Invest Where Items Are Flying Off the Shelves

P/E ratios and profit margins are all well and good, but to find the best retailers and manufacturers, you'll need to keep an eye on inventory as well.

A company's inventory turnover reflects how many times its total inventory value is sold and replaced over a given period of time. You can get it most simply by dividing revenue (sometimes referred to as sales) by inventory. (Investors often use an average of inventory levels at the beginning and end of the period in question.) A high turnover ratio reflects a lot of activity in the warehouse, with shelves rapidly being emptied and refilled, while a low number suggests that unsold items are gathering dust.

Illuminating numbers
Another way to assess inventory turnover is to calculate its "days in inventory." The lower the number, the less time items are sitting on shelves, and the faster they're being sold. The table below offers numbers for several retailers and manufacturers. See how each compares with its competitor(s):

Data: Capital IQ, a division of Standard and Poor's. As of most recent quarter reported.

Efficiency experts
You can see why Wal-Mart is revered and feared among retailers, as its DII number lingers far below those of many of its conventional retail peers. Costco is even more impressive, likely aided by its relatively low number of items carried, which simplifies its operations. Both companies have very effective inventory management systems in place with their suppliers, getting what they need when they need it, and not letting items waste too much time on shelves.

Ford has delivered hard-won turnaround results lately, but its inventory management has long topped most, if not all, competitors. Efficiency has been in Ford's blood from the beginning; it pioneered assembly lines, and later aimed for "just in time" effectiveness.

Altria offers a particularly good example of how valuable it can be to look at long-term trends. Its DII number may seem high, but it has come down to below 80 from around 100 a decade ago, thanks in part to efficiency-improving spinoffs.

Finally, in some industries, you can't afford to have high DII numbers. For instance, Cirrus Logic's numbers have led my colleague Jim Mueller to worry, since in the semiconductor industry, any items languishing on shelves will likely become obsolete quickly.

This kind of information shouldn't be the sole basis for your investment decisions, but it can certainly better inform them. Since solid and improving inventory turnover is one sign of a great company, it can be a valuable number to watch.

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