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Gross Margin Index and Sales Growth Index

September 04, 2013 | About:

David Chulak

29 followers
The Beneish M Score was developed by Professor Messod Beneish designed to discover earnings manipulation. The original scoring consisted of five quantitative ratios and ultimately increased to eight in order to determine whether the company was somehow manipulating or massaging the financial statement numbers in order to make things look healthier to shareholders than might otherwise be the case.

The use of the Beneish M Score is used by both short-sellers and those with long positions in an effort to make certain that the numbers represent a fairly accurate picture of the financial position of the company and whether manipulation may be taking place. Truthfully, the SEC statements are near representations, capable of revealing many weaknesses or manipulations taking place. However, typically companies carry two sets of books. One is for the shareholders and is included in the SEC filings, but most companies have a separate set of books exclusively for the IRS. Only shareholders with ownership of a material percentage (perhaps 5%) of shares may request the IRS books and receive access.

These quantitative concepts classified manipulators between 58% and 76% of the time with the original five ratios. Ultimately, these act as red flags, or perhaps yellow flags that require additional study for those that fall into the manipulators scale. Unfortunately, most investors look exclusively at the overall Beneish M Score and make a judgment from the overall number, but that leaves out much of the needed information. It appears that taking the time to look at the individual elements of the scoring helps the investor to get a much more comprehensive picture as to what is going on.

Specifically, the Gross Margin Index was one of two of the ratios that indicated manipulation for four of the largest manipulators Wall Street has experienced in the last 15 years.

Gross Margin =

Sales from the prior year subtracting COGS or cost of goods sold and divide by sales from the prior year divided by Sales from the current year subtracting COGS for the current year divided by sales from the current year or simply:

Sales (t-1) – Cost of Sales (t-1) / Sales (t-1) /

Sales (current year) – Cost of Sales (current year) / Sales (current year)

The Non-Manipulators Index = 1.014

Manipulators Mean Index = 1.193

GAAP Manipulators = 1.042 (This median number include manipulators studied by Beneish have manipulated through GAAP numbers

Generally speaking, any GMI Index number greater than 1 indicates that the gross margins have dwindled or deteriorated, motivating current management to manipulate the numbers to look better than they might otherwise. A GMI over 1 a red flag that requires more study, but if nothing else, should signal that the potential investor remain cautious. Companies with GMIs over 1 should be scrutinized carefully by the auditor and/or account.

So how successful is the index? Check out the last six years of Enron when it completed its final demise. Anyone observing this red flag should have discovered what was taking place.

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Note that the 1995 gross margin index, which exceeded 1, should have at least been a yellow flag, but years 1996 through 2000 indicated possible manipulation each year and should have been considered red flags each year, requiring additional study due to proximity to the manipulators index of 1.193.

But look at some of the other great failures, such as Qwest, WorldCom and Global Crossing:

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Once again, it’s a red flag indicating possible manipulation. It does not mean that you have necessarily caught the company doing something illegal. Manipulation may be allowed….sorry to say…because of accounting rules and there are numerous ways of hiding it.

American Tower Corp. (AMT), a REIT (real estate investment trust) owns and operates communication sites and/or cell towers. It will acquire the sites, prepare them, pull permits, do the structural analysis required for the towers, etc. By all accounts, a quick or cursory glance at the income statement might cause a novice investor to say, “No problem here,” but let’s look closer.

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A GMI of 1.495 is above the manipulators mean and requires additional study. It does show a red flag that investors should remain cautious. The GMI for American Tower exceeds the GMI for both Qwest and Global Crossing before their disintegration.

The Sales Growth Index was the next ratio that was useful in identifying manipulation in the terrible four that we’ve been talking about. The Sale Growth Index or SGI consists of:

SGI = Sales (current year) / Sales (previous year)

Company executives that are in place of companies with high growth are under constant pressure to maintain the growth and therefore are more prone to manipulate the numbers when a reversal of fortune comes their way. The manipulated earnings median is around 1.607, with a median of 1.134 and should cause a red flag the higher the number. How did Enron and the others do? See below. The next image indicates that manipulation should not have been a great surprise for those invested in Enron.

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So how did American Tower Corp (AMT) manage?

2012 Sales = 2875.96

2011 Sales = 2443.53

SGI = 1.177, meaning possible manipulation

These are two incredibly powerful ratios that should be used by investors, and we will discover more as we continue.

Disclosure: I am short AMT

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

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