Is Inventory the Hidden Clue to Retailers’ Future Share Value

David Berman is a hedge-fund manager who CNN says is like a “patient predator.” He watches retail inventories with the focus of a hungry jaguar. Specifically, he watches for retailers whose inventories are growing faster than sales.

Inventory, Mr. Berman says, is a little-known leading indicator of the rising or falling value of retail stocks. If inventory is rising faster than sales, and if gross margins are unusually strong, earnings and stock value are probably headed for a fall.

Why should retailers care what David Berman thinks?

Because a lot of investors care. CNN, Bloomberg and CNBC have all interviewed him on the topic of financial outlook for the retail industry.

Inventory predicts earnings and share price

Few investors seem to recognize the relationship between inventory, gross margin, earnings and share price, Mr. Berman says. Retail managers are inclined to manipulate operating margins in the short term, he observes, by “playing around” with inventories.

“If a retailer’s inventories are growing much faster than sales,” he says, “then gross margins would be higher than they normally should be, as the retailer has not taken markdowns that a solid, disciplined retailer should take.…

“You don’t want to be an investor when sales slow and when markdowns of bloated inventory finally need to be taken to move the goods.”

Inventory levels, considered in relation to trends in sales and gross margins, are likely to predict future earnings. You can learn more about this relationship through a free article from the University of Chicago Booth School of Business, which you can download here as a PDF document.

Mr. Berman is so focused on the effect of inventory, in fact, that he pays researchers to check store clearance racks for evidence of inventory discipline before his fund invests in a retail stock.

Inventory discipline is key to shareholder value

Here’s what David Berman’s insights can mean to retailers, even if their stock is not publicly traded:

Inventory discipline is not only key to your cash flow and balance sheet, but also to your P&L and share value.

To achieve inventory discipline, you have to manage a lot more than inventory turns. If you don’t exercise consistent vigilance, you won’t have much control over earnings.

What are David Berman’s credentials? He’s a CPA who spent his early career evaluating the finances of retail companies. He worked as an auditor for Arthur Anderson and then as a portfolio manager and analyst for two Wall Street firms.

He graduated in the top 10 percent of his class from the Harvard Business School.

More recently, he is founder and president of David Berman Capital and founder and general partner in Durban Capital, L.P. Durban Capital is a fund with $100 million in assets. The firm specializes in retailing and consumer goods.

David Berman knows a lot about how to spot retailers who lack of inventory discipline, but it’s not his business to teach retailers how to achieve it.

Blue Ridge will help you achieve inventory discipline

Helping retailers achieve inventory discipline is the business of Blue Ridge Inventory. Over the years, Dan Craddock and I have worked with this partial list of current and former clients:

CVS, Rite Aid, Eckerd Drug, Duane Reade, Dollar Stores, REI, Mountain Equipment Coop, AcuSport, Sport Chalet, Sports Authority, Gander Mountain, Dick’s Sporting Goods, Petco, Staples, Office Depot, Tractor Supply, Mill’s Fleet Farm, Northern Tool & Equipment, Ace Hardware, Home Hardware, True Value, Michael’s Stores, Best Buy, Provigo, Williams-Sonoma, Pep Boys Auto, Advance Auto, O’Reilly Auto, Guitar Center, Coldwater Creek, Stein Mart, Unified Grocers, Associated Food Stores, Northgate Gonzalez Market, Associated Grocers of New England, Europris, URM Stores, Dick Blick and Procurator.

For a free diagnostic consultation during January 2013, please contact me at Greg@brinv.com.