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The Speculator
Empty shelves signal a rising
stock
The
most significant sign of company health may be found in warehouses.
The stock of companies quickly selling what's in the storeroom tends
to rise, while unsold goods piling up are a signal of
trouble.
By Victor
Niederhoffer and Laurel Kenner
Cash for the merchandise. Cash for the button
hooks.
Cash for the cotton goods. Cash for the hard
goods.
You can talk, talk, talk, but it’s different than it
was.
"Rock Island,” from Meredith Willson’s "The
Music Man"
Balance sheets
contain gold, but you have to know where to look. We found it buried
in the fourth layer from the top, after cash, marketable securities
and accounts receivable: inventory changes.
Is the company’s
inventory up? Chances are its stock is going to fall.
Is
inventory down? Likelier than not, that stock will rise.
Sounds pretty much like common sense. Button hooks and
cotton goods piling up in the storeroom may have to be unloaded at a
steep discount. The billions of dollars in microchips, routers and
subassemblies on the balance sheet might be obsolete. And here’s an
accounting twist as new as the 21st century and as old as trade: If
a company puts a high value on that heap of inventory, earnings
might be pumped up.
You can ignore it. But you can bet the
market won’t -- not when times are tough and trust is low.
Anecdotes about companies that found their inventory
building up before precipitous declines in price are legion. Take
graphics semiconductor maker Nvidia (NVDA,
news,
msgs).
Its inventory in the year ended January 2002 increased to $214
million from its January 2001 level of $90.4 million. That’s a jump
of 137%; sales rose only 86%. Doubtless Nvidia was building up
inventory in anticipation of much higher sales in 2002. The stock
has declined 85% so far this year.
Or look at
Tellabs (TLAB,
news,
msgs),
which fell 74% in 2001. Its inventory at year-end 2000 had increased
131%, from $186 million to $428 million, from the year-earlier
level, while sales rose just 46%. In 2001, sales fell
35%.
Motorola (MOT,
news,
msgs)
provided an especially noteworthy example in 2000. Inventory
increased some 40%, to $5.2 billion from $3.7 billion. But sales
rose only 14%, to $37.6 billion from $33.1 billion. Motorola stock’s
26% decline in 2001 seems somewhat muted, unless one notes that in
2000, when the market in its wisdom was perhaps already discounting
this, the price dropped 60%.
Companies that suffered sharp
price declines in 2000 after reporting inventory increases at the
end of 1999 are particularly numerous. Start with
Amazon.com (AMZN,
news,
msgs),
where inventory jumped some 650%, to $221 million from $30 million.
Sales grew almost 170%, to $1.6 billion from $610 million, and there
were probably good explanations for management’s decision to build
up inventory. But the market was unforgiving, and Amazon.com fell
some 80% in 2000.
A table summarizing the ending inventory
vs. sales change and next year’s percentage price appreciation
appears below.
| Inventory buildups, stock
takedowns |
| Company |
Year |
Ending inventory (in millions) |
Inventory change |
Sales change |
Next year’s stock change |
| Nvidia |
2001 |
$213.9 |
137% |
86% |
-84% |
| Tellabs |
2000 |
$428.3 |
131% |
46% |
-74% |
| Motorola |
2000 |
$5,242.0 |
41% |
14% |
-26% |
| Amazon.com |
1999 |
$220.6 |
650% |
169% |
-80% | | Source: Bloomberg L.P.
A complex connection
It seems natural
that an inventory buildup relative to sales could be a sign of
trouble. Most of us who have been in business have been victimized
by rosy estimates of the value of inventory that could be sold only
at drastically reduced prices, particularly in industries where
products are subject to rapid obsolescence.
Unfortunately,
it’s not that simple. Many companies that report sharp increases in
inventory are merely responding to sharp increases in sales. Often,
they go on to show great performance in subsequent years. On the
other side, many companies that show sharp decreases in inventory in
a year are responding to drastic declines in sales. And instead of
being star companies with sound earnings, they go on to dismal
market performance.
As readers of our column and all other
sober-minded investors know, anecdotes prove nothing. The diversity
of stocks is so great that a story can be found to prove any
generalization. To settle the issue, what’s needed is a systematic
and scientific study from an investigator knowledgeable in
accounting, statistics and practical investment.
