- As some analysts categorize retail as uninvestable, it’s time to look for bargain investment opportunities.
- Sales are shifting to e-commerce, but earnings are what are going to determine your investment results.
- The combination of brick and mortar and e-commerce might be the investment winner as it gives you fundamentals and growth.
A Wells Fargo analyst, Ike Boruchow, recently called the retail sector “uninvestable,” at least in the short term. He based his statement on changing consumer dynamics that compress valuations, the favorable weather, easy comparisons to 2015 which have made retail look ok, and the 25 companies that have cut their guidance in the last two weeks.
I’m attracted by such statements because the best investments are usually found where all others have given up. Especially when a whole sector is surrounded by negative sentiment, even prices of good companies decline and create amazing long term opportunities.
In today’s article, we’ll analyze how the retail sector is priced in relation to its long-term fundamentals.
The Retail Sector
The sector as a whole has done extremely well in the last 10 years largely beating the S&P 500. The equally weighted SPDR S&P Retail ETF (NYSEARCA: XRT) is up 123%, while the S&P 500 is up only 52%.
Figure 1: SPDR S&P Retail ETF – 10 years. Source: Nasdaq.
However, in the last year and a half, the situation in retail hasn’t been stellar. The sector is down 7%, while the S&P 500 surged 12%.
Figure 2: SPDR S&P Retail ETF – 2 years. Source: Nasdaq.
Let’s take a look at the situation in retail in general.
E-Commerce Is Killing Retail
In contrast to retail stocks, retail sales have been growing in the last two years. However, this growth includes e-commerce sales.
Figure 3: Retail sales, excluding food, including e-commerce. Source: FRED.
Total retail sales went from $340 billion in November 2007 to $413 billion today, thus sales have grown by $73 billion in the last 10 years. E-commerce sales have grown from $35 billion in November 2007 to $101 billion today, thus sales have grown by $66 billion. Excluding e-commerce, total retail sales in the U.S. have grown by $7 billion in the last 10 years, or 2% in total. 2% total growth in a decade is a scary number, especially given that aggregate inflation in the same period was 15%.
Figure 4: E-commerce retail sales. Source: FRED.
Now, should you totally shun brick and mortar retailers and load up on e-commerce instead as the e-commerce sector is expected to continue to grow by 10% a year? Let’s put things into perspective by having a look at fundamentals.
WMT’s sales are $484 billion with $14 billion in net income and a dividend yield of 3%. AMZN’s revenue is $127 billion—just a bit more than a quarter of WMT’s—its net income is only $2 billion, or an eighth of WMT’s, and AMZN doesn’t pay a dividend. This divergence in the above descriptions is typical for growth versus value stocks, and it’s also a great description of the clash in the retail sector.
The fact that e-commerce is the only part of retail that’s growing doesn’t mean that the best returns on investment will come from those stocks. A good example is the Altria Group (NYSE: MO) which has largely outperformed lately even if it is in a declining industry, smoking.
Figure 5: Altria group since 2009. Source: Nasdaq.
For investment returns, the most important thing in the long run are valuations, cashflows, and dividends.
AMZN could be the winner in retail, but the stretched valuations make it a risky play as many things can change in the future. For now, AMZN is the clear leader in e-commerce, but many other retail companies are increasing their online presence while holding onto their brick and mortar stores.
Figure 6: E-commerce market share in two weeks before Christmas. Source: Slice Research.
As most contenders are trying to take a piece of the e-commerce pie, the best investment returns aren’t going to be from AMZN, but from the company that manages to take market share away from AMZN or significantly increase its e-commerce sales while also increasing profitability.
Everyone will be going after AMZN, as among many brick and mortar store closures from the likes of Macy’s (NYSE: M) and JC Penney (NYSE: JCP), others are investing heavily in e-commerce. In 2016, WMT acquired Jet.com for $3.3 billion, Unilever acquired Dollar Shave Club for a billion, and we can expect many more similar acquisitions in the future. Acquisitions will also be made globally as the Indian and Chinese e-commerce markets are very tempting.
What To Look For In Such An Environment
On one hand, we have brick and mortars that are declining or have flat sales but they usually come with profitability and dividends. Macy’s PE ratio is 13.67 and it boosts a dividend yield of 5%, while WMT’s yield is 3% with a PE ratio of 14.59.
On the other hand, we have e-commerce with growth and hopes of enormous future earnings and high dividends. AMZN’s PE ratio is currently at 187.
Both types of investments will probably do fine in time, so in the end it’s a personal decision where to invest based on your risk appetite and income requirement.
Going more in-depth, the best investments is the old-fashioned retailer that is profitable and will manage, through an acquisition or organic growth, to take market share away from AMZN. The only way to spot such a player is to follow how people around you buy things and when you see shifts in online buying patterns, look into the supplier.
I would definitely avoid ETFs as they hold a bit of everything and winners will be leveled out by losers. However, it’s the ETFs that create the best investment opportunities for individual retailers when ETFs sell everything. As an example, the SPDR S&P Retail ETF (NYSEARCA: XRT) saw outflows of $101 million last week forcing it to sell a bit of every position, good or bad. This kind of aggregate ETF sale is what creates bargains.
Looking at how current market sentiment toward retail stocks is, it’s a great time to look for future winners.