The dangers of retail

Asset prices throughout the western world, from property to shares, are at all time highs and show no signs of slowing. Quantitative easing and low interest rates, rather than encouraging new investment and entrepreneurship are simply fuelling price increases in existing assets. Now is the time to be fearful in my opinion, however that doesn’t stop me trying to find great investments even if it is that much harder at the moment.

I recently ran a stock screen of US companies to try and find some interesting prospects. I screened based on a few characteristics: low debt ( <1 x Gross Profit), good returns on investment (EBITDA / Invested Capital > 20%), appears cheap (EV/EBITDA < 5) and excluded any Chinese companies. For more info on how I screen, see my post ‘How to improve stock screens‘, in which I went in detail about why I use the metrics I do. The results were very interesting so I wanted to share them with you, and highlight some possible value traps I noticed going through the list.

Screen results

TickerName MktCap ($m)SectorDiv Yield
CTBCooper Tire & Rubber Co 1,865Consumer Discretionary1.43
NAUHNational American University Holdings Inc 81Consumer Discretionary5.57
ESIITT Educational Services Inc 425Consumer Discretionary0
EGTEntertainment Gaming Asia Inc 20Consumer Discretionary0
BDLFlanigan’s Enterprises Inc. 26Consumer Discretionary0
PENNPenn National Gaming Inc 914Consumer Discretionary0
ZAGGZagg Inc 143Consumer Discretionary0
CSSCSS Industries Inc. 234Consumer Discretionary2.38
ACATArctic Cat Inc. 484Consumer Discretionary1.33
GSOLGlobal Sources Ltd 289Consumer Discretionary0
SZMKSizmek Inc 297Consumer Discretionary0
CTCMCTC Media Inc 1,626Consumer Discretionary6.7
GMANGordmans Stores Inc 89Consumer Discretionary0
TLYSTilly’s Inc 244Consumer Discretionary0
EXPRExpress Inc 1,160Consumer Discretionary0
RCIIRent-A-Center Inc 1,535Consumer Discretionary3.16
AANAaron’s Inc 2,473Consumer Discretionary0.25
SPLSStaples Inc. 7,266Consumer Discretionary4.27
BBYBest Buy Co. Inc. 10,066Consumer Discretionary2.34
LBIXLeading Brands Inc 12Consumer Staples0
WILCG. Willi Food International  Ltd 87Consumer Staples0
OMEOmega Protein Corp 304Consumer Staples0
NAIINatural Alternatives International Inc 41Consumer Staples0
DWSNDawson Geophysical Co 225Energy1.14
TGCTengasco Inc. 26Energy0
EGYVaalco Energy Inc 385Energy0
REGIRenewable Energy Group Inc 396Energy0
TGATransGlobe Energy Corp 536Energy2.79
PZEPetrobras Argentina SA 1,215Energy0
GTEGran Tierra Energy Inc 2,020Energy0
YPFYpf Sociedad Anonima Yacimientos Petroliferos Fiscales 12,080Energy0.83
MROMarathon Oil Corp 25,408Energy2.04
APAApache Corp 36,787Energy1.06
STOStatoil ASA 98,292Energy2.85
CLMSCalamos Asset Management Inc 244Financials3.8
ITGInvestment Technology Group Inc. 691Financials0
QCCOQC Holdings Inc 44Financials0
ITICInvestors Title Co 140Financials0.46
IHCIndependence Holding Co 251Financials0.49
UVEUniversal Insurance Holdings 454Financials2.91
UFCSUnited Fire Group Inc 715Financials2.84
FFGFBL Financial Group Inc. 1,132Financials3.06
PTPPlatinum Underwriters Holdings Ltd 1,756Financials0.49
PRAProAssurance Corp 2,704Financials2.64
ANATAmerican National Insurance Company 3,125Financials2.65
RNRRenaissanceRe Holdings Ltd. 4,314Financials1.1
AGOAssured Guaranty Ltd 4,578Financials1.74
PGRProgressive Corp (The) 14,976Financials1.95
TRVTravelers Companies Inc (The) 32,790Financials2.33
KEQUKewaunee Scientific Corp 43Health Care2.7
ALKAlaska Air Group Inc. 6,873Industrials1
CRRCCourier Corp 148Industrials6.54
CVRChicago Rivet & Machine Co. 33Industrials2.08
MFRIMFRI Inc 76Industrials0
TEXTerex Corp 4,482Industrials0.49
GLBSGlobus Maritime Ltd 39Industrials0
OPLKOplink Communications Inc 311Information Technology0
QLGCQLogic Corp 887Information Technology0
LXKLexmark International Inc. 2,811Information Technology3.19
CAJCanon Inc 36,927Information Technology3.56
ELRCElectro Rent Corp 398Information Technology4.82
VSHVishay Intertechnology Inc. 2,265Information Technology1.56
AVXAVX Corp. 2,269Information Technology2.82
LPLLG Display Co Ltd 9,475Information Technology0
PERIPerion Network Ltd 128Information Technology0
UNTDUnited Online Inc 144Information Technology0
ELNKEarthLink Holdings Corp 378Information Technology5.43
BCORBlucora Inc 811Information Technology0
ONEHigher One Holdings Inc 171Information Technology0
CSCComputer Sciences Corp 9,255Information Technology1.45
INTTinTest Corp 41Information Technology0
UMCUnited Microelectronics Corp 5,924Information Technology2
FFFutureFuel Corp 735Materials2.83
TGDTimmins Gold Corp 242Materials0
TXTernium SA 5,438Materials2.71
CBEYCbeyond Inc 308Telecommunication Services0
ATNIAtlantic Tele-Network Inc. 888Telecommunication Services1.93
NTTNippon Telegraph & Telephone Corp Ntt 66,558Telecommunication Services2.43
USMOUSA Mobility Inc 344Telecommunication Services3.15
SKMSK Telecom Co Ltd 15,048Telecommunication Services3.12
MBTMobile Telesystems OJSC 19,222Telecommunication Services5.2
DCMNtt Docomo Inc 69,831Telecommunication Services3.34

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What struck me was how these companies are concentrated in a few sectors. Out of 83 companies there are 4 dominant sectors – Insurance, IT, Oil & Gas, and Consumer Discretionary. It is the last that I want to focus on in this post.

