using days sales to measure inventory: a dangerous method

an example

I started out on Wall Street as a securities analyst covering the oil industry during the oil and gas boom caused by the second OPEC “oil shock” of 1978-80.  The sharp rise in prices (which today looks a bit ludicrous) from $7 a barrel to $14–implying a spike in gasoline prices above $.50 a gallon!!!–caused a huge increase in drilling for new deposits.

One key shortage element was the steel pipe used to line the well hole already dug, to prevent the hole from collapsing in on itself.  Without steel pipe to line the well you couldn’t drill.  So one of my standard questions during the interviews I did with company managements as I was preparing to write evaluations of their stock prospects was how much steel pipe they had on hand.  It was usually only two or three months’ worth.  It was never enough.  And the makers of the pipe were never able to ramp up capacity fast enough to meet demand, no matter how fast they put up new plants.

Anyway, one day I was talking to the CFO of a small exploration company in Texas.  When I had last talked with him, a couple of months before, he had said his company had about two months’ worth of pipe on hand.  I asked the question again.  He said, “We have a year’s worth of pipe on hand.”

I said, “You must have finally gotten a big shipment in.  How did you do it?”  He replied. “No.  Our drilling plans have changed.”

This was my first concrete indication that the commodity bust, which often follows a big boom, had arrived in the oilpatch.  What the CFO in my story meant to say was that prices had already fallen to a level where the wells his firm had been planning to drill were no longer economical and he could no longer get financing to carry out the projects.

the cash conversion cycle

This is a measurement of how much cash a company needs under current conditions to turn a dollar invested in working capital to make a new product back into cash.  It’s the sum of three parts:  the time it takes from purchasing raw materials until the sale of a final product is made + days credit extended to purchasers – days credit extended by suppliers.

In most cases, the key time element is the first element, the time in inventory.  Hence, the focus on inventory days.

supply and demand is much more important

…as my oil company example shows.


Just as the situation of extremely constrained inventories can prompt one to draw the misleading conclusion that conditions will always be tight, the situation where inventories are massive can also be deceptive.  Housing in the US may well be a current case in point.

Despite the evidence that the housing market has been picking up in the Us for the past year, until just the past two or three weeks media reports have been strongly biased to the negative side.  One of the key figures being cited is the large inventory of unsold homes available for sale.

Two elements are wrong with this analysis, in my view:

–after many years of languishing on the market, and presumably not being maintained, I think it’s questionable whether all the dwellings counted in that inventory number are actually salable.  Maybe a quarter aren’t.

–even small changes in demand can make large differences in the days- sales measure.  For example, the latest Department of Commerce figures show that the inventory of new homes available for sale in the US has shrunk by 29% in the past year to 4.7 months.  Half of that decline is from builders creating fewer new homes.  The other half is from an increase in demand.  It wouldn’t take much more demand to push that figure into shortage territory.

I’m not saying that demand will increase (although I suspect it will).  I just want o point out that relying on days-sales figures for conclusions is potentially dangerous.




musings on 2012

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PSI reader survey


Yes, you’re reading the year correctly–2012.

Why so soon?  Two reasons:

First, stock markets around the world seem to me to be laser-focused on the here-and-now.  As a general rule, any successful investor has to have a perverse streak–the fact that everyone is doing one thing is prima facie a reason to set out in a different direction.  Besides, focusing exclusively on today and tomorrow is playing the day traders’ game.  Great for passing the day, great for your broker–bad for your portfolio.  The edge, if there is any (the evidence is that day traders in the aggregate lose money), in this game is with the guy who has the most advanced trading software or the itchiest trigger finger or, in today’s world, is co-located with the marketmaker.

That’s not me.  I don’t think it should be you either.  We should be working smarter, not harder.

2.  Some people are beginning to argue that what we are now experiencing is not a simple correction in an ongoing bull market, but rather the first signs of a fundamental change in the direction of the market to the downside.

Their argument starts with two suppositions:

–turmoil in the Middle East will intensify, resulting in significantly higher oil prices.  This, in turn, will create a substantial headwind to world economic growth;

–the earthquake/tsunami/ nuclear power plant disaster in Japan will tip that country into recession (it wouldn’t take much, since Japan is barely growing). That, by itself, will have a negative effect on world growth.   In addition, supply chain disruption caused by damage to manufacturing plants in Japan will create added problems for industry internationally.

Together, the argument goes, these two forces are enough to cause a fragile world economy to slide back into recession.  Down world economy implies down world markets.

