Margins Screen and Even More Losers

by Louis Corrigan ([email protected])

Atlanta, GA. (Sept. 29, 1998) -- We've been tracking how my proposed margins theorem would have performed on some of the mechanical models' losers. With its help, we would have done the bump with ICN Pharmaceuticals <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ICN)") else Response.Write("(NYSE: ICN)") end if %> and Coca-Cola Enterprises <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CCE)") else Response.Write("(NYSE: CCE)") end if %> -- and enjoyed our quick exits. The theorem also had us partying down early with Whole Foods Market <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WFMI)") else Response.Write("(Nasdaq: WFMI)") end if %>, though we're still on the dance floor and feeling tired. Today we'll look at a couple of interesting cases in which it would have left us with two left feet.

As all the world knows, Zip drive maker Iomega <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IOM)") else Response.Write("(NYSE: IOM)") end if %> was a Fool's dream come true...until the dream turned into a nightmare. Iomega was a selection in this year's Investing for Growth-Classic (IFG-C) and Investing for Growth-Relative Strength (IFG-RS) models at $12 7/16. By my study date of August 26, all that Jaz had lost more than a beat, sitting at a lowly $4 3/16 after being clobbered for a 66% loss.

Back out Iomega and the IFG-C would have been up 15.1% rather than 6.9% while the IFG-RS would have gained 30.6% versus 20.9%. How would the margins theorem have done on the Big Easy that turned into the Big Ouch?

Though the astonishingly successful introduction of the Zip drive sent FY95 sales up 131%, margins didn't start growing (that is, EPS growth didn't start outpacing sales growth) until 1Q96. By then, Iomega's stock had already zipped ahead, from a split-adjusted $7/8 in April 1995 to around $8 in April 1996. About the time my margins theorem would have said "buy," David and Tom Gardner were sitting pretty on the cover of Fortune magazine because they had bought nearly a year earlier. By doing so, they had created a buzz in the financial world, and more important, attracted thousands of individual investors online to see how they too could learn to beat the Street.

By my theorem, you would have held until the 4Q96 report showed that profits weren't keeping up with sales (Zip drives were beginning to be offered in more PCs, and selling to manufacturers is a lower margin biz). But you would have jumped back in after 1Q97, when EPS soared 100% on a sales gain of just 63%. You would have held on until.... well, too late.

You wouldn't have bailed until the 1Q98 results showed margins down into negative territory. So after buying around $8 in April 1996, you would have sold at maybe $9 in late January 1997 before buying back at about the same price three months later and then finally cashing out for good at nearly the same price in April 1998.

Thus, for one of the most exciting (and potentially, quite profitable) stocks of recent years, my theorem would have pretty much made you....zippo! Considering that you could have invested your money in the ever-rising S&P 500 during this period, your opportunity cost would have been quite high.

This seems like an important finding. Why didn't the margins theorem work on this red hot investment?

Iomega's success depended on two new products, the Zip and the Jaz drives. Technology products tend to have a limited life cycle and to decline in price during the tail end of the cycle. Iomega's stock ramped up in anticipation of the Zip being a hit. And it was. Yet, bracketing off some added drama due to a short squeeze in the spring of 1996, the stock's multi-step decline came in anticipation of the life cycle of these products peaking and Iomega failing to either A) significantly boost profitability as expected (through high-margin disk sales) and B) introduce new hit products.

A company with a small number of products is very dependent on the natural cycle of those products, and investors will key off of news that provides hints about that cycle. In other words, the stock will anticipate the changes that will only later be reflected in the company's profitability. A great and actually quite similar example of this dynamic can be seen in the recent collapse of 3D graphics chip maker 3Dfx <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TDFX)") else Response.Write("(Nasdaq: TDFX)") end if %>, another Fool Port holding.

Input/Output <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IO)") else Response.Write("(NYSE: IO)") end if %> offers a related example. The company designs and manufactures seismic data acquisition equipment for use in oil exploration. Its stock drilled a homer in 1997 during the boom in oil services stocks. Its collapse was presaged by the Asian slowdown that first registered with Wall Street last October. The Relative Strength -26 week (RS26) model portfolio would have bought it at $29 11/1 on December 31, which turned out to be about the worst time to buy it. By my August 26 study date, it had lost 62% of its value, falling to $11 3/8 as it headed below $10 after issuing a 1Q98 profit warning on August 24.

As one might imagine, this business is cyclical and ultimately quite dependent on the price of oil. This example suggests that the margins screen is completely useless for spotting the right time to buy or sell a company in a cyclical industry. That's because investors who follow such cyclicals react to minor changes in external events that may affect these companies' future profits. So a lot of good news is already built into a stock before the bottom line begins to swell. Conversely, bad news may be factored in long before operating results show it.

In this case, my modified margins theorem would have led you to buy the stock a few months before the RS26 did, just after the 1Q98 earnings report (the August period of 1997). Prior to that, Input/Output had recorded three quarters of declining year-over-year EPS. That 1Q98 report was the first of four consecutive quarters showing rising sales and soaring margins.

Yet the stock peaked at around $33 in October and really never looked back. The course since then has been all downhill despite the improving results. The stock was already beginning to factor in the downturn in this latest oil services cycle, and the 1Q99 shortfall is simply what the market's been projecting.

So while the margins screen wouldn't have helped you avoid disasters in Input/Output or Iomega, its failure to do so suggests you should be cautious about investing in any cyclical business. The opportunities, of course, can be enormous, but you need to understand the peculiar dynamics of the specific industry and be prepared to follow the macro and company-specific events that can cause a cycle to turn down.

This should be of special interest to folks following the relative strength models. These models may pick up a cyclical company relatively late in its upswing, especially if that cycle is about to be cut short by an "exogenous event" (like falling oil prices due to global recession). Input/Output started causing seismic tremors for RS26 investors almost immediately.

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