Well, given my last post, I thought I should double up the two step and give a quick rundown of 4 interesting fundamentals that are coming through at the moment.
This is by no means an exhaustive review of fundamental analysis (still my preferred outlook despite my recent foray with momentum price factors). I would highly recommend to anyone interested in the topic the handbook that started it all: Security Analysis by Benjamin Graham, who beyond being an outstanding academic and writer was also Warren Buffet’s teacher and first employer in the financial services industry.
But on to a quick 4 fundamentals intro of business operations and balance sheets according to 24:
Inventory stocks are important in the economy. Essentially, inventories are what companies sell, hopefully at a profit, but without them there can’t be business per se. Even when looking at the economy from a services outlook: inventories still matter. Without some level of inventory: service can not exist. Think of a plumber without pipes, a carpenter without lumber, an airline without planes. I’m being deliberately vague here in order to assign the somewhat broad nature of what ‘inventory’ can actually consist of – indeed, for a consulting agencies, inventory might be the stock of available experienced working hours from qualified consultants. As such the measure can be fairly diffuse and different on a per company level.
So what about inventories? As the economy contracts and negative business cycles enter into plain view, companies tend to cut back on inventory. Instead of continually trying to beat demand by ordering a slight excess of inventory compared to excess demand, they might prefer running the risk of meeting some level of shortfall on their stocks but be certain that their inventory is indeed sold. This is called inventory depletion.
However, this can not last forever. Inventory, at some point or another will run out and at which point a company will need to replenish it if it chooses to stay in business. In the case of a particularly bad economic situation, some companies might prefer to stop entirely, which might leave some excess stock available for other companies to pick up before a re-order is due. But again, this can’t last forever. At some point or another, these need to be replenished. This is called inventory restocking.
If you look at the quarterly GDP figures for the end of ’09 and early ’10 in the US, you can see that this effect was in full swing. Companies had massively cut inventory purchases prior to those periods and were then left with an urgent need to pick-up from their ‘slack’ in their inventory chain as stocks diminished. This pushed up economic performance quite strongly. But admittedly, it is hard for a company to exactly know how much needs to be obtained at any point in time.
While the economy is rolling forward at normal pace, statistical measures or standard heuristics can be applied, use past historical trends and reapply them. Furthermore, the continual usage of Just In Time management methods, improved efficiency in inventory storage and delivery, and ongoing technological progress assists in this. But these factors can go under shock in the early phases of a recovery. The private sector needs to find its bearings once more. What ‘past’ trend can be applied this time? Which supplier can I contact to get inventory now? Where do I store my inventory as I closed my storage facilities while I was depleting.
All of this complicates the process a little so, potentially, a bit too much inventory can be bought in one go in order to diminish the ongoing risk of getting it wrong: once it’s in stock we can steadily reduce this and then bring back the old management methods once more.
The good news is, that initial one-stop restock has occurred about this time last year. Since then, what we’ve seen has been the gradual rebuild of inventory chains and inventory motivation. Increasing ISM readings, often used to monitor inventory trends, seem to attest to this. But none of this is really happening quite hard and fast enough as we would like. Which brings me to my next point:
Loss provisions are a tricky thing for any company to manage (see previous post for some good news on that front). They are basically an estimate of how much a company can expect to recover from monies owed: perhaps a lot one year, perhaps less another, but there isn’t a fixed rule as to how much actually does end up coming through. This remains a matter of management discretion. The further complication of provisions used to smooth out operational earnings further complicates the process. But I digress here, so let me regress to the matter of Loss Provisions and how it relates to inventories.
Inventories, as for other business to business services, are often contracted with a specific business payment plan in place. The standard 30 day terms come to mind. But another way of looking at that is that the inventory order is actually a receivable to the supplier for at least 30 days. If it’s money in receivables then it must also be provisioned for. As the economy gets worse, three things therefore can happen: one, the supplier needs to allocate ever more capital towards covering potential losses over monies on receivables; two, buyers may start coming in worse than even the supplier expected and therefore cause further increases over provisions (that are then maintained forward); and three, all this money set aside for provisions can reduce the amount the supplier himself will use in his own operation and his own inventory purchases.
So we now have an unfortunate cycle that can cause further heartache to the economy. But as things pick up, what do we have? Inventory starts rolling through, further inventory restocking and at smaller but more constant increments leads to increased inventory turnover and increased receivables and payables turnover. So here again we get another pick up in activity that can measured through. With the lead in inventory, once more loss provisions can be reduced and companies can perform better, this loss provision reversion is called the write-back.