Could this be right?

my thoughts

it’s normally too soon to be worried…

Typically, the market begins to turn to earnings prospects for the following year in June or July of the current one.  Until summer, the market usually concentrates on the details of this year’s profit performance and doesn’t worry much about anything farther into the future.

…but these aren’t normal times…

2010, of course, was by no means normal.  Last year, investors refused to look any more than a month or two ahead until September or October.  Only when the positive evidence from corporate earnings reports became overwhelming did the market grudgingly begin to concede the possibility that 2011 might be an up year for company profits.

Once stocks began to move up, however, they didn’t stop until they had discounted everything positive that might happen in 2011.  Very unusual behavior, but the reason I had been expecting a correction.  It’s just too soon, for any market–but especially for one that has been so skittish, to begin to discount possible 2012 earnings gains.

The bears might cheerfully concede that that’s how the downturn began a month ago.  But, they would claim, the Middle East + Japan have turned a correction into something fundamentally different.

…so maybe a long glance ahead makes some sense

Another factor to consider:  we’ve just passed the second anniversary of the start of the bull market.  This is just an early warning indicator of the maturity of the advance. Some bull markets, like the one that began in 1992, have lasted far longer than two or three years.  But we can’t rule out the possibility of a market downturn in the easy way we could have in 2010.

So, contrary to the way things usually, maybe–just to be safe–it makes sense to take a guess at what 2012 might be like.

my yearend 2010 view

My base case for 2011 made at the end of last year:

–earnings of $100 for the S&P 500, which might be a little aggressive,

–a multiple of 14x, maybe 15x if we’re lucky,

= an index target of 1400-1500 for the S&P.

a rough guess for 1012?:

–eps growth of 10%-15%, as economies gradually return to normal and short-term interest rates begin to rise,

–a multiple of 13x-14x on those earnings,

= a target of 1430-1610 on the S&P.

If those guesses were anywhere near the mark, it would imply that 1012 would be an up year, but with the market rising less than 10%.

what’s changed since then?

How do Japan and the Middle East change these figures?  I don’t feel comfortable putting down precise numbers for either.  But I think it’s safe to say that the entire negative effect, both in Japan and elsewhere, of the earthquake will occur in 2011.  This means 2012 will benefit not only from the absence (we hope) of a comparable negative event, but also from the positive stimulus coming from reconstruction efforts around Sendai,.

Similarly, the negative effect of higher oil prices, provided they stay within a reasonable distance of the present level, will be felt throughout most of 2011.  Absent comparable increases again in 2012, the negative effects will fall out of year over year comparisons by next March.

Consumer pain will be felt most intensely in the US, where low energy taxes mean that the percentage increase in prices will be larger than elsewhere and where consumers use mind-boggling amounts of petroleum products.  But, on the other hand, the US consumer is showing surprising strength, and is in the best position today to withstand the negative effect of more expensive oil.

my conclusion

I find that these thoughts are pushing me toward a conclusion that’s different from what I’d expected. Japan may clip a percent or so off S&P 500 earnings growth this year, but will add a similar amount next.  Higher oil prices may shave another, say, 2%, from S&P earnings growth in 2011 but have little effect on the 2012 tally.

In other words, the Middle East and Japan will end up making the growth rate of 2012 earnings over 2011 results higher than it otherwise would have been.  An S&P level above 1400 may therefore prove hard to surpass in 2011, but one of 1550–a 10% gain–looks easier to achieve in 2012.  By slowing down and stretching out the pace of economic recovery, Japan and the Middle East may make it more probable that the rebound stretches well into 2012.

the Fedex 2Q11 (ended November 30th) results

the results

Yesterday I listened to the FDX 2Q11 earnings conference call, which was held before the market opened in New York last Thursday.

FDX reported earnings of $1.16 a share on revenues of $9.63 billion.  The revenues were up by 12% year on year, the eps less than half that.  Earnings per share also just barely hit the bottom of the range of $1.15 – $1.35 that FDX guided analysts to when it reported 1Q11 results on September 16th.

Despite the close call, FDX raised its guidance for the full fiscal year from a range of $4.80 – $5.25 a share to a new range of $5.00 – $5.30.

The company did caution that its third fiscal quarter is always vulnerable to bad weather, of which the midsection of the US has already had plenty so far this month.  So it’s not yet clear what the quarterly breakout of the earnings will be.


The International Priority (IP) business, notably deliveries from Asia to the US, continued to grow rapidly, with revenues expanding by 14% over a year ago.  Notably, the domestic parts of the FDX distribution chain grew at about the same rate, and benefitted from improved operating efficiencies.

So what went wrong?

