E-mail this article Printer-Friendly

Why “efficiency experts” make good investments

You can judge a stock by a host of different numbers, says this U.S. advisory, but how can you tell if it is really doing the job efficiently?

News of layoffs has been coming through far too often of late.

While the stock market is showing signs of life, the economy is still contracting (and we can’t even be sure that this is the market rally that signals a recovery five or six months down the road).

Layoffs are the hard, cold residue of an economic crisis. Companies must cut into their costs somehow. Yet there are many other ways to trim the fat, and they are often more effective than just slashing and burning.

And the companies that keep their ledgers balanced and their cash flowing steadily make better investments than those that are simply throwing everything overboard in hopes they’ll stay afloat.

One prominent U.S. advisory tells us how to identify the companies it calls “efficiency experts.” It also recommends three stocks that fit the guidelines.

Many analysts urge you to look at cash flow ratios, and quite rightly, says Dow Theory Forecasts. But you can also measure several telling indicators of company efficiency.

Nimble players

The terms sound like refugees from a chartered accountants’ manual (not that there’s anything wrong with that, especially when you need your taxes done). But this advisory turns them into an investor’s checklist.

“Days receivable, days inventory and operating cycles measure flexibility, helping investors identify nimble players — and avoid lumbering firms that could get tripped up by the downturn,” says the advisory.

The first measuring stick is “days receivable.” This is calculated by taking the ratio of 12-month revenue to average receivables and dividing by the 365 days in the year.

This gives you a glimpse at the solvency of a company’s customers. If the figure for days receivable is on the rise, it’s taking longer to collect on the bills. This doesn’t just crimp a company’s cash flow, it could also foretell an increase in write-offs of doubtful accounts.

As lean as possible

Inventory is the other side of the cash-flow coin. Obviously, firms don’t want a lot of money tied up in assets that are languishing on the shelves. So they try to keep their inventory as lean as possible without getting caught short on potential sales.

You can judge how well a company manages its inventory, says the advisory. This time the indicator is called “days inventory.” You take the ratio of the 12-month cost of goods sold to average inventory, and divide this by 365. The lower the number, the less unwanted inventory is hanging around on the shelves.

The third indicator simply adds the two previous measurements together. It’s called the “operating cycle” and it measures “the length of the entire transaction from the time a product hits inventory to receipt of payment for a sale.”

The quicker any company turns inventory into cash, the better — and the more elbow room it has to deal with changes in business conditions. Like a recession.

A whole lot of small stuff

These efficiency indicators will vary widely from one industry to another, so it’s best not to compare apples and oranges.

An integrated oil firm like Exxon Mobil (NYSE-XOM), which basically has one large product to move, has a small “days inventory” ratio. It was 13 this past quarter, and averaged 16 over the last eight quarters.

On the other hand, Johnson & Johnson (NYSE-JNJ) has a whole lot of small stuff to move, and its days inventory was 118 in the last quarter and 124 on average over eight quarters. But both are very efficient.

You can find the figures needed to calculate these efficiency indicators in the financial statements of U.S. and Canadian companies. Nowadays, of course, these are readily available online.

This advisory highlights three American stocks that get high marks for efficiency.

A shorter operating cycle

The first stock in the spotlight is Exxon’s fellow oil giant Chevron (NYSE-CVX). This firm has had disappointing results for several years.

But it has taken steps to shorten its operating cycle by processing receivables more efficiently. Its days inventory were a crisp 11 in the last quarter.

At the same time, it is increasing production, so its inventories may rise. Some of its new projects won’t be profitable until oil reaches $60 a barrel, but others will pay off even at lower prices. The stock is a buy today and a Long Term Buy (best buy for the next 24 months).

Laboratory Corp. of America (NYSE-LH) cut days receivable in the December quarter even though many of the hospitals that are its clients struggled with their financing. Lab Corp saw its bad debt rise last year, so it is taking firms steps to keep it under control.

Among other moves, it is offering incentives to improve collection and having patients swipe cards at the time of procedures in order to charge immediately for costs not covered by insurance. This stock is a buy now and a Long Term Buy.

Another medical firm, cardiovascular specialist St. Jude Medical (NYSE-STJ) made a sharp improvement in its operating cycle in the December quarter as it turned over inventory much faster. Days inventory fell 9 per cent while sales rose 11 per cent. Not only does this help the bottom line, it may also help St. Jude acquire some troubled rivals. It is a Focus List Buy (best buy over the next 12 months) and a Long Term Buy.

If a company is smart enough to maintain its efficiency in times like these, just think how smart it’ll be when this mess is over.