The Motley Fool: The Foolish Workshop, Sept. 22, 1998

More Looks at the Losers

Atlanta, GA. (Sept. 22, 1998) -- Today I'm continuing to check how my margins theorem would have done at detecting the losers in the mechanical model portfolios. But first, another word on ICN Pharmaceuticals <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ICN)") else Response.Write("(NYSE: ICN)") end if %>, discussed last Friday.

As I said, had you followed the theorem, you might have purchased ICN in November 1997 after the Q3 97 earnings report came out and sold out on March 5, 1998 after the year-end numbers were released. That trade would have been a wash, with the buy at no more than a split-adjusted $36.70 and the sell at $36. Simply following the margins theorem, though, you would have escaped the ensuing collapse to $14 suffered by some of the model portfolios.

I'd call this a modest victory for the theorem, except that I think it was basically just good luck that nothing too bad happened to the stock during this stretch. As you know, I differ from Robert Sheard in that I don't think any screening method (including the mechanical models) produces an investable portfolio without added research. The bare minimum of research (just reading the company's quarterly filing) would have been enough to convince a sensible investor to avoid ICN, in my opinion.

Indeed, I believe ICN offers a classic example of why those of you following one of the mechanical models should spend a least some amount of time getting to know these companies. Otherwise, you're occasionally going to buy something scary!

Twenty minutes worth of research would have paid off handsomely. As of my August 26 study date, ICN traded at $20 3/8 (it's since fallen another 30%). Look at these model portfolios on that date with and without ICN.

 
 Portfolio  Return    Return 
                      less ICN 
 RS-IBD     35.6%     43.6% 
 RS26       10.5%     15.8% 
 IFG-RS     20.9%     27.3%

Let's turn now to another loser....

Coca-Cola Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CCE)") else Response.Write("(NYSE: CCE)") end if %> is the Real Thing's leading bottling operation. It gets stuck with the heavy-duty capital spending and the price wars while Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> takes in gazillions of dollars making high-margin syrup and thinking up new marketing schemes. The bottler made the Keystone portfolio last December at $35 9/16. By my August 26 study date, the carbonation was gone and the stock sat at $26. Here are the firm's annual net margins:

 
 FY95  1.18% 
 FY96  1.34% 
 FY97  1.50%

This low margin business appeared to be becoming much more profitable, with FY96 sales up 17% but EPS up 40% and FY97 sales up 42% but EPS up 54%. But wait, checking the income statement, we see that a one-time tax break from operations in the United Kingdom added $0.15 per share to FY97 earnings. That accounted for nearly all of the EPS increase: revenues jumped 42%, but EPS excluding this benefit fizzed just 7%.

The story quarter to quarter is a little more complicated, especially because of some acquisitions. The numbers play out this way: margins were up in Q2 97 and Q3 97 (even backing out the tax benefit) but down the next three quarters, in part due to higher interest expenses related to the acquisitions. Following the theorem, then, you would have bought the stock after the Q2 97 report in the low to mid $20s and sold in the low to mid $30s after the Q4 97 earnings were released.

Those figures are fuzzy because I can't find the specific dates for the news releases. Still, the general point holds. The margins theorem here would have produced a profitable trade that got you into the stock long before it made the Keystone portfolio. In turn, you would have cashed out early this year before the stock popped.

One more for today....

Whole Foods Market <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WFMI)") else Response.Write("(Nasdaq: WFMI)") end if %>, the nation's largest chain of natural food supermarkets, turned up in the two relative strength portfolios at a December purchase price of $51 1/8. On my August 26 study date, the stock had slimmed down 9% to $46 9/16. Since then, the veggies have gotten even more mushy.

Whole Foods has had two terrific runs over the last three years, including one that started at $11 and then stalled out at $37 in September 1996 around the time of a major acquisition. The second run began in February 1997 and topped out in March of this year following another major acquisition. Those deals play havoc with the historical earnings data that's readily available online.

Still, it appears that the streak that ended in September 1996 was preceded by falling margins in the April quarter, barely rising margins in the June quarter, and then the acquisition, which clouds the financials.

The margins theorem appears to work moderately well on the next run. Margins soar beginning with Q1 97 ending January 19, 1997. Making adjustments for the Q4 97 acquisition, they appear to have been rising every quarter since then, though the gains in both sales and margins have been dropping.

 
 Quarter    Sales      EPS 
 Q1 98      30.5%      83.3%  (inc. merger charges) 
 Q2 98      25.0%      37.9% 
 Q3 98      20.6%      21.2%

So the margins theorem would not have offered a useful check on the mechanical models in that it would not have saved you from the recent loss. On the other hand, the theorem would have led you to buy Whole Foods a whole lot earlier, at around $23 a share. You would still be holding, but instead of being down 20% over the last nine months, you would be up 78% over the last 19 months.

Retail establishments often key off of same-store sales gains since they offer a useful and frequent update (usually once a month) on whether the underlying business sans expansion is doing well. If same-store sales are growing nicely, margins are probably up unless the company's pumping the profits into an expensive ad campaign or some other project. Anyone investing in retail stocks should keep an eye on these monthly numbers. Whole Foods' same-store sales are still growing, but the July quarter results were lower than they have been in over a year.

While the margins theorem alone would suggest you should hold or buy Whole Foods today, the contracting growth in both sales and margins suggests you would probably want to look a little closer at the business. The market is seeing signs of an impending slowdown.

Looking at these three losers, it's not surprising that the margins screen can prove useful but not always sufficient. The case of Whole Foods is particularly interesting because it suggests that after several quarters of rising margins, a stock may have gained so much momentum that any hint of a slowdown can knock it down significantly even before that slowdown actually reduces margins. That's why you would want to use the margins screen not just to get a kind of simple answer (Buy/Hold or Sell/Avoid) but as a tool for following the trends of the business. In the case of Whole Foods, the trend suggests margins might contract in the current (4th) quarter.

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