Rules of the Game: No Profit, No Deal

 | Apr 05, 2013 | 1:00 PM EDT  | Comments
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It seems pretty basic: Invest in companies that are profitable and whose management is clearly focused on creating value for shareholders.

I'm going to insert tongue in cheek (somewhat) for the moment, so don't get too literal on me, but let's take a case in point: Facebook (FB) CEO Mark Zuckerberg has famously stated that the company's goal is to connect the world, not to make money.

You could argue that his announcement Thursday about the Home software, which will be available for free, supports that view.

Interestingly enough, Facebook has been profitable, regardless of Zuckerberg's stated intent. It earned $0.53 per share in 2012, and analysts expect that number to grow by 8%, to $0.57 per share this year. In 2014, Wall Street sees an even better growth rate, 37%, to $0.78 per share.

So the numbers put the lie to the CEO's statements, for which investors are undoubtedly grateful. There have been some calls for Zuckerberg to step down and cede control of the company to COO Sheryl Sandberg, a more experienced Silicon Valley executive.

I don't really care what happens in Facebook's executive suites. I don't own the stock, and I'm really just commenting on some recent news stories putting the spotlight on the company's management.

But it got me thinking: I've never been a fan of the speculative investments in companies that don't generate profits. Back when I was a shorter-term trader, some of these stocks were OK, as essentially flips. I'm thinking specifically of biotechs, which can be unprofitable for years but can offer fast trade opportunities when there is news, good or bad.

But I continue to run scans to get ideas for our Equity Overlay strategy at Portfolio. One factor I always screen for is profitability. Plain and simple: I'm not interested in putting our clients into a speculative, unprofitable company. Maybe it's expected to become profitable at some future date. Wonderful! We'll reconsider the stock at that point. Until then, no dice.

I plugged some of the current Equity Overlay holdings into one of my basic profitability scans. You might be surprised, given the current technical weakness in the stock, but virtualization software specialist VMware (VMW) scores nicely, in terms of its track record of profitability.

Analysts see the company growing earnings at a rate of 13% this year, to $3.23 per share. In 2014, that's seen rising another 15%, to $3.72 per share. Consensus estimates for each of those years have been increasing.

Return on equity is a strong 24%, and cash flow per share is also compelling at $3.50.

Growth stocks are currently out of favor, but those cycles ebb and flow. While momentum traders will shy away from this stock right now, those who have greater confidence in the fundamentals and earnings outlook may choose to hold or even scoop up some bargain-priced shares.

Will the stock go lower before it rallies back to its 52-week high of $118.79, reached almost a year ago? Maybe. Does the business case for greater storage and networking capabilities appear bright? It sure does.

Later this week, I'll look at some of the other large-cap stocks with strong earnings that we hold in some client portfolios. As always, any analysis I do here does not constitute a recommendation for any given investor. It's absolutely impossible to say whether or not a stock is suitable for your portfolio without doing a plan to determine your financial needs and objectives.

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