1.  After what was reported as only three hours of deliberation, a jury in Indianapolis awarded now-defunct airline ATA $65.9 million in its suit against FDX that it wrongfully terminated a long-term contract with ATA to transport US troops.  A reserve for this judgment–FDX said nothing on the call about a possible appeal–clipped about $.15 from eps.  That’s also the main reason the IP business had flat year-on-year operating income.

2.  FDX overestimated the strength of the IP business during the second quarter.  It extrapolated the frantic rate of shipment growth of the spring and summer into the fall.  But that didn’t happen.  Revenues in the IP segment grew by 23% y-o-y in 1Q2011 after an almost 30% gain in 4Q10–but decelerated to 14% growth in 2Q11.  (True, comparisons are affected by the fact that FDX’s business really began to pick up from recession lows in the second quarter of last fiscal year.  But FDX guidance still anticipated better than what it got.)

3.  FDX is now projecting a better full year than it was three months ago.  I’ll get to this in a minute.  Because of this, it is also projecting bigger bonus payments to employees than it was.  Therefore, it made a higher provision for bonuses in 2Q, and presumably also had to make a catch-up accrual for 1Q.  FDX mentioned this as a factor but gave no further details.

why the slowdown in the international business?

In ordering from suppliers, a merchant faces two complementary inventory risks:

–he can order what he is confident he can sell plus some more, and risk the expense of holding excess inventory for longer than he wants or selling it at clearance prices, or

–he can order only what he knows for sure will sell–or maybe less, and risk losing business as customers come into the store and find the shelves bare.

FDX wasn’t 100% clear on the point, but it seems to believe that retailers got cold feet as they planned for the holiday selling season.  They collectively made the cautious decision that the risk of being out of stock was much more acceptable than the risk of having excess inventories.  So they slowed down the pace of their new orders from Asia.

They are now finding out, too late to do anything about it, that customers are in a much better spending mood than anticipated.  As a result, store inventories will be severely depleted by the end of December.  This means, in FDX’s view (I think they’re right) that there’ll be a mad rush to restock early in the new year.  That will be very good for FDX.

In addition, FDX clearly believes that world economic growth is beginning to gain momentum and will continue to do so for at least this year and next.

my thoughts

I haven’t done enough work on FDX to have an opinion about it as a stock.  Clearly, earnings are going to improve, both as the global economy expands and as the costs of resuming normal operations–restoring pay and benefit cuts for employees and reactivating planes mothballed in the desert during the recession–now being charges against income–fade from the financials over the next couple of quarters.  To me, the real question is how much of that good news is already reflected in today’s stock price.

Be that as it may, FDX is a large, sophisticated company.  Because of the business it’s in, it has unusually good insight into the workings of the world economy.  It sees, directly or indirectly, manufacturers’ production plans and retailers sales experience.  And it must already have a good feel for the tone of business for the next several months.  I happen to think the company’s view of world economic growth is correct.  But, unlike my guesses, theirs is based on a wealth of commercial data that few other entities have.  So I think FDX is evidence that it’s still right to be bullish.



Wells Fargo: US economic recovery ISN’T sub-par

a better than average recovery

A month or so ago, I wrote about the thesis of Jim Paulsen, the chief investment strategist for Wells Fargo, that the US is actually doing a bit better than average for economic recoveries over the past twenty-five years.  The perception that the economy is relatively weak comes, in his opinion, from comparing apples with oranges–from comparing this recovery with all post-WWII economic rebounds, not with those of the last quarter century.  This latter group, however, are the only ones that occurred with an economy like we have in the US today.

Anyway, I’m suddenly on the mailing list for Dr. Paulsen’s monthly commentary (Thanks, Wells Fargo!).

a new angle

In his December comment, Dr Paulsen expands on his idea of a “back-loaded” economic recovery.  I don’t necessarily intend to talk about Dr. Paulsen every month, but I think he is making some interesting points.   They argue that we will be seeing accelerating economic performance out of the US economy in the months ahead.

women entering the workforce

In a nutshell, Dr. Paulsen’s November observation is that the US economy of the 1950s through the mid-1980s had a faster potential rate of growth than we have today because in the earlier period  the large-scale entrance of women into the workforce acted as a significant tailwind that we no longer have.

the effect of inflation

In his December commentary, Paulsen makes the additional observation that the switch from the inflationary mindset of the Seventies and early Eighties to a disinflationary one of the Nineties and beyond also has a significant effect on the behavior of corporations.  As he puts it, in the earlier period, “sales always rose and prices could always be increased.”  Therefore, it made no sense to worry about staffing levels or the size of inventories.  Price increases would always ensure that companies could report a satisfactory, and rising, level of profits.

