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Imagine you have two options for investing your savings: keeping it in a piggy bank at home or investing in a local business. If the business can use your money to earn more than what it would cost you to lend it out (think of this as the interest you’d want if you just kept your money), it’s a sign that investing in the business might be worth considering.

The key is the business must not just earn a profit but a sufficient profit to compensate for the cost of the capital invested in the business, both debt (borrowed money) and equity (owner’s money). We refer to profit above and beyond the cost of capital as “economic profit.” Today, especially with higher interest rates, many companies are not earning their cost of capital and generating an “economic profit.”

Here are the main reasons why we focus heavily on profitability in this way:

• Value Creation: When a company earns more from its investments than what it costs to finance them, it’s effectively using creditor and investor money to generate more money. It’s not magic, but businesses who can do this are evidencing smart business decisions that grow value.
• Efficient Use of Resources: A company that can consistently turn a profit higher than its costs is doing something right. Whether it’s innovative products, efficient operations, or strong customer relationships, it means they’re using their resources wisely.
• Competitive Edge: Maintaining higher returns that cover costs while adequately compensating providers of capital can hint at a competitive advantage. They may have a better product, a stronger brand, or more efficient operations. Whatever it is, it sets them apart from the competition.
• Growth and Stability: We find companies that manage their investments well are generally more stable and have better prospects for growth. They might fund new projects from their earnings, reducing the need for external borrowing and possibly increasing their value over time.

When a company’s returns on capital outpace its cost, it’s a sign of good health and intelligent management. It doesn’t guarantee success, but it’s a positive indicator that the company is on the right track, making it an attractive option for inclusion in a portfolio.

A Look at Today’s Companies

We decided to look at nearly 1,000 of the largest U.S. companies. Based on Bloomberg data, about half of companies are not earning sufficiently high return on capital to cover their cost of capital. Not surprisingly, the problem is more acute among the lower-graded companies in our study, based on our own “WCA Quality Grade.” That grade considers quantitative factors ranging from profitability, profit consistency, and debt level.

The table below breaks these companies down by “WCA Grade” from “A” to “F” and summarizes key facts. Not surprisingly, the “A” quality companies ranked highest on “economic profit,” and the “F” stocks the lowest. The further we go down the scale, the less likely we find companies earning their cost of capital, and the more likely we find companies failing to earn their cost of capital (based on the most recent data). The tradeoff for buying cheap and high-yielding stocks often comes at the expense of profitability. In our view, this tradeoff can be a costly and sometimes risky one that may not pay off in the long run. Instead, we find a focus on reasonably-priced stocks with steady dividend increases is a better way to go.

Quality and Profitability: Large U.S. Companies by WCA “Quality Grade”

Conclusion

While it might be tempting to do so, we find that starting the portfolio-building process with a focus on yield or “cheapness” puts the “cart before the horse.” And doing so only increases the chances the portfolio will be weakened by overexposure to potentially inefficient and less competitive businesses that may struggle to grow over time and may be more prone to weakness during tough times. Ultimately, ensuring strong profitability in quality companies is vital to value creation, which is why we will continue to focus sharply on profitability in assessing quality and value.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Senior Risk Manager
973-549-4028

Tom Serzan
Analyst
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
Director, External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
Client Portfolio Manager
973-549-4031

Disclosures

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.