The 5-Sigma Report

The market has handed investors some nice, consistent returns over the extremely long run, but in the short term, it can often be as unpredictable as an episode of The Real World. In a pair of articles, I explored the market's so-called "fat tail" distribution -- the tendency of stocks to make huge moves that seem extremely statistically improbable. Since then, I've been following "5-sigma moves," or one-day price moves that are five standard deviations or more from a stock's average one-day change.

Keep in mind that we're looking at the price change relative to the stock's historical volatility, and not just the same old jittery "most active" stocks. So even though stocks like Imclone, Kronos, and GSI Commerce saw some big movement last week, you're not going to see them on this list because of their higher average volatility.

Here's a taste of a few of the 5-sigmas from the past week:

Stock

Date

Change

Sigmas

Affiliated Computer Services (NYSE:ACS)

3/20/07

16.9%

8.8

Paxar (NYSE:PXR)

3/23/07

18.8%

8.3

Vonage Holdings (NYSE:VG)

3/23/07

(25.9%)

8.1

Scholastic Corp. (NASDAQ:SCHL)

3/22/07

(12.6%)

6.5

Systemax (NYSE:SYX)

3/20/07

(22.1%)

5.5

Sources: Yahoo! Finance, author's analysis.

That tricky net income
When it comes to stocks, it pays to go further than skin deep -- or, in this case, headline deep. Had an investor (or, shall we say, a trader) seen the headlines after computer seller Systemax's fourth-quarter earnings release, that trader might have been inclined to grab some stock ASAP. The Reuters headline read "Systemax Q4 Earnings More than Double," MarketWatch's was "Systemax Quarterly Profit More than Doubles," and the AP ran "Systemax 4Q Profit Soars." Even the company's own press release exclaimed, "Systemax Reports Record Sales in Fourth Quarter and Full Year 2006."

That trader would have been disappointed if he did rush to buy the stock, because it tanked in the aftermarket and in trading the following day. But why would a stock tank after the company more than doubled earnings? Well, because the bottom line doesn't always tell the full story.

It's not that the headlines were incorrect. Technically, they were perfectly accurate -- it's just that net income can often be a tricky beast. In the case of Systemax, the dramatic improvement in the bottom line wasn't driven by a major improvement in business operations for the fourth quarter; it was due to a much lower tax bill. In its 2005 fourth quarter, the company paid $15.5 million in taxes, an effective tax rate of 82%. This dropped down to $3.9 million, a 33% rate, in this year's fourth quarter. On an apples-to-apples basis with a 33% tax rate for both years, net income would have been down 37% for the quarter.

The decline can also be seen further up on the financial statements. Gross margins declined from 14.7% to 12.9% for the year-over-year comparison, and operating margins were darn near cut in half. Investors apparently took note of this as they sold off the stock like it was going out of style (is it?).

Love that big picture
But that's not the whole story. The other part of the story is the big reaction to just one quarter's results.

Systemax sells computers and computer accessories through a number of channels, including the TigerDirect.com website (which is how I know them). As anybody familiar with players like Gateway (NYSE: GTW  ) or Ingram Micro (NYSE: IM  ) can tell you, gross margins in the computer/computer-related industry are nothing to fool around with -- they're razor-thin. So it's certainly disconcerting to see Systemax's gross margins fall the way they did.

For the full year, though, the company actually improved gross margins slightly over the prior year. Operating margins were also up to 2.6% for the full year from 1.8% in the prior year, and they have been steadily marching upward every year since hitting a trough back in 2000. Top-line growth was also a respectable 11% for the year, up slightly from the prior year.

This also isn't the first time Systemax has squeezed itself on the gross-margin line in the fourth quarter. The company was able to keep pretty high gross margins for the fourth quarter of 2005, but in 2004 they declined to 12.9% from 15.6% in the prior quarter. Similarly, in 2003, fourth-quarter gross margins dropped to 14.2% from 16.6% in the prior quarter. In both instances, first-quarter gross margins rebounded significantly.

Investors seem to have toned down their bearish sentiment on the company since the drubbing last week, and the stock has bounced back more than 10% at the time of this writing. All in all, Systemax's stock over the past week serves as another reminder to keep emotions and quick-fire judgments out of your investing. I'm sure that anyone who bought stock right as Systemax announced its "doubling profit," or sold when the stock was in free-fall over its falling gross margins, would agree.

Check out what other Fools think of Systemax at The Motley Fool's CAPS investing community.

Fool contributor Matt Koppenheffer enjoys his weekly statistical rendezvous even more than he likes watching the crazies duke it out on The Real World. He does not own shares of any of the companies mentioned. Paxar is a Hidden Gems pick. The Fool's disclosure policy rocks the Casbah, cat box, and cash box all at the same time.


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