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Profit During Earnings Season Using These Key Metrics

Many investors spend too much time during earnings season focusing on gross profit margins. They figure that a drop in these margins means a company is losing pricing power, or they worry that the cost of goods sold is rising too fast. Yet there are often good reasons for gross margins to be flat-to-down compared to prior periods. For example, in many competitive industries, flexibility on price is a key to growing the customer base.

The best-run companies know that even if each new contract doesn't deliver the gross margins seen in in the past, they can still flow profits to the bottom line. That's because fixed overhead expenses are already in place and those new incremental revenues cost relatively little to service.

To see what kind of companies have a history of operating leverage, I screened for companies that have boosted earnings per share at a much faster pace on average over the past three years than sales growth. And I eliminated any companies that have not boosted sales at least 10% annually in recent years.

It's no surprise that hundreds of companies make the cut, especially since corporate America has been continually streamlining since the Great Recession of 2008. The real feat is to keep that kind of operating leverage going in coming years. I narrowed the list to only those companies that are expected to see EPS grow much faster in 2015 and 2016 as well. It's an impressive group.

I talked about the key ingredients of such a high-leverage business model in of . I noted that Harman appears poised for decent top-line growth, yet "management is carefully tweaking the income statement to squeeze out higher profits." The company just reported better-than-expected quarterly results, and though shares have rallied higher in recent days, I still see considerable long-term upside.

I talked about the key ingredients of such a high-leverage business model in my recent profile of Harman International Industries, Inc. (NYSE: HAR ) . I noted that Harman appears poised for decent top-line growth, yet "management is carefully tweaking the income statement to squeeze out higher profits." The company just reported better-than-expected quarterly results, and though shares have rallied higher in recent days, I still see considerable long-term upside.

You can really see the impact of sales leverage in building materials supplier Eagle Materials, Inc. (NYSE: EXP ) . Solid sales growth in fiscal (March) 2013 and 2014 led operating margins to steadily rise: They stood at 4% in fiscal 2012, 13% in fiscal 2013 and 20% in fiscal 2014. Thus far, in the first six months of fiscal 2015, they have surged to 25%. Analysts expect more of the same, as a steady upturn in residential and commercial construction boosts sales in the 25% range in fiscal 2015 and 2016, and EPS at a much faster pace.

Speaking of the construction sector, homebuilder Lennar Corp. (NYSE: LEN ) is on the right path to higher operating margins. The company generated an 11.5% operating margin in fiscal (November) 2013, which was the best showing since fiscal 2005. And that figure is expected to steadily rise, to 16% by fiscal 2016, according to Factset Research. Part of the gains are coming from well-timed sales of land to other builders, enabling the company to boost operating income even faster than sales.

Equally important we're entering a timely phase for such stocks. According to an analysis by Merrill Lynch, homebuilders outperform the broader market 75% in the November-January timeframe whenever the September reading of housing starts comes in ahead of the consensus forecast -- which it recently did. That sets up a "hope trade" as investors buy homebuilder shares heading into winter in anticipation of better industry trends in the spring. "Within our coverage universe, Lennar has performed the best historically during November-January, outperforming in 88% of instances since 1982, with an average relative return of 16%," note Merrill's analysts.

Risks to Consider: Many of the stocks on the table above sport fairly robust valuations as a reward for their exemplary operating performance. So consider these to be solid buy-and-hold investments, and not short-term trades.

Action To Take --> Harman International, Eagle Materials and Lennar share another key trait: They are all expected to benefit from industry changes (Harman and the "Connected Car") or secular tailwinds (the housing recovery). As a result, they appear well-positioned to continue expanding their operating margins. Of the three stocks, Harman and Lennar hold the greatest appeal from a valuation perspective.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.