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You Want Me to Do WHAT with my Inventory?

Stephen Roseman

It's not only investors who have been risk-averse since the credit crisis. Of late, it seems that plenty of company managements, especially in retail, have been similarly concerned about repeating their collective experience of the credit crisis.

The only difference is that instead of investors underweighting equities, many companies have decided to reduce "inventory risk," at least with respect to their corporate balance sheets. Inventory risk is a euphemism for buying too much of something that doesn't sell. Really what these companies are doing is asking vendors and manufacturers to hold more inventory on THEIR balance sheets and take on more inventory risk themselves. With friends like that, who needs enemies, right?

The problem is that not unlike investors who have underweighted equities, the decision to buy too little inventory (read: future potential sales) means that many companies are underperforming the economic potential of their business in exchange for better managing quarterly earnings. Of course, this is bad for everyone when it happens. It's unfair to the vendors that need to earn to their potential so they can design/invent/create new products. The retailers generate lower revenues, which in turn means they create fewer gross margin dollars to offset operating expenses. This leads to management cutting expenses (including jobs) to preserve their bottom line, ostensibly to make investors happy with lower-than-potential earnings. Not a great outcome for most stakeholders.

It's not surprising that the retailers that have excelled historically have followed a fairly simple formula: They have what their customers want to buy, in stock when their customers want to buy it, and at the price that their customers will find sufficiently compelling while also allowing the retailer to generate attractive gross profits. Typically these businesses were focused on being the best retailers they could be, without regard for quarter-to-quarter reporting.

I know that one can make a reasonable argument that being underweight inventory is a great way to protect that bottom line in case of another slowdown. The issue at hand is that, as investors, when we invest in companies that can grow and thrive, it is out of our "risk bucket." We WANT companies to take the risks that made them interesting and/or differentiated businesses with the potential to generate high returns on capital. Otherwise we could all be better served keeping our money in the relative safety of Treasurys, which are likely a better bet than an under-inventoried retailer, if it's safety we're after. But that won't allow us to compound capital so that we may outrun inflation or build wealth. Here's to hoping that retailers build more inventory.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security.

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