Discounts - Good or Bad?
I’m a big fan of retail stocks. Granted, it’s probably not the best time to be in retail, but all markets turn around and this will too. Now, is the best time to keep your money to the sidelines and really spend some time analyzing potential bargains for when the market finally begins to bottom. In the case of retail stocks, it could be more than a year from now, but when the consumer comes back in force, these stocks will be the first to benefit. Why do I like retail so much? Well, because it’s the type of business you can experience, analyze, and forecast without a lot of expertise. The model is simple. Make a product, sell the product. Yet, it’s accomplished through the management of inventory, pricing strategy, customer experience, and marketing. Today, we’ll look at one aspect of this - discounting prices.
Most of us probably see price discounts as a boon to our customer experience. It’s great to walk into a store and find that perfect shirt or TV for half off. We feel good having hunted out a deal and gotten something that we value for a cheap price. But, as investors in a business, seeing a large amount of sales or marked down items in a store is always a warning sign. Why?
Store managers use sales and mark downs to drive store traffic and clear inventory. This implies that the store has either misread their consumers’ desire for the most recent influx of inventory or are simply not able to attract consumers any other way. This does two things to the business. It decreases inventory turn as products sit on the shelves and devalue and also lowers profit margin. More to the point, the use of sales and discounts is a dangerous crutch. As customers get used to waiting for the inevitable sale, the business loses pricing power and loses its hold on high-margin, full-price-paying customers.
An example of this would be Gap stores. After missing on its style calls for several seasons, many Gap stores have been forced to use huge sales and repeated mark downs to clear inventory for next season’s clothes. At some point, it lost brand cache as a result of both its poor design choices and lack of pricing power. It became the go-to bargain basement for clothes shoppers. At some point, the consumer demographic changed from all the hip and with-it teens to white nerds (see Weird Al’s “White and Nerdy”) and asian moms.
The example of Gap is an extreme one, but one to be wary of when your favorite business begins price cutting. Management may claim that it’s trying to drum up market share, but losing pricing power is always dangerous. In the end, the need to cut prices to create market share only signals loss of competitive position and even the possibility of commoditization of the product.
Take PCs for example. Back in the 90s, brand clout was more than enough to allow for premium prices on a home computer. Then, Dell came in and changed the game by offering low-cost computers that were every bit as good as the so-called brand name computers at the time. What they didn’t realize is that they changed the game in a way that would ultimately hinder the growth of the company. Consumers began to realize that most computers were the same and that price was really the only differentiator. Computers became a commodity (like corn, oil, or gold) rather than a differentiable product and nearly all computer manufacturers have since lost their pricing power and ability to charge high margins. The entire business is now based on volume and susceptible to price shocks in their supply chain.
So, when analyzing the moves of a target investment. Take a look at their price stability. Or, take some time to get a feel for the competitive strategy management claims to be pursuing. If nothing else, just ascertain that the company has managed to maintain its profit margins. Because, we may love discounts as consumers, but they are very bad for us as investors.
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