This again, brings me to my next point:
So now we have some write-backs coming through on our books. But what does that mean? Well, a write-back will essentially be excess cash that now does not need to be set out against losses as previously assumed, in other words: excess capital. Admittedly, it can also be used to inflate profits up a bit and to repay some dividends to shareholders but this isn’t really purely ‘operating’ profits. Instead, these write-backs could be viewed as newly ‘freed’ capital that can now be reallocated back to operations. In other words, an injection in free working or operating capital.
What does this do? Well, with more capital available, the private entity can increase inventory purchases, which can reduce loss provisions, which can then free up more capital… As the capital is re-applied efficiently, the company can then go back to its core focus of growing its profits, which then in turn improve its performance. Which then brings me on, in part, to the fourth part:
Okay, so this isn’t really a direct result of the last point per se. In reality, financing operations should occur at all steps of the process, kind of like oil lubricating the machine through-out. Increased hedging can reduce uncertainty on deliverable contracts or on deliveries from suppliers which can reduce loss-provision write-ups and collateral posting requirements (think oil forward contracts), increased financing can improve payable terms and ensure smooth payment across the inventory cycle, and finally, as capital gets freed up, increased financing can help capital to be more efficiently allocated and deployed, both internally and externally to a company.
Admittedly, the converse can happen as well. Financing can lock-up and then cause dislocation across many facets of a business. We’ve witnessed this, and we’ve become very afraid from it as a result, so in part I would view this as a leading indicator that this last aspect, our point 4 in the fundamental double two-step, will be the one that comes less strongly in this instance.
This being said, it will still occur as it is a core aspect of most of the other items listed above. Think Just In Time management without any credit facility: great, my inventory is here but I just can’t pay for it, now what do I do? Or trying to manage doubtful-debts and payments without external reliable financial counterparty.
So how do we monitor this across the whole economy with millions of companies, thousands of different business orders and too many other facets coming through all at once? Well, thankfully, the markets give us a helping hand in this by providing us with an ongoing incentive to go out, seek, and apply this information in an applied and professional manner.
Putting Some Context To Our Process
And to round off this piece, let’s add a bit more depth to the past article just mentioned previously in 24: a large financial house is able to reduce its loss provisions in its commercial and investment banking divisions.
In other words, there is increased potential for companies to meet their payments on credit facilities, in taking advantage of these facilities in buying inventory, for companies to meet their equity raising targets and external capital allocation decisions or, in other words, a bit more virtuous circling than may first meet the eye from an anodine balance-sheet item.
Ah, well, there is one item that I left out (I did warn this list was far from exhaustive). But, unfortunately, this is one that hurts a little: it’s called jobs. The thing with a highly efficient and productive economy is that the above points still occur without necessarily pulling in more work-hours into the process. However, this isn’t in itself a stable point: instead, it is a question of pressure.
As the growth builds up and upon itself, further pushes are required from companies in order to perform and further services and techniques are required for ongoing performance growth. Doing well one-day is not enough in a modern economy: the core focus is doing better tomorrow. Note here: the core driver is growth.
Suddenly, we don’t just need one storage hangar, but we need two. We don’t just need to store inventory, we need to shuffle inventory efficiently in line with demand. We need independent price and quality control process to support this process. Or, in other words, we need more security personel for our new hangar, we need new staff to manage transport and delivery of our inventory, we need independent price and quality control agents to review the process and to manage the new operational scale. And at this point we have growth in aggregate employment.
How all these factors then come through, at a price level, is also an interesting aspect.
In theory, this movement should be a random walk, with the primary incentive being one of ongoing self-interest pushing towards a more efficient boundary. But is this efficiency constant at all times? Or must there be just enough inefficiency, at specific discrete time intervals, in order to motivate and push towards an ever increasing efficient boundary? Are we currently looking for these inefficiencies or are we presuming that efficiency is already a stable state? And out of these two assumptions, search for inefficiencies or presumption of efficiency, which is more efficient to pursue?
These are questions I am leaving for another article, in the interim, fundamentals still remain and they count, not just on 24-something, but also in the real economy, the one we live in and the one we count on.
- Background Links
Security Analysis by Benjamin Graham