Value Investing

How To Use Inventory Analysis To Predict Future Stock Returns

Question of the week: Can you find catalysts by looking at the numbers?

I received this question after last week’s look at Juniper Networks. I shared how it was a Quality+Value play, but not a company I’ll be buying. I don’t see any sort of catalyst that would help the stock price go up. It’s intrinsic value will likely stay flat or continue up at a low growth rate, well below the market.

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I don’t invest looking for catalysts, and for many companies, I don’t need one because a cheap company is the catalyst. Once the market catches on, the price shoots up. That’s what happens with mispriced companies, special situations and distressed companies.

Catalysts also work both ways. There is a positive catalyst and a negative catalyst.

The main way to find a catalyst is to obviously do your homework. Reading papers, industry reports, talking to industry experts, going through opposing opinions and the usual scuttlebutt.

Tough part is that qualitative analysis is a very artistic form of analysis is hard to share or teach in a structured manner.

On the flip side, you can also gather information and catalyst hints about the company by the numbers.

Accounting is the language of business and financial statements tell a story. When the words of management and your qualitative analysis match the story coming from the numbers, get ready to pounce.

Before starting, three of the best books on financial analysis and reading between the lines are:

I’ve been recommending these three books for years. If it’s not in your library, get it.

Inventory Analysis for Catalysts

The majority of companies hold inventory and it is vital to the business operation. Yet I rarely come across anyone analyzing it deeply.

It is constantly overlooked.

If you understand the flow and state of inventory, it gives you a huge advantage as an investor. You can buy into the stock quicker with conviction, or get out before a crash from the signs.

That’s because not all inventory is equal and analyzing inventory has tell-tale signs of what is going on with business operations. If you can get this insight faster than other investors, now that’s a big advantage.

For example, when I invested in Aerogrow (AERO) 9 year ago, I ended up noticing serious issues with inventory. Their inventory value on the balance sheet looked OK, but their receivables were going out of control. The company had too many finished goods they couldn’t sell and their money was locked up in their warehouse. I lost money on AERO, but the stock continued to go down to the point where they were on the verge of bankruptcy. Ultimately, they managed to get an investment from Scott’s Miracle-Gro (SMG) to keep it alive.

One moral of the story – don’t underestimate inventory.

With proper inventory analysis, you can understand things like:

  • whether sales will grow or decline
  • current health of the company
  • whether management is making good decisions with cash flow

Why Boeing’s Inventory Analysis is So Powerful

Boeing (BA) has been on a tear over the past year.

Inventory Analysis Future Stock Returns

Boeing Stock Outpacing Amazon

It’s outpaced tech giants and has even left Amazon in the dust. There must be something there.

Here’s what Boeing’s inventory looked like. Take a minute to see if you can find the catalyst clues without looking at the answers.

Boeing Inventory Analysis. Can you see it?

Boeing Inventory Analysis. Can you see it? | source: old school value

Here’s what I see.

Boeing Annual Inventory Analysis vs Stock Price | Source: old school value & Google Finance

Boeing Annual Inventory Analysis vs Stock Price | Source: old school value & Google Finance

In the image above, I’ve outlined 3 main periods with very positive signals. 2011, 2013 and 2017.

Anytime raw materials goes up, it’s a good sign and there are a couple of reasons why.

  1. Raw material prices are so cheap the company is stocking up. This will lower future COGS and increase margins and profit.
  2. Order are being fulfilled and the company is buying to meet the demand.

Combine the increase in raw materials with an increase in accounts receivables and it’s a sign that Boeing is getting ready to collect money. Planes are expensive and customers don’t pay everything in one lump sum, especially when they are ordering a huge fleet of new planes.

I’ve highlighted three periods with this type of pattern. 2011, 2013 and 2017. In 2011, nothing happened with the stock, but in 2013 and 2017, Boeing’s stock price made some big moves.

2017 has the best pattern of inventory where all the stars aligned.

  • account receivables increased
  • raw materials increased
  • work in progress increased

I don’t pay too much attention to purchased components, but it is the same concept.

When I say not all inventory is the same, you can see what I mean. If you just compare the total inventory bottom line of 2016 to 2017, it’s a 2.7% increase, after a drop of 8.6% in 2016.

This gives the impression that nothing big is happening, which is the opposite of what went down in 2017.

Take a look at this quarter over quarter analysis.

Boeing Inventory Analysis QoQ | source: old school value

Boeing Inventory Analysis QoQ | source: old school value

  • Q1 revenue was down compared to previous years as orders are being made, raw materials are being used
  • Revenue still down in Q2 compared to prior years, but the same pattern is evident. Raw materials levels continue to go down, works in progress is up more. The difference in works in progress is better than the Q1 comparable. I also see that 2015 showed better signs.
  • Q3 marks a big change. Previously Boeing isn’t buying as much raw materials, but Q3 shows the increase in raw materials while maintaining works in progress. Accounts receivables is also up 12% meaning that their orders are being booked into the accounting books.
  • This is where you see everything come together. Boeing is killing it in Q4. They are holding more raw materials than before and works in progress still higher than previous comparable quarters. All excellent signs.

Can Inventory Analysis Predict Future Stock Returns?

Here’s the elephant in the room.

Inventory analysis is a lagging indicator. It’s not going to help you be the first one to get on the train. Half the crowd will already be on the train.

But that’s not a bad thing because instead of getting stuck in an aisle seat, you’re reserved with a big window seat.

Where inventory analysis shines is being able to see the operations for what it is. You’re not guessing or speculating about how many planes are going to be made this quarter. Instead, you get a very good view of the supply and demand. After all, isn’t that how any business grows? No demand with high supply is a complete failure. High demand with no supply is an operational and cash flow issue. High demand with high supply is the ultimate dream.

Up to Q4 of 2017, you can see Boeing really kicking it into high gear. But what about Q1 of 2018?

That’s harder to figure out because inventory analysis requires the Q1 results and filings to come out. By then the stock is going to move higher or lower. However, if you look at the quarter over quarter commentary above, a company like Boeing can’t switch gears so quickly that in Q1 of 2018, all the inventory numbers trend down.

This is where you combine your added intuition to the numbers to come out on top.

This is just one of the ways you can find catalysts from within the numbers.

More Reading on Inventory Analysis

Disclosure

No position in BA

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Article by Jae Jun, Old School Value