The past week has been filled with all kinds of goods news. First, the preliminary GDP report indicated much stronger growth than expected. This was followed by the ISM manufacturing survey that came in at 57, the first time over 50 in 19 months. Yesterday the services component also showed a dramatic rise, and the fastest in 15 months. And today investors were greeted to a rosy Beige Book with a majority of the districts indicating a pick up in economic activity.

Retailers are finishing up reporting earnings for their fourth quarters. Overall, the results are very impressive. The American consumer continues to open their wallet every chance they get. Everyone already knew sales were strong following the holiday season. Several, including myself, hypothesized that gross margins would decline as promotional activity was the driving force behind the sales gains. However, most retailers have actually been able to maintain gross margins at the same level from the year-ago period. It should come as no surprise that there still exists a very segmented marketplace. Several discounters actually were not only able to maintain margins, but actually increased margins. Department stores and some specialty apparel retailers typically experienced margin erosion. Just today, Kohl's reported gross margins improved 18 basis points and Costco maintained similar gross margins compared to last year.

The current recession, or according to some economists - the one that never was, is certainly an unfamiliar scenario for economists. There have been very few recessions led by the business sector. The current recession has not only been led by the business sector, but has been totally confined to businesses as consumers have continued to show no fear. In fact, the preliminary GDP report for the fourth quarter showed a dramatic sequential increase, but a hefty 3.1% increase year-over-year. These results were driven by an unsustainable 13.5% increase in purchases of durable goods. Everyone knows zero percent financing fueled a huge jump in auto sales. For the fourth quarter, the increase in auto sales represented 62% of the growth in durable goods purchases year-over-year, and without growth in auto sales GDP would have declined, both sequentially and year-over-year.

The economy is being driven by offering special financing to as many consumers as possible. This week GM went back to the well. It replaced its $2002 rebate incentives with zero percent financing. The FT reported that GM has excess capacity of one million units. With that much overcapacity it is no wonder that GM has to do everything it can to keep sales up.

Today, Merrill Lynch announced the first step in its plans to overhaul how research is conducted by its analysts. Merrill now wants analysts to consider "the use of broad measures beyond pro-forma earnings to evaluate a company's quality of earnings with the objective of establishing an enhanced standard of accountability and transparency for our clients." Maybe it's just me, but shouldn't it be assumed that research analysts actually conduct research?

Currently, the Association for Investment Management and Research (AIMR), the governing body for the CFA program, is advocating a continuing education program "to maintain the integrity of the CFA charter." Wouldn't the CFA charter hold more integrity if AMIR simply enforced its own standards? AIMR's Standards of Practice already maintains that CFA should:

"Exercise diligence and thoroughness in making investment recommendations or in taking investment action.

Have a reasonable and adequate basis, supported by appropriate research and investigation, for such recommendations or actions"

It would seem that these standards would prevent analysts from simply using pro-forma income statements as a basis for research. Also, what does it say about the profession when a vice-chairman of a major money management firm admits that "nobody really dug into footnotes" on a 43 million share position.

When analyzing retailing companies there are a few simple areas to watch that will allow investors to generally avoid "torpedo stocks." (Click to see Gap as an example). Most retail companies that investors are interested in are high growth retailers. It is generally better to look at these retailers on a per store basis as much as possible. The first and easiest "red flag" is same store sales growth. This is released every quarter along with reported financial results. Several retailers also report total sales and same store sales growth on a monthly basis. Trends in same store sales should be noted and if growth turns negative it is usually a good time to reevaluate the thesis of owning the stock. There are several reasons same store sales growth declines. The obvious one being, consumers do not like shopping there any more. But, for rapidly expanding retailers, cannibalization is another concern. Cannibalization happens when new stores take sales away from an existing store. It can not only happen by locating a Gap store too close to an existing Gap store, but by opening another concept in close proximity. Gap also owns Banana Republic and Old Navy. The Old Navy concept offers lower priced clothes, while Banana Republic is higher end. Investors were concerned, or should have been, that Old Navy stores would not only cannibalize Gap sales, but that the cannibalized sales would be replaced with lower priced goods. Sales per square foot is another item useful to see how well the company is performing. This measure will also indicate how well the company is leveraging its stores and generally can provide a ballpark indication of the return on capital. Again, once the trend turns negative it is usually a sign that either new stores are cannibalizing existing stores, or the company is opening larger stores and is not able to leverage the additional size into comparable sales growth, which would also indicate the company's return on capital is likely declining.

After calculating inventory days of sales, determine inventory on a per store basis. This is simple, just take inventory and divide by the number of stores. This helps determine the health of the inventory situation. For fast growing retail companies this can help find inventory problems that could be masked by rapid growth. It will also provide a check for rapidly expanding companies. Days of sales calculations are based on the relationship between sales and inventory. Usually this is very helpful, however what if the company just opened several stores toward the end of the year. The stores obviously have to have inventory on hand, but they have not contributed to sales? By determining that inventory per store is inline, you could prevent a false positive.

Retailers are often able to leverage their suppliers and get favorable financing terms. If a retailer is able to receive inventory but not have to pay for it for 30 days, it frees up working capital for other uses. This can be measured by calculating the inventory yield. The formula for inventory yield is: (Gross Profit - Account Payables) / Inventory. Slight changes in this can have dramatic effects on the business, but will not necessarily be evident right away.

I focused on aspects that are more specific to retailers. Obviously additional analysis would be required, but this should provide a primer on avoiding torpedo stocks in your portfolio. I must add, I do not recommend that individual investors sell short individual stocks. There is simply too much risk by not having a diversified portfolio.