|How to Interpret a GEARS
The RISK chart illustrates the components of the growth rate of the company, as they have changed over time. By measuring how the relative share price behaves in response to those changing variables, we are able to measure the relative importance of each variable, and search out a pattern in the data that reliably anticipates the direction of the performance of the stock. The GEARS report summarizes the pattern and presents the investment decision.
We can use the history of Motorola Inc as an example of the RISK graphic layout. The most important drivers of the earnings growth rate of a company are the Sales Growth Rate and the Gross Margindisplayed in the third panel from the top in the Components Of Profitability chart. The only long-term driver of premium earnings growth is premium sales growth. Gross margins cannot rise into the long term. Once the gross margin reaches 100%, it stops rising. In the early stages of a companys life cycle, high and/or rising sales growth often produces a period of premium earnings growth. For more mature companies, periods of accelerating earnings are commonly driven by rising margins.
We measure the reliability of each variable as a predictor of the direction of the share price, by using a correlation calculation. At the bottom of the Gross Margin Table, we calculate a correlation between the gross margin and the relative share price of Motorola Inc. (MOT) at 0.91 (perfect correlation is 1). This implies that historically the share price of MOT has followed the gross margin closely.
The same calculation for the correlation of Motorola sales growth to Motorola share price is 0.84, implying that sales growth has had the less reliable effect on the share price than the gross margin has. Companies with a high proportion of fixed costs and relatively volatile sales growth, will tend to have a higher share price correlation with sales growth than with margins. A higher degree of correlation between margins and share price, rather than sales growth and share price, is common for stable sales growth companies. When sales growth is stable, changes in the direction of EBITDA growth are more likely to be caused by changes in the direction of the margin.
The second chart from the top in the RISK Chart set is the long-term monthly Relative Investment Return of the stock. Our goal in measuring the level, direction and quality of earnings growth of the company is to anticipate important changes in the direction of the relative investment returns of the stock. The history and timing of GEARS transaction decisions for each stock are indicated on the Relative investment return chart with buys and sells indicated with vertical lines through the chart at the end of the month the transaction was recommended. The efficacy of those recommendations for the individual company is detailed in the investment return section at the top of the table on the risk chart. More details about GEARS performance are in the performance section.
The bar chart in the middle of the RISK page measures extraordinary and unusual items, discontinued operations and unconsolidated subsidiaries as a proportion of sales. These items are accounting distortions of the company growth rate that increase the volatility of the earnings record, without providing insight into the direction of the growth rate. Accounting distortions are a problem for any statistical analysis of the corporate record, and the bar chart does not account for them all. Sometimes non-recurring expenses are not classed as extraordinary or unusual, and cause discontinuities in the gross margin, sales growth rate or costs.
The Depreciation, Inventories and Receivables chart (third from the bottom in the RISK chart set) is an attempt to link the balance sheet with the income statement, using the balance sheet as an income statement forecaster. The variables are measured as a proportion of sales to normalize for the growth of the company.
Rising inventories tend to predict lower gross margins. If the company is building more than it is selling, and accumulating inventory, there is a better chance that product prices will come under pressure, depressing the gross margin.
Rising receivables, as a proportion of sales, tend to predict lower sales growth. If the company is building receivables as a proportion of sales, it means that customers are being encouraged to buy now. That tends to overstate the current sales growth rate, and increases the chance of lower sales growth in the future.
A common pattern in the balance sheet data is rising receivables and falling inventories. That pattern indicates a company that is financing inventory into its distribution system. Once the distribution system is full, the company suffers both lower sales growth and a lower gross margin.
In our Motorola Inc example, the inventory increases of 1984-85, 1988-89 and 1993 all successfully anticipated a decline in the gross margin. The early 1998 increase in inventories suggests that the currently falling gross margin is likely to continue down.
The major sales acceleration at MOT in 1991-1994 was successfully anticipated by lower receivables. Changing receivables are important leading indicators for most companies. Changing inventories are accurate predictors with varying success across companies, but are more reliable for product-driven companies and retailers than they are for service-oriented companies.
Also on the Depreciation, Inventories and Receivables chart is the measure of depreciation and amortization expenses as a proportion of sales. This non-cash cost item is the link between EBITDA growth and earnings growth, and is useful as an early indicator of deteriorating earnings quality. If depreciation expenses are falling, then earnings growth is rising at a faster rate than EBITDA growth. Often we will begin to see the cash flow growth rate fallbut because of lower depreciation expenses, earnings growth does not fall.
Referring again to our Motorola Inc example, note that from 1992 to 1994, the depreciation expenses fell from over 8% to nearer 7% of sales. That decline accelerated earnings relative to EBITDA, and resulted in a decline in valuation relative to earnings. That decline in valuation often makes stocks look cheap relative to earnings when their cash flow growth rate begins to decline.
The second chart from the bottom of our RISK chart set (EBITDA Margin...) is an attempt to analyze the relationship between EBITDA growth and free cash flow. The solid line is the EBITDA margin. This is simply the gross margin less SG&A expenses, and is a reliable measure of the direction of cash flow growth. This variable is often highly correlated with the share price, since change in the direction of the EBITDA margin is an important indicator of the direction of growth.
In the case of MOT, the relative investment performance of the shares is 86% correlated with the EBITDA margin. By deducting capital expenditures and interest costs from the EBITDA margin, we arrive at a measure of the free cash flow margin. Because capital expenditures are lumpy, this variable can be volatile and less useful as a result. Still, it is useful to note declines in free cash flow growth, since a lower gross margin is often predicted by higher capital expenditures. This is particularly useful if we measure an increase in capital expenditures across an industry, since excess capacity is a common reason for lower margins industry-wide.
The bottom chart (Asset Turnover and Assets to Equity) is a long-term measurement of balance sheet efficiency. Unfortunately, asset turnover and assets-to-equity are less valuable in recent years, as the larger number of unusual and extraordinary losses accumulate as distortions to both the asset and the capital accounts of the balance sheet.
The compound pattern of all these variables converge each quarter to produce a conclusion on the stock. That decision, and the rationale for reaching it, are produced in the GEARS Report.