Signs of Trouble

I've got some good news and some bad news for you. First, the bad: There is no such thing as a crystal ball when it comes to investing. The good news is there are definitely some things that help us predict a company's future performance. Not a crystal ball, maybe, but more like Aunt Mabel's knee that acts up when it's about to rain.

The bad and the good
One achy knee I like to use is the state of a company's inventory situation. It's a rather simple concept: If a firm's inventory of finished goods is growing significantly faster than its sales, it could mean that demand for its products 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. And when that happens, the stock price usually suffers also.

On the flip side, a buildup of raw materials is usually a positive sign. Unlike finished goods that aren't moving, more raw materials means the company may be planning to ramp up production. Perhaps management is seeing more orders than expected, and is stepping up to meet the greater demand.

Thornton O'glove, an investing legend and one of the early pioneers in the art of inventory analysis, says, "An increase in raw materials inventories usually means business is speeding up, and this will be reflected in future revenues and profits."

Peering inside the factory
In his book Quality of Earnings, O'glove remarked that 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."

O'glove used this analysis to great benefit, and it's one of the cornerstones of David and Tom Gardner's success in their Motley Fool Stock Advisor service. To illustrate, I put together a couple of screens to help us find companies in both good and bad inventory situations.

The first is a "good inventory" screen, which looks for raw materials growing faster than sales. In order to identify businesses with existing strong demand for their products, I also limited the list to firms with sales growing faster than finished goods.

Next, I flipped things around, in an effort to find firms possibly in trouble. This screen looks for sales growing faster than raw materials and finished goods growth exceeding sales growth.

One caveat
Bear in mind that inventory analysis isn't helpful for firms where inventory isn't a major part of the business. eBay (Nasdaq: EBAY), for instance, simply acts as an intermediary for the billions of dollars of goods sold on its site; it never possesses the actual inventory. Even a company like Microsoft (Nasdaq: MSFT), with products such as the XBox 360 and the Zune, won't benefit from such analysis, because these products make up only a small portion of total revenue.

What now?
Inventory analysis may not provide a crystal-ball glance into the future, but it is a pretty good predictor. It can raise a red flag at the appropriate times, and if management can't offer plausible explanations for flagging sales and growing inventory, we'll strongly consider selling the stock. Conversely, strong sales and a raw materials buildup is a positive indicator in our research.

As I mentioned, Tom and David have become very good with such analysis in their four-plus years with the Stock Advisor service. It's one of the reasons they've achieved a remarkable 51% average total return with their stock recommendations, versus 14% for the same amounts invested in the S&P 500.

They are currently offering a 30-day free trial that includes their top five stocks to buy now. Here's more info.

Rex Moore is a Stock Advisor analyst and is ready for warmer weather. He owns shares of eBay and Microsoft. eBay is a Motley Fool Stock Advisor recommendation. Microsoft is an Inside Value pick. This information is brought to you by the Fool's disclosure policy.