Fool.com: Fall Into the Gap (Workshop) September 15, 1998

Fall Into the Gap

Atlanta, GA. (Sept. 15, 1998) -- Last week, I proposed a theorem for making use of our Fool's margins screen and tested it against Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> and then Best Buy <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BBY)") else Response.Write("(NYSE: BBY)") end if %>, the two top performers from the workshop's mechanical models. We found that my theorem worked perfectly for Dell, while Best Buy presented challenges.

The main problem was our screen's 15% sales growth threshold. If we looked instead for a 15% or greater EPS advance even on lame sales growth, we could have found Best Buy last September, long before it appeared as part of the relative strength mechanical portfolios. Since then, the stock has soared, hitting an August high of $54 13/16 for a 357% one-year gain!

So now we turn to the Gap <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GPS)") else Response.Write("(NYSE: GPS)") end if %>, the third best individual performer among the mechanical model portfolios, with a 71% year-to-date gain as of August 26, my study date. It's worth noting right now that these three stocks are responsible for all of the aggregate gains recorded by the mechanical portfolios set up last December 31. Indeed, of the portfolios, only the Keystone would have been in positive territory as of August 26 without these stocks (up 10.3%, but still lagging the Standard & Poor's 500 Index's 11.7% year-to-date performance at the time).

The Gap's annual net margin numbers for the last decade do and don't tell the story.

 
 FY87         6.6% 
 FY88         5.9% 
 FY89         6.2% 
 FY90         7.5% 
 FY91         9.1% 
 FY92         7.1% 
 FY93         7.8% 
 FY94         8.6% 
 FY95         8.1% 
 FY96         8.6% 
 FY97         8.2% 
 1/2 FY98   7.5% (vs. 6%)

As might be guessed from the rising margins, the stock enjoyed a remarkable run between the end of the disappointing FY88 and the end of the terrific FY91, moving from the low $3 range (adjusted for splits) to the January 1992 high of $19 5/8. The margins then dipped (a sell signal) and the stock plunged as low at $8 7/16 by September 1993. The margins staged a recovery, but the stock did not break though the January 1992 high until April 1996. Revenue gains had slowed considerably, from as high as 30% in FY91 to as low as 11% in FY93. Sales growth didn't top 20% again until 4Q95, and that's when the stock finally hit new highs.

During this period, the Gap would have made the Fool's current margins screen only once, in 1Q94, when sales rose 17%. Buying the stock in May 1994 after that report and selling in August 1994 following the 2Q94 report, when sales increased just 12%, you would have suffered a 7% loss during a three-month holding period.

Starting with the 3Q95 earnings, the Gap strung together four consecutive quarters that made our margins screen. Following the theorem, you would have bought the stock around $16 in November '95 and sold in November '96 around $20, for a 25% gain.

You wouldn't have gotten interested again until November 1997 after the 3Q97 results were in. Following the theorem, you would have bought back in at $34 1/2 and held to the present, as the Gap delivered three more quarters of spectacular revenue and earnings growth on the way to the all-time high of $68 last month.

So while my theorem would have led you to make some so-so trades earlier this decade, it also would have given you the Gap either somewhat earlier than or at about the same time as the mechanical models. A nearly 100% profit in just ten months is not bad!

But as Best Buy suggests, perhaps we could have done even better tinkering with the sales threshold on our margins screen. Applying the theorem but assuming that rising margins on any sales gain was sufficient to buy or hold, you would have....

1) Bought the Gap at $11 1/2 in November 1993 after the 3Q93 report (sales up 9%, EPS up 26%) and sold around $10 1/2 in February 1995 after the 4Q94 report (sales up 14%, EPS up 9%). This sixteen-month holding period would have produced a 9% loss.

2) Bought the Gap at $16 in November 1995 after the 3Q95 report (sales up 17%, EPS up 28%) and sold at $20 in November 1996 after the 3Q96 report (sales up 20%, EPS up 17%). This was the 25% gain seen above.

3) Bought the Gap in February 1997 at about $16 1/2 after the 4Q96 report (sales up 10%, EPS up 15%) and sold in August 1997 at $28 after the 2Q97 report (sales up 20%, EPS up 13%). This was a 70% gain in six months.

(Depending upon how closely you interpreted the EPS, though, you might have sold in May '97 at around $22 since the EPS growth of 10.7% outpaced sales growth of 10.6% only due to rounding. Taking the EPS one spot beyond the decimal, EPS were up just 8.8%.)

4) Bought the Gap in November 1997 at $34 1/2 just as you would have done using the current screen.

Overall, I think lowering our margin screen's sales threshold (to anything positive) would have worked pretty well with the Gap. We would have suffered a slightly greater loss on a longer holding period during the mid '90s, but we also would have enjoyed a lucrative extra trade during 1997. To summarize, we would have bought at $11 1/2, sold at $10 1/2; bought at $16, sold at $20; bought at $16 1/2, sold at $28; bought at $34 1/2, held to the present.

I haven't run the numbers to see if such trading would beat the buy-and-hold Gap investor (my guess is it wouldn't), but in terms of market timing, it's not bad. The margin screen still looks useful, though it probably could use some supplementary help. In any case, applying the theorem to either margin screen would have saved us from major losses. That's part of what we want our margin theorem to do. Next time, we'll start looking at the mechanical portfolios' losers to see if the margins screen offered any warning signs.

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