Studying the inventory
Fortunately, such
a study has been completed. Jacob Thomas, Ernst & Young
professor of accounting and finance at New York’s Columbia
University, and one of his former students, Huai Zhang, now a
professor at the University of Illinois, have produced the most
innovative and useful study that we have found on balance-sheet
analysis, in a paper called “Inventory Change and Future Returns.”
Thomas and Zhang use as their starting point the
well-documented finding that a company’s stock performance tends to
suffer after a period in which accrued earnings exceed cash
earnings. Accrued earnings are the kind that are reported in the
annual report and the earnings statement, and they’re what the media
report. The main difference is that accrued earnings recognize
revenues when a sale is legally binding and match expenses against
the revenues. Cash earnings recognize sales and expense in the
period during which the money arrives and the expenses are paid.
Companies have been required since 1988 to reconcile the difference
between cash and accrued earnings on their statements of cash flow,
one of four required financial statements that every company must
submit to auditors.
More and more investors and analysts are
focusing on the cash-flow statement. Thomas, an immigrant from
India, and Zhang, an immigrant from China, have made an important
contribution to financial analysis by systematically testing which
items on the cash flow statement are most predictive of future
returns. After analyzing 39,315 company years from 1970 to 1997,
they conclude: “We find that inventory changes represent the main
component that exhibits a consistent and substantial relation with
future returns.”
Companies with the greatest reductions in
inventory (scaled by assets) show a price-plus-dividend return of 4
percentage points greater than the average for all companies.
Companies with the greatest increase in inventory, on the other
hand, show a return 7 percentage points less than that of the
average company. The difference held in 27 of the 28 years of the
study. The usual statistical tests indicate this is a highly unusual
event that could be explained by chance on substantially less than 1
in 1,000 occasions.
Amazingly, the returns in the next year
for these chosen companies add another 4% differential to the
abnormal return.
Two other components of the balance sheet
also have a large impact on returns, although significantly less
than does inventory: depreciation expense (the higher the better),
and change in accounts receivable (the less growth the better.) Both
these items give an abnormal return differential of 4% for the
favorable companies vs. the favorable ones.
Why the back room matters
Why do
inventory changes matter so much? The professors offer three
possible explanations:
- Demand shifts. High inventory could be a signal that
demand is declining and future profitability is in danger.
- Overproduction. For manufacturing companies, producing
more than initially anticipated causes per-unit inventory costs to
be lower this year, which results in lower cost of goods sold and
higher profitability. Everything reverses in the following year
when fewer units are produced to bring inventory levels back to
normal.
- Inventory misstatement. Companies may use inventories
to manage earnings. The cost of goods available for sale is
determined by previous periods’ ending inventory and current
periods’ costs for producing and purchasing inventory. At the end
of the fiscal period, we have to assign cost of goods available
for sale to either cost of goods sold or the ending balance of
inventory. If you overstate the latter, cost of goods sold will be
understated and earnings will then be overstated. The following
year, inventory is written down, and profits take a
hit.
The professors conclude that earnings management is
the likely suspect. They do not, however, attribute the inventory
effect entirely to the practice of earnings management. “Consider
the following scenario,” Thomas wrote in an e-mail to us. “Cisco
Systems (CSCO,
news,
msgs)
is running along on all eight cylinders, making routers and such
like. There is a sudden decline in demand, but they think they can
overcome it. Things get bad enough where they should reasonably be
writing down some of the unsold inventory, but they don't because
they're a bit optimistic. In the year after the inventory buildup,
they finally admit things are bad and take a write-down, and returns
fall. Would you construe the reluctance to take a write-down as
earnings management? Some people would not call that earnings
management and view it simply as reasonable optimism about one's
prospects.”
Inside the
study
It might put things in perspective to relate the
motivation for the professors’ work. We shall concentrate on the
junior author, Zhang, since Thomas, the senior author, is already
acknowledged as being among the giants in the accounting field.
Zhang, his former student, impresses us as a star on the rise in the
profession.
