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-Plus-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. Its intrinsic value will likely stay flat or continue up at a low growth rate, well below the market.
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 obviously to do your homework: reading papers and industry reports, talking to industry experts, going through opposing opinions and the usual scuttlebutt.
The 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:
- "Quality of Earnings" - my review
- "Financial Shenanigans" - my review
- "What's Behind the Numbers" - my review
I've been recommending these three books for years. If they're not in your library, get them.
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) nine year ago, I ended up noticing serious issues with inventory. Its inventory value on the balance sheet looked OK, but its receivables were going out of control. The company had too many finished goods it couldn't sell and its money was locked up in its warehouse. I lost money on Aerogrow, but the stock continued to go down to the point where it was on the verge of bankruptcy. Ultimately, it managed to get an investment from Scott's Miracle-Gro (SMG, Financial) 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, Financial) has been on a tear over the past year.
Boeing stock outpacing Amazon
It has 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? Source: Old School Value
Here's what I see.
Boeing annual inventory analysis versus stock price | Source: Old School Value and Google Finance
In the image above, I've outlined three main periods with very positive signals: 2011, 2013 and 2017.
Anytime raw materials go up, it could be a sign of several things.
- Raw material prices are so cheap the company is stocking up. This will lower future cost of goods sold and increase margins and profit.
- Orders 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 had 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 | Source: Old School Value
- First-quarter revenue was down compared to previous years as orders were being made, raw materials were being used
- Revenue was still down in the second quarter compared to prior years, but the same pattern was evident. Raw materials levels continued to go down; works in progress were up more. The difference in works in progress was better than the comparable first quarter. I also see that 2015 showed better signs.
- The third quarter marked a big change. Previously, Boeing wasn't buying as much raw materials, but the third quarter showed the increase in raw materials while maintaining works in progress. Accounts receivables were also up 12%, meaning that their orders were being booked into the accounting books.
- This is where you see everything come together. Boeing is killing it in the fourth quarter. They were holding more raw materials than before and works in progress were still higher than previous comparable quarters. All were 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 in the fourth quarter of 2017, you can see Boeing really kicking it into high gear. But what about the first quarter of 2018?
That's harder to figure out because inventory analysis requires the first quarter 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 first quarter 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:Â No position in Boeing.
