The Crystal Ball Deficit of 2006

Fasten your seatbelts, and get your coffee pots percolating, Fools. The end of the year is nigh.

You're about to be besieged by articles demanding your attention, promising to tell you what 2006 holds in store for you and your portfolio. Forbes, MSNBC, Marketwatch -- we may even write a few here at the Fool.

But guess what -- we don't really know what will happen, and neither do the other guys.

It's not easy, seeing green
Few financial writers possess inside sources at the shadowy international cabal of bankers based in Zurich that plans out the market's movements one year in advance, on the 32nd of December of each year. Even fewer of us possess sufficient clairvoyance to foretell those movements without an inside source.

Musing on the market and pontificating on the "what ifs" can be a pleasant pastime, but no one knows what will happen. If you enjoy theorizing, sit back with a cup of joe and read what the crystal ball gazers have to say. If not, it might be a good idea to just turn off the computer for a while, take a little vacation, and come back in January when the forecasting begins to trail off.

Here ends today's Public Service Announcement.

But since we're on the subject
Speaking of forecasting, I want to speak a bit about another kind of forecasting -- one with a basis in fact. It's called the theory of positive inventory divergence.

Zzzzzzzzzzzzzz.

Wake up! Remember what I said about the coffee? I promise if you can stay awake through this, I'll tell you something useful -- a promise the "market forecasters" can't make.

Ready? Here goes
Positive inventory divergence is a theory that master stock-sleuther Thornton Oglove laid out in his book Quality of Earnings. In its essence, the theory has three parts:

1. When a company's inventories increase faster than its sales, this is bad;
2. Especially when we're talking about finished goods inventories;
3. But not necessarily when we're talking about inventories of raw materials.

That's it in a nutshell. Pretty simple stuff. To elaborate just a little, Oglove says that when a company builds 100 widgets in Q1 2005 vs. the 50 widgets it built in Q1 2004, this means nothing. Until, that is, you learn that the company sold 50 widgets in Q1 2004, but only sold 55 widgets in Q1 2005. If that's the case, inventories of widgets grew 100% year-over-year, while sales of widgets grew only 10%.

The logical consequence of widget inventories growing faster than widget sales goes like this: At some point, unsold widgets start overflowing the warehouse, the company must slash prices to move inventory, and profits plummet.

Case in point: You all remember the "big bath" that Cisco (NASDAQ:CSCO) took back in 2001, right? It wrote down $2.2 billion worth of inventories as part of a $4 billion charge against earnings. That same year, Lucent (NYSE:LU), too, took a huge charge to earnings -- $7 billion.

Take a look at a few numbers from the companies' respective 10-K filings with the SEC for the year preceding these infamous write-downs. See whether you can spot the warning signs.

In both cases, sales growth was impressive, but inventories were piling up!

And it gets worse
Time-pressed investors face a significant problem when trying to analyze inventories. When companies release their quarterly and year-end reports, they rarely break down their inventory numbers. They don't tell you how much of their inventory is steel, plastic, wiring, and other assorted raw materials needed to build their widgets. Or how much is fully assembled, ready-to-ship, but-no-buyers-in-sight widgets sitting unloved and unsold on warehouse shelves.

To get that information, you need to dig into the 10-Q and 10-K filings. Let's take a closer look at Cisco, for example.

As you can see, raw materials inventory barely budged. The widgets weren't selling, so Cisco wasn't stocking up raw materials to build more. Meanwhile, half-built widgets, finished widgets, and finished widgets conveniently termed "demos" more than doubled. This, my friends, was a danger sign, plain as day.

That's negative inventory divergence
So here you have two fine examples of how negative inventory divergence can warn you of an impending disaster. ("Negative" refers to raw materials growth stagnating while finished goods pile up.) There's only one good reason for finished goods to pile up like this: They're not selling.

But we were talking about "positive," weren't we?
Indeed we were. And here's where I take issue with the positive inventory divergence theory. I agree with Oglove that it's bad when finished goods grow faster than sales. No argument there.

But the theory posits that it's a good thing when raw materials grow, period. Faster than sales. Slower than sales. Growth of raw materials is always supposed to be good because it means that management believes it needs extra widget parts to meet future widget demand.

The problem lies in the phrase: "management believes." Because it's not just you and me -- and MSNBC, Forbes, and the rest of them -- who cannot predict the future with 100% accuracy. Neither can management. Or to paraphrase Kevin Costner: "Just because you build it, doesn't mean the buyers will come." Consider what we've seen in our own experience here at Motley Fool Stock Advisor.

In the middle of 2004, Fool co-founders David and Tom Gardner highlighted five Stock Advisor companies where raw materials had increased much faster than finished goods. Of these companies -- Daktronics (NASDAQ:DAKT), Dell (NASDAQ:DELL), PossisMedical (NASDAQ:POSS), KenseyNash (NASDAQ:KNSY), and Shuffle Master (NASDAQ:SHFL) -- guess which ones proved the validity of positive inventory divergence?

Year-over-year earnings growth for calendar year:

Data courtesy of Capital IQ. Note that fiscal quarters may differ from the calendar quarter labels shown.

That's right. Kensey Nash and Shuffle Master were the only two companies to exhibit immediate and sustained improvement in profits to accompany their mid-year raw materials build-ups. And of those two, only Shuffle Master continued to prosper -- Kensey's next two quarters saw profits decline: first 9%, then 21%, then finally plunge into the red.

As it turned out, Tom ultimately decided to recommend that readers sell Daktronics, Kensey, and Possis in May 2005. Positive inventory divergence or no, the businesses simply failed to meet his standards.

Crystal ball or one-way mirror?
The official Foolish line is that positive inventory divergence remains a useful tool for seeing how management views a company's future. But like all tools, this one has a flaw: it is the very nature of mankind to be fallible. Managers make mistakes. They sometimes buy more raw materials than they need. They're sometimes too optimistic about the future. In my Foolish opinion, this built-in handicap limits the ability of positive inventory divergence to accurately predict business success.

Negative inventory divergence, on the other hand, clearly works. When finished goods pile up unsold, there's no question that business is bad. Eventually, those goods must either be marked down to get them out of the warehouse, or written off as entirely unsalable, as Cisco did in 2001. Either way, profits are bound to suffer.

Your Foolish takeaway
Inventory divergence theory isn't the simplest of concepts to master. Nor can it always accurately predict a company's success. But because it helps to predict disasters before they happen, this tool deserves a place in every investor's tool chest. At Motley Fool Stock Advisor, we use this and other tools to help our members achieve their investing aims, whether that's early retirement, funding the kids' college education, or just plain making money. To date, these tools have helped us to trounce the market averages, beating the S&P by more than 38 percentage points over the past four years. Want to learn more? Click here and we'll tell you all about it.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. If he did, The Motley Fool would require him to tell you so. We're sticklers about things like that.