Monday, April 21, 2014

The importance of Inventory in Value Investing

Inventory plays a very important role in investing and typically is the driving force behind differences between cash flow from operations and net income. Too much inventory is almost always a bad thing - the question is what is the definition of too much inventory. Advanced manufacturing companies today are using just in time (JIT) techniques where their inventory stocking is calculated in hours. Lower inventory means:

  • lower stocking area
  • lower capital consumption in creditor payments
  • lower chances of perishable items being unusable
  • higher chances of using FIFO
  • lower chances of having rejections lying in inventory
  • lower theft and pilferage
  • better production systems
High inventory means:
  • Too much capital utilized in an unproductive asset
  • Questions start to arise on inventory valuation as small changes can impact the PAT by large percentages
  • Too much finished goods stock might be affected by changing market prices
If you are interested in the topic of low inventory management I can recommend several books on lean manufacturing the most famous one being The Toyota Way by Dr. Jeffery Liker.

I was motivated to write this article after reading about AVT Natural Products. The company showed up on a high ROE, high ROCE and low P/E screen I setup. Then I found this extremely detailed article on this company on Value Pickr by Mahesh shah and I thought I had hit upon a great value investment - largely exports, high margins, high returns, low P/E until I studied the inventory of the company.

When we study the inventory of the company it turns out:
  • At the end of FY 2013 inventory stood at 
    • 32% of sales
    • 65% of raw materials consumed during the year
    • 1.89 times the annual PAT
    • Over 50% of the invested capital was invested in carrying inventory
  • The company claims they carry excess inventory to cover the risk of crop failure - which implies that the business by design requires large investments in inventory
  • Over 65% of the inventory is lying in finished goods stock 
    • Inventory is supposed to be marked at lower of cost or net realizable value as per the statements but I do not know how the FG stock has been valued
    • If the finished goods have been valued at expected sale price then profits have already been claimed on sales that have not been made yet
  • No information has been provided on the shelf life of the inventory
  • If the inventory % of sales had been kept constant between FY2013 and FY2012 the cash flow from operations might not have lagged PAT
Given these concerns about inventory I am worried about the moat quality and the real financial picture vs the picture painted by the published financials and am staying away from the stock at the moment until I can get more details.

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