Hey True Religion, What's Happening to Your Money?

There are two parts to successful investing: finding the winners and avoiding the losers.

But looking just for the former, especially if you focus mostly on revenue and earnings, can leave you exposed to the latter.

In order to fully benefit from your winners, you need to spot the ones to stay away from. After all, a 200% gain is completely wiped out by four other picks dropping 50% each. As for that winner, revenue and earnings are not the place to see trouble coming in time to do some good. You don't want to wait for an ugly earnings surprise that gives your stock a massive haircut before getting out.

That's why just about the first thing I read is the balance sheet. This is where the company's financial health is found and where sickness' warning signs often show up.

One balance sheet tool I like is the cash conversion cycle (CCC). It measures how fast the company turns its cash into inventory, sells that inventory, and then collects the cash on those sales. It's measured in days and, generally, the lower it is, the better. (For details on how it's calculated, check the Foolsaurus investing wiki entry.) It is possible to have a negative CCC, as Dell showed to great effect for several years. Seeing CCC increase can mean it's a company to avoid or exit.

This metric doesn't apply to every industry, however, such as banks. It's primarily for companies that interact with suppliers and customers, buying from one, selling to the other.

Here are three companies operating in the same industry that recently caught my eye:

Company

CCC (TTM)

1-Year Change

3-Year Change

5-Year Change

True Religion Apparel (Nasdaq: TRLG  )

106.8

9.6

34.2

39.3

Joe's Jeans (Nasdaq: JOEZ  )

129.3

(24.9)

84.6

106.1

Phillips-Van Heusen (NYSE: PVH  )

91.0

(5.7)

(3.1)

(0.3)

Source: Capital IQ, a division of Standard & Poor's, and author calculations. TTM = trailing 12 months. All numbers are in days.

True Religion has apparently lost control of its cash cycle, increasing it by nearly 60% from five years ago. Most of that increase, however, has come in the past three years, and it's mostly because of a massive increase in days inventory outstanding. In other words, it's not moving inventory as quickly as it should. That's a pretty big warning sign, Fools, that requires, at least, further investigation into what management is doing with the situation and whether those methods are successful.

Of course, the cash conversion cycle should not be the end of your research and it's best to follow trends over time. However, it can provide useful pointers to either getting in or staying away.

Go past the obsessive focus on quarterly earnings and you'll be way ahead of the vast majority of the market's individual investors. By learning to calculate and use the cash conversion cycle, you'll more likely stay with a winning company or spot a deteriorating situation early enough to either avoid the company in the first place or get out before the company "surprises" with a bad earnings report.

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Fool analyst Jim Mueller, who works with the Stock Advisor newsletter service, doesn't own shares of any company mentioned. The Fool's disclosure policy has cycled through the company three times while you read this article, showing off on a unicycle.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 27, 2010, at 10:58 AM, HenryCavendish wrote:

    You might want to use your own cash to buy a clue. True Religion has transitioned from a wholesale company to a retailer over the period you reference.

  • Report this Comment On November 01, 2010, at 2:38 PM, stapelbroek wrote:

    Five years ago True Religion only sold to retailers. Today, just over half their sales come from company-operated stores. I believe that would explain a lot of the change in CCC numbers. Additionally, they've taken quite a few classic styles and boosted inventory so they can fulfill last-minute restock requests from retailers who are keeping inventory leaner. Because there is virtually no inventory obsolescence on these styles, it's a better return on their money than holding cash.

    I'm not saying this necessarily makes TRLG a good buy, just that there is a logical explanation for the change in the numbers.

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