long term.

ROE is a simple indicator. It’s calculated as Net Income / Shareholder´s Equity, and it provides a measure of how efficient a company is when it comes to generating earnings with each dollar of shareholder´s equity. As investors, we want to buy those companies which generate higher profitability for every dollar of our money, because they will likely be able to reinvest earnings at superior rates of return.

One outstanding example about a company which has increased its ROE dramatically over the last years is Apple (NASDAQ: AAPL). The iPod, iPhone and iPad have been tremendously successful products increasing earnings at an amazing speed. Since Apple outsources most of its production process, it doesn´t need to invest much capital to build those devices. The rapid increase in earnings has produced a big rise in profitability too, giving the Cupertino giant a ROE ratio of more than 44% vs. numbers in the low single digits ten years ago.

Not many companies in the world have that kind of profitability, and it’s worth noting that Apple still has many growth opportunities ahead. The recently launched iPhone 5 is selling at record speed in spite of some well-deserved criticism regarding its lousy mapping features. Apple is rumored to be launching a smaller iPad in October, and a new Apple TV is expected in the middle term. Digital products like music, movies and apps could be an important source of growth over the following years, so the growth story for Apple is far from over.  This highly profitable stock with attractive growth prospects trades at a very moderate valuation, with a P/E ratio below 16.

Shareholders in IBM (NYSE: IBM) have benefited strongly from the company's decision to focus on the highly profitable areas of software and services while leaving behind the commoditized hardware business many years ago. This has produced a substantial increase in the company's ROE, from less than 16% in 2002 to near 75% currently. IBM has positioned itself as a leader in value-added services and innovation, reaching extraordinary profitability levels. Carrying a P/E around 15, this is attractive investment alternative from a valuation and profitability point of view.

Consulting can be a very lucrative business, providing many opportunities for services with big profit margins and little need for investing in fixed assets,  that's one of the reasons why Accenture (NYSE: ACN) holds a ROE ratio above 66%. Even facing economic hurdles, the company reported better than expected earnings last week. Europe was a surprisingly positive region for the Accenture, as many of if its clients in the old continent are hiring the company to help them at reducing costs and streamlining their business.

The company made a smart strategic move when it identified the outsourcing trend early in the game; Accenture established delivery centers in low-wage countries like India and the Philippines, and it positioned itself as a leader in that area. Most of these projects are recurring long-term contracts that don't fall into clients' discretionary budgets, and this gives Accenture a more predictable revenue stream than competitors enjoy. At a P/E ratio of 18, the stock is not too expensive.

Just like technology and services, the pharmaceutical business is another fertile area where above-average ROE ratios can be found. Once a company has developed a successful drug, profit margins can be huge, since capital requirements for production are usually quite low compared with the income produced by highly demanded pharmaceutical products. 

GlaxoSmithKline (NYSE: GSK) has a ROE ratio above 66%, and this global pharmaceutical has many exciting opportunities in vaccines and consumer products in addition to its drugs portfolio. The company plans to move close to 30 new drugs into late-stage development from 2012 to 2015, and it has compiled more than 100 early-stage compounds in its pipeline. Glaxo is trading at depressed valuations due to investor’s pessimism about Europe; it carries a P/E ratio below 14 and a dividend yield barely under 5%.

One company with unusual profit margins for its industry is Colgate-Palmolive (NYSE: CL), which owns a dominant position in oral care, with a market share of 45% in the global toothpaste market. Colgate is well known for actively working to keep its costs under control and the company has also been capitalizing the current low interest rate scenario to leverage its operations at ultra-low interest rates. Colgate has an outstandingly high ROE of 93% and trades at a reasonable P/E ratio of 21.

These five stocks combine exceptional profitability with reasonable valuations, making them solid candidates to be considered for a long term portfolio of high quality names.

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acardenal owns shares of Apple and IBM. The Motley Fool owns shares of Apple, GlaxoSmithKline, and International Business Machines. Motley Fool newsletter services recommend Accenture Ltd., Apple, and GlaxoSmithKline. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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