We are concerned when gross margins are too high or too low relative to industry peers. An abnormally high margin could suggest that a company’s business is too good to be true – in other words, it is a fraud. Meanwhile, an abnormally low margin might suggest that a company is in financial difficulties.
We assume that gross margins are determined by the industry within which a company operates more than its geographic location. For example, trading companies tend to report medium average gross margins of less than 15%, while software companies have margins of around 65%, as shown in Figure 109.
Our accounting screen is set to trigger a red flag when gross margins are in the lowest 20 percentiles or exceed the 80th highest percentile relative to GICS industry peers, and/or when there is an abnormally large deterioration relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the deterioration in gross margin exceeds the 80th percentile relative to the change experienced by GICS industry peers between 2010 and 2015.
Gross margin volatility: In addition to penalising companies with unusual gross margins, we also penalise those where the gross margin is unusually stable relative to peers. Past frauds can display margins with an unusual lack of volatility. For example, between FY07 and FY11, Chaoda Modern Agriculture (682 HK) reported a gross margin with a standard deviation of just 3%, in the lowest 11th percentile relative to industry peers. This uncanny ability to maintain such stable margin in a highly volatile sector was likely because the company was faking its revenues.