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Why You Could Be Ignoring The Most Essential Metric For Growth Stocks

These are gloomy times at the headquarters of digital advertising firm Rocket Fuel, Inc. (Nasdaq: FUEL ). Many of the company's employees became paper millionaires during the September 2013 initial public offering ( IPO ). Shares opened for the first day of trading at $29 and soared to $62 by the end of the day. These days, shares languish around $8 and most employee stock options are deeply underwater.

Yet this company's share price implosion was quite predictable. That's because management pursued the maxim "growth for its own sake." They forgot that investors eventually expect sales growth to turn into profit growth. Indeed this is a lesson learned -- and forgotten -- every decade. Back in 2008, strategists at consulting firm AT Kearney spelled out this growth trap in great detail.

A simple look at Rocket Fuel's financial statements paints a picture of a company with minimal expense restraint.

Although investors initially applauded this company's remarkable growth trajectory, they couldn't understand why losses kept on rising. Rocket Fuel's desire to "step on the gas" in terms of headcount spending has ultimately been a huge turn off.

Instead, investors need to steer clear of companies with negative operating leverage. As my colleague Nathan Slaughter wrote in the May 2015 issue of StreetAuthority's Total Yield newsletter, "some companies are cut from a different cloth. They don't really have to do anything special, yet systematically earn more from each new dollar of sales than from the preceding dollar. So the bigger they get, the fatter their margins become. It has to do with the way they are built."

These kinds of companies reap scale economies with each passing year. And they can generate a big payoff for investors. "While others require increases in operating costs to generate increases in revenue on a one-to-one basis, these companies need to expend very little to haul in a lot more cash," Nathan writes.

Of course this all sounds nice in theory. You'll still find companies such as Amazon.com, Inc. (Nasdaq: AMZN ), which can coast on the notion of "growth for its own sake." Investors continue to ignore Amazon's utter lack of operating leverage -- shares are up 57% year-to-date -- but the chickens may eventually come home to roost, as my colleague Joseph Hogue just noted .

Yet Nathan has found that companies with operating leverage, what he calls "margin expanders," consistently reward shareholders. He found that 162 companies that are listed in the United States have expanded their profit margins for each of the past five years. This hypothetical basket of stocks delivered a 157% total return, nearly 50 percentage points higher than the S&P 500.

Nathan took things a step further, focusing on the 13 companies that deployed those margin gains into share buybacks. All of them have produced steadily lower share counts. How have such stocks fared? Quite well.

I did a little digging into these 13 stocks (which you can read about in that issue) and found the most compelling current bargains this group. They are:

I did a little digging into these 13 stocks (which you can read about in that Total Yield issue) and found the most compelling current bargains this group. They are:

Territorial Bancorp, Inc. (Nasdaq: TBNK )

This Hawaii-based bank has a market value of $227 million against shareholder's equity of $215 million. Frankly, shareholder's equity would be a lot higher if this bank had not retired 21% of its shares outstanding since its 2009 IPO.

Cash has also been deployed for dividend streams. Dividends per share have been growing at a double-digit pace for four straight years -- for one simple reason. As the bank's share count decreases, the amount of money earmarked for dividends goes further.

Robert Half International, Inc. (NYSE: RHI )

This firm, which focused on temporary staffing and management recruiting (i.e. headhunters), was forced to tighten operations after the economy slumped in 2008. Yet from that lower baseline of business, moderate sales gains have led to a steady upward march in operating profit gains. In fact, free cash flow has surged for five straight years, to a recent $180 million.

This company may just be getting started. Global employment trends continue to strengthen from the lows seen a few years ago, and that means more business for the place of temps and more turnover among mid-level and upper-level management. That sets the stage for further margin expansion.

Risks To Consider: Margin leverage in a growing economy is not hard to achieve. Yet if the economy were to stall out, or if companies decide they need to give their employees a big raise, future margin gains may prove elusive.

Action To Take --> This is a good litmus test for any growth stock you are researching. As quarterly results roll in this earnings season, take a quick snapshot of year-over-year margin trends. If they're not heading north, then shares may be heading south.

If you'd like to learn more about Total Yield stocks and how they've beaten the market -- even during the 2008 financial crisis and dot-com bubble -- then please click here .

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.

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