- Retail is a dangerous business as there is always a new player on the block.
- Traditional retailers see declining sales and margins while E-commerce retailers see growing sales and declining margins. This is not a good combo for investors.
- As always, there will be many opportunities to make money, but be sure to know what you’re doing and forget about moats and long term buy and hold investments.
In Buffett’s biography, The Snowball, retail is described as a marathon business where you have a new, fresh runner joining the race at every mile.
One of Buffett’s first retail investments was a holding company, Diversified Retailing Company Inc. (DRC), formed by Buffett, Munger, and Gottesman in 1966 with the goal of acquiring retail businesses. Their first acquisition was Hochschild-Kohn, which on paper looked like a great buy due to its substantial discount from book value, good management, unrecorded real estate values, and a significant LIFO cushion. Despite the good fundamentals, they sold three years later at no profit. Selling without losing money might not seem all that bad to you, but it’s a terrible thing for Buffett because it means he has missed opportunities to better allocate capital.
Before looking at the current possibilities in retail investing, a quote by Charlie Munger that summarizes the business is a good way to get in the right mindset when contemplating investing in retail:
“Retail is a very tough business. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix.”
Today, retail is much different than it was 50 years ago, but the same market forces rule: competition, changing consumer trends, low profitability, and great, if often misleading, fundamental indicators.
Everybody Thinks Retail Is Dying
Retail isn’t dying, but it certainly isn’t growing either. Since 2000, U.S. E-commerce retail sales have grown from $5 to $102 billion, while total retail sales have grown from $240 billion to the current $417 billion. Excluding inflation and E-commerce sales, brick and mortar stores have seen their sales stagnate for the last two decades.
Figure 1: E-commerce sales are leading total retail sales growth. Source: FRED.
The result of the above is two sided. On the one hand, e-commerce platforms enjoy amazing valuations which should be justified by their growth prospects, while on the other, traditional retailers have entered bargain hunting territory. We’ll discuss the investing pros and cons of both.
E-commerce is the engine of growth in retail. The National Retail Federation (NRF) expects e-commerce retail sales to grow between 8% and 12% in 2017. However, growth doesn’t mean profitability, especially for investors.
Amazon Inc. (NASDAQ: AMZN) has a PE ratio of 173 with a net profit margin of 1.7%. In order for AMZN to become a good long term investment, it has to grow its net earnings by 10 times to reach a reasonable valuation of 17 which could eventually lead to a dividend of a few percentage points. Knowing how complicated retail is, especially e-commerce, I wonder whether AMZN will have the time and the strength to justify current valuations as every other e-commerce retailer is after AMZN. The higher AMZN’s stock price, the higher the risks are for shareholders, and any kind of bad news could make AMZN’s stock drop by more than 25%, as was the case in 2014 and 2016.
Figure 2: AMZN’s sudden price declines. Source: Nasdaq.
A streak of bad news like lower margins or slower growth is what makes AMZN a very risky investment as it could lead to permanent loss of capital, especially if investors start to attach a lower valuation to the company. Examples of what could change in the e-commerce world are a recession, so be sure to price one in when assessing your portfolio, and new entrants into the sector as everybody will always try to take a piece of AMZN’s marketshare.
Smaller e-commerce players show how difficult e-commerce really is, especially to become profitable. Wayfair (NYSE: W) is a good example as it saw its net loss almost triple in 2016 despite revenue growth of 50%. Overstock.com (NASDAQ: OSTK) is also incapable of improving profitability as revenue grew 8.5% in 2016, while the operating margin remains at 0.4%.
All of these difficulties have happened in an excellent economic environment that’s full of liquidity and easy credit. Therefore, these low margins are tolerable now, but don’t forget Munger’s words, every retailer sooner or later gets into trouble and is hard to fix. I wonder how many of these retailers will get into trouble if a recession comes along.
As brick and mortar retailers try to incorporate e-commerce sales into their business models, they find the same difficulties described above—high costs that lead to low or even negative margins—but they don’t have other options as customers are clearly shifting toward online shopping with mobile leading the growth.
Figure 3: Total U.S. E-commerce sales forecast. Source: Business Insider.
Inevitable negative E-commerce margins come in combination with stagnating sales and high levels of competition in the traditional retail world. The best example of how far competition in retail goes comes from the fact that despite Macy’s (NYSE: M), Sears (NASDAQ: SHLD), and J.C. Penney (NYSE: JCP) closing 300 stores, other retailers like TJX Companies (NYSE: TJX), Ross Stores (NASDAQ: ROST), and Burlington Stores (NYSE: BURL) plan to open the same number of stores.
On the fundamental side, Macy’s offers a dividend yield of 4.9% and strong repurchasing activity which has lowered the number of shares outstanding by 25% in the last 5 years, but it also shows declining book values, declining margins, and debt growth. A similar story holds with other traditional retailers, so investors should be careful when analyzing such companies as, to continue with the Macy’s example, its debt to equity ratio of 1.73 signals much trouble ahead, especially if interest rates increase. Therefore, don’t be fooled by the attractive dividend as it is highly unlikely that it will grow in the future and it’s more likely that it will eventually be totally cut.
Given the availability of capital, new players will always try to succeed in the retail world and push the old retailers out. However, the constant competition will make it extremely difficult to emerge as a long term winner, and even if here and there a company like Amazon or Wal-Mart emerges, there are thousands of companies that fail miserably making retail a difficult sector to invest in but a great sector to trade.
By following trends, sales, and looking at what’s going on in department stores and malls, an investor that specializes in retail should be able to make excellent returns. Buy and hold investors should avoid retail as the environment is either too competitive (traditional) or too expensive (Amazon) to hope for long lasting stable growing returns and dividends.
International retail is a bit different because markets aren’t yet saturated, but the highly competitive environment is similar to the one in the U.S. However, the positive trends and expected global retail sales growth of 6% should create excellent trading or short to medium term investing opportunities, especially in Asia.
Figure 4: Forecasted total retail sales worldwide. Source: E-Marketer.
What will grow even faster than traditional retail is global e-commerce which is expected to double by 2020.
Figure 5: Global E-commerce sales will be driven by China. Source: E-Marketer.
Emerging market retailers have two very important advantages, demographics and economic growth, but they also have disadvantages like weak logistics and scattered customers. Such an environment again makes it difficult to invest in retailers as it is practically impossible to figure who the winner will be, if there will ever be a retail winner.
There will always be possibilities to make money in retail, as in any other sector, no matter the trends, but in a complex sector like retail, you have to be smart with what you do. Companies like Costco (NASDAQ: COST), TJX, and Ross are doing very well, while others like Macy’s, GNC Holding (NYSE: GNC), and GameStop (NYSE: GME) are performing poorly.
The first thing with retail is that you have to forget about the long term and ride the trends. With low interest rates and available credit, there will always be someone going after the marketshare and business models of companies like Costco. Therefore, it’s essential to approach investing in retail through a dynamic analysis as you can forget about long term moats. A dynamic analysis comprises understanding what’s going on in the market, looking at what the kids are buying, and then, investing and even more importantly, taking out the profits before the company over-invests itself as 99% of the retailers always do.
Disclaimer: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I have no business relationship with any of the above mentioned companies.