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David Chulak
David Chulak
Articles (77) 

Slowing Down to Take Inventory

February 01, 2012 | About:

Each investor must determine how much time they are willing to allot to investment research. Unless you are a full-time investor or broker, you are typically limited in the amount of time available, so the amount of information on each investment vehicle becomes overwhelming to the researcher. Often, the vast amount of information leads to dread or anxiety which leads to less-than-quality research. While it is incumbent upon the investor to research the financial statements thoroughly, there is no list of what’s more important than the other.

Below offers just one idea in your research of financial statements that might be considered along your path for better decision making. The point of the exercise is to make it simple but instructive, leading to a conclusion you are comfortable with. If interest is shown, there are many such ideas that can be illustrated regularly.

Peter Lynch, former portfolio manager of the very successful Fidelity Magellan Fund, wrote a book entitled, "One up on Wall Street," where he discusses his ideas for watching inventory. While not important for service or financial type companies, Lynch encourages watching that the inventories for a company are not piling up. The point is that you are trying to verify that the sales or revenue are increasing at a greater rate than the rate of growth of inventory.

Let’s take a few examples:


You will note that Lowe's ratio of inventory to revenue (inventory/revenue) is consistent. The variations are minor. Second, note that the rate of growth of revenue distances the rate of growth of the Inventory. All of this is a good sign. Note that the ratio between 2011 and the trailing twelve months are increasing, but is still an insignificant number.

Now, let’s look at Lowe's (NYSE:LOW) greatest competitor, Home Depot (NYSE:HD):


Home Depot’s ratio of inventory to revenue is very consistent, all around 15. What is noticeable, however, is that the inventory is growing at a rate higher than the revenue growth. Lynch determines that if the rate of inventory growth is twice the rate of growth of revenue — sell. Moving on, note that the numbers completely change between 2011 and the trailing 12 months. Once again, the numbers are in line and the revenue is now outpacing the inventory.

You can expect variations as we’ve shown, but let’s consider one more company, Kirkland (NASDAQ:KIRK):


Between 2010 and 2011, revenue grew at 2.22%, but inventory grew at 12.96%. This is a very big variation and worthy of catching our attention. So keep digging. Note that the ratio (inventory/revenue) rises from 9.69% to 10.71%. That is not suspicious, however; looking at the next 12 months, we see the ratio climb to 14.24%. We should now be concerned because we’ve confirmed that inventory is growing much faster than the revenue. Part of the worry is always that obsolete type items may not be sell-able in the future and the company may be stuck with merchandise they cannot get rid of. Fortunately for Kirkland, the type of product they carry can typically be sold, with the exception of their seasonal lines.

Taking it one step further, we go from the 2011 figures to the trailing 12 months. Note how the rates vary. This is a major red flag.

Many investors will walk away at this point when they see these types of numbers, but also understand that as value investors, the company may be in the midst of dealing with these very tribulations and this may be one of the reasons for the price of the stock being currently depressed.

Once again, ultimately, you must decide, but looking at this ratio only takes a few minutes and can save you a lot of anguish.

Disclaimer: I have no positions

in KIRK, HD or LOW

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.

Rating: 3.4/5 (7 votes)


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