Consumer Discretionary

dress-shop-97261_640I mentioned at the start of the article that I think now is the time to be fearful, when others are being greedy. We have just about “recovered” from one of the deepest recessions in living memory, yet many retailers are still struggling and those are the names you’ll find in the table above. The US economy isn’t out of the woods yet though. Considering the scale of money printing and low interest rates, growth has been fairly poor, and the government’s deficit is still a problem. I am not predicting another recession, but it would be foolish to rule out the possibility of economic weakness in the future. And the ones that will be hit are the ones already struggling, retailers such as Gordman Stores (NASDAQ:GMAN).

I’ve picked out Gordman Stores as I actually looked at it a couple of years ago, at the time I thought it was fairly valued, had a strong balance sheet with a reasonable cash pile and share price looked in line with future growth prospects. Of course things didn’t go according to plan for Gordman and it now finds itself on my distressed list. Like for like sales have been taking hit after hit, and although it has low debt, it has substantial operating leases on its stores.

Like for like sales are the big unknown when investing in retail, you can project revenues into the future without much trouble based on store growth, and then estimate some profit margins, but at the end of the day you are at the mercy of the companies like for like sales. These have a profound impact on profits due to the tight profit margins retailers operate at. I’m no stranger to investing in retail, in fact my current portfolio has 2 British retailers, Tesco and JD Sports. By chance, both are a great example of how like for like sales can make or break an investment.

A tale of two retailers

I’ll start first with Tesco. At one point this made up around 25% of my portfolio (forgive me, I was young and stupid!) and by sheer luck I managed to sell that down to its current 1.3% position size at a small 5% profit, despite it being one of my worst investment decisions. From the moment I bought the stock it was hit by profit warning after profit warning as like for like sales went into decline. Those great returns on equity of 20% that had attracted me to the investment suddenly fell to more mediocre levels and the future growth I had predicted now looked in peril. The position was underwater for almost my entire holding period, until by chance the shares rallied as the company announced it would curtail its UK expansion plans due to the weakening like for like sales. For me this was a disastrous announcement as the company was generating huge profits from building new stores and then doing a sale and leaseback of the land. Without those profits in the future this investment was a whole lot worse. The market didn’t seem to pick up on that and I exited for a small profit, wiping the sweat off my brow.

So how had Tesco gone from the giant of UK retailing to a struggling supermarket with falling like for like sales? I could come up with a few theories with the benefit of hindsight but let’s be honest instead, consumer sentiment towards them changed and I don’t know why. Suddenly customers were shopping at cheaper alternatives that were once looked down upon as crap, now all of a sudden they were in fashion. I don’t think there is anyone that could have predicted this a few years ago, Tesco had a strong management and growth plans that didn’t seem to stop until world domination. It was unthinkable that it would one day be struggling against smaller players.

Let’s move onto what has been my most successful investment ever, JD Sports, which sells sports fashion clothes in the UK. The company was strong even during the recession but shares took a big hit when they bought a struggling hiking gear retailer from bankruptcy which immediately began haemorrhaging money. That gave me a great opportunity to buy into a quality business at a great price. My thesis was that the core JD stores where worth more than the market cap and the market would value it correctly once this new acquisition had either broken even or been liquidated after a fear struggling years. What I didn’t foresee was the incredible performance of the JD stores, which have had like for like sales growth of around 5% a year since I bought. For a clothing retailer this has to be among the best in the industry. Shares are up over 110% despite the unprofitable segment still losing money. One of JD’s main competitors didn’t survive the recession, which obviously helped them increase sales, but still I don’t think there is any way in which this like for like sales growth could have been predicted.

Some say that management matters in retail, and of course it does but it isn’t enough. I noted at the time that JD Sports had one of the best managements in the retail industry, that had turned it around in 2004 and were still at the helm. Yet apart from the JD stores, the other segments which consist of some other fashion stores have barely broken even each year. In retail it appears even the best management cannot remedy the effects of consumer sentiment.

Conclusion

Hopefully these stories have made you think twice before investing in a retailer. You must accept that you are at the mercy of like for like sales performance and in most cases there is no reliable way to predict what that will be like. In times of economic struggles, retailers that have already been struggling with like for like sales declines are likely to be the first casualties. In my current “risk off” mode I want to protect myself from the next big catastrophe, whenever that may hit. I may miss a few great turn-arounds, but I’ll also hopefully miss the bankruptcies. I have analyzed many retailers over the last couple of years, but this has always been in the back of my mind and has stopped me investing in any. Now more than ever I think it is important to protect your portfolio’s downside rather than assume a rosy future.

Disclosure: Author is long LSE:JD and LSE:TSCO and has no position in NASDAQ:GMAN

Investing Sidekick

Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares.

1 thought on “The dangers of retail”

  1. Hello! I’ve been following your website for some time now and finally got the courage to go ahead and give you a shout out from Dallas Tx!
    Just wanted to mention keep up the fantastic work!

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