When examined in conjunction with accounts receivable, inventory can be one of the most reliable predictors of the future direction of a company -- and is therefore something we keep a close eye on when digging for Hidden Gems. Today, we'll look at inventory on its most basic level, and a few weeks down the road we'll do some fine-tuning and break down this balance sheet item into its different components.

What's so bad about carrying a lot of inventory, which shows up as an asset on the balance sheet? Well, if that particular line item increases substantially faster than sales, it could indicate that demand for a company's product has fallen off, and it will soon have to discount -- or even write off -- some of these goods. In either case, earnings will take a hit.

Peering inside the factory
One of the early pioneers in the art of inventory analysis is Thornton O'glove. In his book Quality of Earnings, he tells the story of one Bernard Smith, who made big money shorting stocks in the early 1930s. One day, "Sell 'Em Ben" decided to visit a manufacturing company that was defying Depression-era odds and setting new highs on a regular basis. Because of his reputation, though, management refused to see him. So, Smith ambled around to the back of the plant and saw that, of the company's five smokestacks, only one was actually producing smoke. Taking this as a sign that production had been cut back severely, Smith shorted the company -- and cashed in when its share price crumbled several weeks later.

Luckily, these days we don't have to risk trespassing charges in order to gauge a company's business condition before it tells us (and everyone else) with an earnings warning. Inventory and receivables figures, monitored on a quarterly basis, "could have predicted the collapses in the price of perhaps four out of every five stocks, which occurred during the high-tech washout in 1984-1985," according to O'glove.

This is something that Matt Richey, Bill Mann, and Tom Gardner pointed out in one of the most instructive articles ever to appear in Fooldom: Lessons From Lucent. This piece illustrated how Lucent's (NYSE:LU) inventory and receivables zoomed ahead of sales during 1999, setting the stage for a 30% drop in the stock's price -- even as the Nasdaq rose another 50% at the frothy top of the bull market.

Potential trouble
Here are a few companies struggling today with ballooning inventory. I'm not suggesting any of these will be taking the "Lucent Plunge," but the numbers below definitely raise a red flag. As you read the tables, "Q1" shows year-over-year growth for the most recent quarter, Q2 the next most recent, etc.

Action Performance (NYSE:ATN) Q1 Q2 Q3 Q4
Sales growth -8% -17% -4% -22%
Inventory growth 56% 57% 29% 59%

F5 Networks (NASDAQ:FFIV) Q1 Q2 Q3 Q4
Sales growth 45% 33% 17% 8%
Inventory growth 280% 300% 167% 133%

Gateway (NYSE:GTW) Q1 Q2 Q3 Q4
Sales growth 3% -17% -21% -20%
Inventory growth 145% 28% 16% -27%

Sales growth -50% -46% -45% -46%
Inventory growth 89% 23% 25% -35%

Renaissance Learning (NASDAQ:RLRN) Q1 Q2 Q3 Q4
Sales growth -8% 2% -3% 1%
Inventory growth 59% 41% 17% 13%

Schering-Plough (NYSE:SGP) Q1 Q2 Q3 Q4
Sales growth -6% -21% -16% -17%
Inventory growth 17% 27% 41% 41%

Investors and potential investors should do their best to understand what's behind these numbers. Does management offer plausible explanations for the flagging sales and growing inventory?

Some of these companies are attracting short sellers like J. Lo attracts husbands. Action Performance, which sells die-cast scaled replicas of motorsports vehicles, currently has almost 40% of its float shorted. Educational software maker Renaissance Learning is at 22%, and 17% of Internet equipment maker F5 Networks' float is sold short. While high inventory in and of itself doesn't necessarily point to a deteriorating business, the odds begin to look worse when it comes with high short interest.

More to the inventory story
There is certainly much more to evaluating companies than just considering inventory levels, but there's no doubt they are a good predictor of future troubles. In a future Hidden Gems column, I'll explain more about the different components of inventory: raw materials, work-in-process, and finished goods -- and how they can tell us whether a business is heading for a slowdown or gearing up for more production.

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Rex Moore never met a deadline he didn't meet. He helps Tom Gardner dig for Hidden Gems, and owns no companies mentioned in this column. The Fool has a disclosure policy.