1 Key Ratio to Help You Detect Investment Problems in the Horizon

Here in the Motley Fool Singapore, we encourage a motley view of companies to enable investors to think as broadly as possible. One way we do this is with our ongoing Tug-of-Fools series. This series, of course, includes an encouraging bull case, and a sceptical bear case.

But, as important as it is to think both like a bull and bear for any investment idea we’re studying, how exactly do we go about thinking through a bear case?

Let’s get some hints

In his 1987 book “Quality of Earnings”, author Thornton O’Glove encouraged investors to take a sceptical view of companies, and to always look behind the curtain at any company’s financials. He contended that the individual investor could do simple common sense checks to figure out if there were any possible problems in the horizon.

In particular, Mr. O’Glove suggested two key ratios to watch. One of them is inventory analysis. He wrote:

“[E]xcesses of inventory, time and time again, is a good indicator of future slowdown in production.”

He added that this was especially true for industries which are subjected to rapid changes in products and taste. Chief examples included high fashion and seasonal goods.

To do this check, he suggested comparing the change in inventory levels with previous reporting periods. The percentage change in inventory can then be compared to the percentage change in revenue for the company for the same periods. If the change in inventory exceeded that of revenue, it might lead to problems down the road.

Testing this out in the SGX

Let’s take a look at the revenue and inventory levels for F J Benjamin Holdings Ltd (SGX: F10) starting from the financial year ended 30 June 2011 (FY2011) up to FY2013. From its last annual report, F J Benjamin Holdings reported 212 high fashion stores – mainly located in Asia. You can find out more about the company here.

Below is the summarized comparison of the revenue and inventory levels.

  FY2013 % Change FY2012 % Change FY2011
Revenue* S$373,403 (5%) S$393,237 11.1% S$353,918
Inventories* S$117,694 6.5% S$110,445 17% S$94,390

* Singapore dollar figures in $’000

Source: Company’s annual report; author’s calculations

During this two year period, sales rose 5.5% but inventory moved up faster at 24.6%. In FY2012, the company pursued an expansion of the watches segment in China. Sales of watches grew 19% in North Asia for that financial year. However, overall sales only grew by 11% while its total inventories grew at 17%.

In this case, it is possible that the company was too aggressive in its expansion and was caught out when consumer sentiment changed dramatically in FY2013. Sales for watches in Taiwan and Hong Kong dropped 31% and excess inventory of watches piled up. Following the drop in revenue of 5% in that fiscal year, the net profit for F J Benjamin also fell 70%.

The downturn in revenue and profit may have lead the company’s share price to underperform the market. From 30 June 2013 to 20 Aug 2014, its share price declined 27% from S$0.26 to S$0.19. During the same timeframe, the SPDR STI ETF (SGX:ES3), a proxy for the Straits Times Index (SGX:^STI), actually rose 4.4%.

Foolish Bottom Line

It pays to think about the upsides and downsides of a business as broadly as possible. After all, we as individuals have only limited knowledge of the world at large –  the collection of high quality thoughts from others might help us become better investors. The inventory analysis represents one of many useful ways to look at a business.

To end, I would share a key message in Mr. O’Glove’s book which he wanted all individual investors to know. Although it was written in 1987, I believe it to be a timeless observation and his words still ring as true today as it was many years ago:

“I would like to suggest that you can consult an expert whose advice can be trusted, someone who will be on hand whenever you need him or her, and who can be counted upon not to try to deceive. … That expert is you, or at least can be, if you make some effort”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.