7 Stocks Raising a Red Flag

While high-frequency trades spit out by computer algorithms may appear to drive today's market, there is still room for investors to earn fat returns through old-fashioned fundamental analysis.

Beginning in 2002, activist value investor Bill Ackman became convinced that the bond insurers were much riskier than their triple-A rating suggested. When the extent of their exposure to structured mortgage securities came to light during the credit crisis, the stocks imploded and Ackman's short positions turned into huge winners.

A showman and a serious analyst
Although he is primarily known for his brash persona, Ackman is first and foremost a deeply inquisitive security analyst. On MBIA alone, he amassed 140,000 pages in documentation in the course of his research. One of Ackman's favorite investing books is Thornton O'Glove's Quality of Earnings, a primer on a rigorous, skeptical approach to financial analysis that enables investors to identify "time bomb" stocks for protection -- and profit.

A taste of "quality of earnings"
All serious investors should put Quality of Earnings on their reading list. In the meantime, let me give you a taste of what O'Glove calls "the best method I have ever discovered of predicting future downwards earnings revisions of Wall Street security analysts." This method covers two balance sheet accounts: "accounts receivable" and "inventory." In this article, I'll focus on the latter:

What is the inventory account?
Inventories represent raw materials, as well-finished or unfinished products that are ready or will be ready for sale. Inventories are classified as current assets on the company's balance sheet.

What can the inventory account tell you?
I can't answer this any better than O'Glove has:

"Obviously, higher trending inventories in relation to sales can lead to inventory markdowns, write-offs, etc. In addition, it is important to note that an excess of inventories, time and time again, is a good indicator of future slowdown in production."

An easy way to track the growth of inventory relative to sales is a metric called days sales of inventory, which is the value of the inventory expressed as a multiple of the company's daily revenue. By definition, when the DSI increases from one period to another, inventory growth is outpacing sales growth. The following table contains seven stocks from the Russell 1000 index that exhibited a high increase in their DSI over the most recent four quarters:

Source: Capital IQ, a division of Standard & Poor's.

NVIDIA case study: Watch the trend!
I'm not suggesting you go out and short every stock on this table based on these results. However, the case study of NVIDIA -- the "worst" offender in our table -- shows that days sales of inventory can be a powerful warning sign. The table below shows the steady deterioration in the company's DSI over the four quarters leading up to the company's fiscal second quarter ended Aug. 1:

 Source: Capital IQ, a division of Standard & Poor's.

On Aug. 12, NVIDIA announced a second-quarter loss of $141 million, which was heavily affected by a write-off of approximately $75 million on inventory that was no longer sellable. While the stock actually finished up on the following day, the damage was already done: NVDIA shares had lost nearly 40% over the three-month period leading up to the earnings release. Investors tracking days sales of inventory wouldn't have hung around that long -- they didn't need an extra quarter to confirm what was plainly an alarming trend.

Your next step
If you'd like to learn more about ways to spot ticking time bombs to protect your portfolio or profit on "short" ideas, enter your email below to receive John Del Vecchio's, CFA, free report 5 Red Flags -- How to Find the Big Short. Del Vecchio has an impeccable record as an analyst and a money manager; most recently, he managed the Ranger Short Only portfolio from 2007 to 2010, where he outperformed the S&P 500 by 40 percentage points. John's report is free, and it's the first step toward putting powerful analytical tools to work for your portfolio.