The holiday season of 2008 may go down in history as one of the biggest nail-bitters in the last few decades. Motley Fool analysts have assessed the state of retail going into this critical season -- the stocks, sales strategies, consumer trends -- and identified the winners and losers at the mall and in investors' portfolios. Click here for the complete report.

If holidays had an annual theme, this year's would be inventory glut. As we mentioned in another segment of our holiday retail special, we ran into some serious merchandise overload during a recent trip to the mall.

Why retailers stocked up on SKUs to the max during one of the worst economic times in history is beyond me. What I do know is that the only way for retailers to work through the mess they've created is to implement some hefty markdowns. More importantly, retailers who have their inventory levels under control might just have superior long-term potential.

Bulky inventory = slimming margins
One of the most destructive operational problems that retailers can run into is holding physical goods that no one wants to buy. Of course, when consumers are spending away during the good times, merchandise flies off of the shelf and poor inventory management can be easily masked. In fact, having excessive inventory of popular items throughout a booming economic cycle can generate even more sales and higher earnings.

But when the wallets close and spending slows, retailers who can't make quick inventory alterations in response to consumer-spending trends find themselves drowning in unwanted inventory. Ultimately, they face shrinking margins, since heavy markdowns become necessary to move the excess goods.


Sales, Last 12 Months

Inventory, Last 12 Months

Year-Ago Gross Margin

Current Gross Margin






Chico's FAS (NYSE:CHS)










American Eagle





Source: Capital IQ, a division of Standard & Poor's. Margins are for trailing 12 months.

Inventory management is one of the most important operational aspects of a company. By following inventory growth trends and making sure that inventory paces alongside, sales growth can indicate strong management and is a characteristic of some of the best retail investments for both the short and long term.

Following are a few of my top picks that should thrive this holiday season because of their superior inventory management.

These are a few of my favorite things
The Buckle (NYSE:BKE) has developed a computerized system that tracks merchandise from when it's checked in at the company's distribution center until it arrives at the stores or to the customer. This system allows management to track which merchandise is selling at specific locations and transfer merchandise to other stores if necessary on a daily basis. Thus, stores can carry a reduced inventory load while meeting customer demand. It's no wonder this company has grown inventory at less than half the pace of its sales growth over the past two years.

Another first-class merchant with superior inventory control is Costco (NASDAQ:COST). The company has developed a unique method of building strategic alliances with its suppliers, such as Kimberly-Clark (NYSE:KMB). Costco shares its sales and inventory information directly with Kimberly-Clark, so that the supplier can send new inventory to replenish the shelves as needed.

In fact, Costco excels so well in this category that its inventory turnover sits at around 12 times per year, meaning it typically receives payment for its inventory before it even has to pay its suppliers. With just 4,000 SKUs, in comparison to 5,300 at Sam's Club and 40,000 at an average grocer, Costco's limited inventory selection allows the company to alter its offerings quickly. For example, in the tough economy, Costco can easily pare down its stock of big-ticket electronics. The efforts are evident: Inventory levels have risen just 3.3% on the balance sheet over the past year, while sales have grown by 12.6%.

Unlike Macy's, where certain floor space must be allotted to certain designers, Nordstrom (NYSE:JWN) doesn't enter into contracts with designers. So if something doesn't sell well, it doesn't stay in stores for long. Nordstrom's flexible floor layout allows new products to be offered consistently so that productivity per square foot can be continuously improved. That has helped sales per square foot improve from $321 in 2001 to $402 in 2007.

Further, a virtual inventory system allows all stores to see inventory at all other stores and at the fulfillment center, so sales associates can have a product shipped directly to a customer's door if it isn't in stock at a particular location. Accordingly, inventory turns are 20% higher than the industry average.

The retail-stock litmus test
Because retailers typically order inventory six months in advance of shipment, conservative inventory management is always vital, so that retailers can respond quickly to fickle consumer trends. Strong inventory management is a valuable sign of superior managers who know how to run an operationally efficient retail entity. Ultimately, it's these retailers that will sidestep the current consumer slowdown and excel in the long run.