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

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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

I 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.