Born in China, Zhang earned his bachelor’s
degree from Beijing University and came to the United States for his
doctorate. “I entered Columbia's Ph.D. accounting program with a
blind trust in accounting numbers,” Zhang told us. “Four years
later, when I got out, I had developed a healthy skepticism. The
flexibility offered by GAAP allows a company's management to
manipulate the company's earnings while the investor community's
steep penalty for not meeting analysts' forecasts sends the
management off in that direction. My paper with Jake shows results
consistent with investors being misled by earnings management
through inventory. It's just another piece of evidence for my view
of the world: accounting can be dirty.”
The case for relying
on cash earnings rather than accrued earnings, with particular
emphasis on inventory, would seem to be sound as a nut. But wait:
the Thomas-Zhang study was based on companies taken from Standard
and Poor's Compustat data files. While Compustat's files are widely
used, we have grave concerns about using them because of their
retrospective nature, and what we consider their survivor bias.
MIT professor Andrew Lo, of whom the cognoscenti in this
field always speak in superlatives, has pointed out that Compustat
“backward-revises” its data, posing insidious problems for
researchers. With Compustat, “today's values for 1997's IBM current
assets need not be the same as last month's values for 1997's IBM
current assets,” Lo wrote us. “Compustat’s backfilling is a problem
every single month, including this month. Do the following analysis
(I've done it): this month, take all observations in the Compustat
files for October 2001 and save it; then next month do the exact
same thing for the exact same date; now run a variable-by-variable
comparison of the two supposedly identical files -- you'll see at
least 200 discrepancies, if not more. And these issues don't even
touch on the quality of the data, spottiness of the coverage and
timeliness of the updates.”
Another potential problem is that
Thomas and Zhang examined many different balance-sheet items and
methods of computing them before settling on the specific ones in
the paper. This approach may yield statistical bugs related to the
correlation of many balance-sheet items with each other as well as
to the serial correlation in these items between consecutive years.
Thomas agreed that backfilling of Compustat data is a
potential concern, but said it hasn’t been a problem in the last
decade. “As far as I know, the last major backfill was done in the
‘70s.” He added: “To me, the two big questions are a) Why did the
market not see this mispricing until it becomes very evident in the
next quarter’s reported earnings? And b) Does the mispricing occur
even now?”
Who are you going to call when you fear for your
profits and you wish a scientific update? Yes, the Spec Duo. We’re
always available with pencil and envelope for studies that use
prospective sampling and take into account the market’s
ever-changing cycles.
We will report our findings in detail
in the next installment of our fundamental analysis series, along
with some other ratios that we have found of equal value to the
inventory measure mentioned above. Suffice it to say now that
congratulations to the professors are in order. Our results
conclusively show that inventory changes in the last three years
have been significantly related to subsequent negative return.
We’ll also note that the five companies in the Dow Jones
Industrial Average ($INDU)
with the largest inventory gains in 2001 (thus highly bearish) were
Home Depot (HD,
news,
msgs),
McDonald’s (MCD,
news,
msgs),
Merck (MRK,
news,
msgs),
General Electric (GE,
news,
msgs)
and Caterpillar (CAT,
news,
msgs).
To date this year, they are down an average of 22.6%. The five Dow
companies with the largest inventory drops (bullish) are
International Paper (IP,
news,
msgs),
Honeywell (HON,
news,
msgs),
3M (MMM,
news,
msgs),
Eastman Kodak (EK,
news,
msgs)
and IBM (IBM,
news,
msgs).
They have an average year-to-date return of 9.2%.
Final note
This is one in a series of
articles analyzing selected items from the financial statements of
companies. Previously, we reported on the book-to-pay ratio, the
ratio of reported income tax expense to actual cash taxes paid. In a
subsequent installment in this series, we shall highlight certain
companies’ cash flow statements, including our favorite, General
Electric (GE,
news,
msgs),
which as readers of this column know has repeatedly refused our
requests for an interview.
We are open to all suggestions,
augmentations of a practical and theoretical nature on all subjects
related to the general topic we are considering, which includes such
things as quality of earnings, distortions of earnings, earnings
management and confidence in financial reports. Along these lines,
we would be pleased to interview and report the results of any
academicians in this field who believe they have useful insights.
At the time of publication, Victor Niederhoffer did not
own or control any of the securities mentioned in this article.
Laurel Kenner owned Exxon Mobil shares.
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