The world has changed dramatically since the Sixties and the Seventies.  The Fed’s thirty year long fight against inflation has stamped out in customers’ minds the idea that prices inevitably rise.  In the new environment, a company has got to concentrate on keeping costs low and increasing productivity.  Hiring increases and capacity additions come only as a lost resort.

my thoughts

In my view, Dr. Paulsen’s observation about inflation is basically correct.   In fact, the old inflation-prone world of the Seventies is so foreign to today’s experience that it’s hard for people who didn’t experience it to comprehend how or why the economy ran the way it did back then.

But there are also a lot of other things different about the Sixties and Seventies:

–the industrial firms in Europe and Japan were still rebuilding after WWII

–trade barriers were much higher than today

–therefore, there were far fewer true multinationals, who aimed at selling large amounts of stuff at moderate prices all around the world

–electronic products, where performance always gets better while prices decline, were a much smaller percentage of industrial production

–the rate of technological change was much slower (so fewer worries that bloated inventories might become obsolete)

–there was no Internet and no online commerce

–there was no supply chain management software, so managements had little of today’s ability to analyze and control operations.

Yes, the Fed’s actions in the Eighties destroyed expectations of inexorably rising prices.  But the world is much more complex now.  Change is faster and competition is much more intense.  So cost control and productivity increases are essential for firms to remain competitive.  And today’s managements have powerful tools that allow them to dramatically curtail operations–as they did in late 2008 and early 2009–confident that this is the profit-maximizing thing to do.

good news

Today’s coin has another side, however.  Cost cutting and squeezing more output from a given amount of capital equipment can only go so far.  At some point, firms have to add people and plant in order to continue to grow.

Jim Paulsen thinks, and I agree, that we’re now at that point in the current recovery.  Productivity growth has been slowing for a while.  And there’s substantial evidence that companies are beginning to hire at a faster rate.  If so expect profits for publicly listed companies to accelerate in the months ahead.

Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?

Wall Street has spawned millions of clichés.  They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.

Market truisms are often mutually contradictory.  But, excepting the ones from TV, they often outline possible approaches to important investment issues.   That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.

the big middle

In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.”   The idea was to avoid undue risk at potential cyclical turning points in the market.  A manager would do this by becoming more defensive as he saw three signs:  the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.

He might miss the actual market peak by months.  But he was prepared to profit from the subsequent downturn.  As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing.  He would wait for the market to clearly turn upward again before becoming more aggressive.  Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.

No one talks about this overall strategy anymore.  Why not?

–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were.  The closed economy model is a thing of the past.  Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.

–The investment business is much more competitive today than it was then.  Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up.  His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short.  And it’s always the customer’s right to take his business elsewhere if e chooses.

–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before.  In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too.  Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.

To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on.  Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.

the falling knife

Opinion is divided on how to approach sharp market declines.  “Don’t try to catch a falling knife” expresses one technique.  I’m not sure what the origin is.  I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.

The “falling knife” idea is a variation on the “big middle” theme.   The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces.  See the bottom and watch the turn happening before entering the market.

blood in the streets

The “blood in the streets” approach is to some degree the opposite idea.  Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap.  Don’t wait for the turn.  By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.

more professionals are embracing the “blood” idea…

…in my opinion, anyway, for two reasons.  The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore.  Increasingly, the time period over which clients are judging professionals’ performance is shrinking.  Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case.  But this performance pressure is also being felt by long-only managers.

What should individuals do?

The most important thing is to ask yourself two related questions:

–Are you willing to accept the extra risk of trying to trade a downdraft in the market?

–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?

Assuming the answer to both questions is “yes,”  these are my thoughts:

1.  Ask yourself what the primary trend in the market is.  Are stocks generally going up or generally doing down?  Are we in a bull market or a bear market?

In my opinion, you should only be interested in counter-trend movements.  Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market.  Conversely, only use a sharp upturn to become more defensive during a bear market.  Otherwise, do nothing.  During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted.  Welcome to a world with derivatives trading.

2.  Calculate probabilities as best you can.  The point is that you don’t need to find the absolute bottom in order to act.  For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy.  Your own risk tolerances will determine what the appropriate ratio is for you.

3.  Separate market events from stock-specific ones.  In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones.  Similar stocks in the same industry should show roughly similar volume and percentage change patterns.   These patterns should also be similar to the stocks’ behavior during past declines.  An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of.  In such a case, discretion is the better part of valor.  Choose a different stock to buy, or don’t transact at all.

4.  Don’t force yourself to do anything you don’t feel comfortable with.  I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.