Lannett: A ‘Fool Ratio’ Strategy Buy

06/02/2015 8:00 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese, editor of Validea, selects stocks that meet the investing criteria of select market gurus with leading, time-tested investment strategies. Here, he looks at a healthcare play that scores a 91% rating based on the Motley Fool's small-cap growth strategy.

Lannett (LCI) develops drug products sold to generic pharmaceutical distributors, wholesalers, chain drug stores, private label distributors, managed care organizations, and governmental entities.

The Motley Fool small-cap methodology seeks companies with a minimum trailing 12 month after tax profit margin of 7%.

The companies that pass this criterion have strong positions within their respective industries and offer greater shareholder returns. LCI's profit margin of 34% passes this test.

The investor must also look at the relative strength of the company in question. Companies whose price has been rising much quicker than the market tend to keep rising. LCI, with a relative strength of 91, satisfies this test.

Companies must demonstrate both revenue and net income growth of at least 25% as compared to the prior year. These growth rates give you the dynamic companies that you are looking for. These rates for LCI-146.94% for EPS and 70.53% for sales-are good enough to pass.

Insiders should own at least 10% of the company's outstanding shares. A high percentage typically indicates that the insiders are confident that the company will do well. In the case of Lannett, insiders own 17%.

A positive cash flow is typically used for internal expansion, acquisitions, dividend payments, etc. A company that generates rather than consumes cash is in much better shape to fund such activities on their own, rather than needing to borrow funds to do so. LCI's free cash flow of $0.54 per share passes this test.

LCI's profit margin has been consistent or even increasing over the past three years, passing this requirement. It is a sign of good management and a healthy and competitive enterprise.

This methodology also strongly believes that companies, especially small ones, should have tight control over inventory. It's a warning sign if a company's inventory relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more.

Inventory-to-sales for Lannett was 21.54% last year, while for this year it is 16.38%. Since the inventory to sales is decreasing, the stock passes this criterion.

The 'Fool Ratio' is an extremely important aspect of this analysis. If the company has attractive fundamentals and its 'Fool Ratio' is 0.5 or less, the shares are looked upon favorably.

These high quality companies can often wind up as the biggest winners. LCI-with a 'Fool Ratio' of 0.33-passes this test.

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