A Retail Investing Framework
Generally speaking, I see myself as a value investor. Why then, would am I so often looking towards retailers and generally consumer facing businesses for my best investment ideas (see: A Retail Reversal and Irrational Retail Valuations)? After all, many of the best retail stocks are those that rely on growth to provide shareholder return. And, in the case of liquidation, the bulk of their assets are held in inventory and property* that are rarely liquidated at full value. Then again, Warren Buffett, a value investor if there is any, has made serious bets on consumer product and retail businesses like Coca-Cola (KO), CarMax (KMX), Wal-Mart (WMT), and Costco (COST).
* To be completely fair, significant value in property can often be unlocked to stave off bankruptcies or generate tremendous shareholder return through sale-leasebacks which generate plenty of cash or potentially attracting buy out firms interested in getting a piece of the real estate.
Warren Buffett’s consumer products and retail business picks are typically mature businesses with a proven cash flow. But, a look at the top ten returning stocks over the ten years leading up to the peak of the markets in 2007 finds that 30% would have been significant retail or consumer facing businesses – Chico’s (CHS), Apple (AAPL), American Eagle (AEO). Arguably 40% with Dish Networks (DISH). The only other industry or sector with similar representation in this list was oil and energy stocks and this was due to the commodity price bubble more than any thing else. Admittedly, retail stocks take a beating in recessions, but CNN Money’s recent article highlighting stocks which have bucked the trend in the decade ending in 2009, is similarly heavy on retailers Apple, Autozone (AZN), and Carters (CRI).
The appeal of retailers is that they are simple, easy to understand businesses. Investing in such businesses, however, requires more nuance than just solid financial analysis. Value for these businesses can be transient ebbinging and flowing with consumer tastes and management execution which ultimately drives demand. This also means that, in many cases, investing in these kinds of businesses is never just a buy and hold proposition. Yes, some companies like Coca-Cola have significant moats around their businesses and the type of brand value that its hard to imagine any situation that could affect its ability to sell product and throw off cash. But, most of the time, a long term investment in a retailer or other consumer products business is really a form of “educated speculation.” As such, here’s my framework for how best to “speculate” in these businesses.
1. Know your target
I use a simple four question framework when first approaching a retail or consumer product business known as VRIO.
- Value – What is the firm’s value proposition to its consumers? Is this compelling?
- Rarity – Is the firm uniquely able to provide value to its consumers? What competition is the firm up against?
- Imatibility - Is the firm’s ability to deliver on its value proposition easily imitated? What barriers to entry are there?
- Organization - Does the firm have the core competencies to continue to execute its value proposition? Is it organized, ready, and able to do so?
Businesses which provide a unique and high value product to its consumers, have limited competition, and significant barriers to entry with the in-house talent to continue to adjust and execute will always be able to defend their earnings power, an important factor in protecting the value of your investment. In addition, firms with these qualities are usually in the best position to act as market leaders, growing and scaling their businesses faster than other market participants.
2. Determine relative value
As I’ve re-iterated, my belief is that assigning an exact value to these types of stocks. As such, I spend time researching comparable businesses and their valuations. Businesses with strong VRIO characteristics are potential market leaders and investors typically reward them with better than average valuation premiums. As a result, your best bets will be to find strong VRIO characteristics in businesses that have not yet been bid past their peers on a valuation basis.
Metrics of particular interest to me are P/E and PEG (see article: PEG Analysis). Also, because many of these businesses use significant amounts of debt to finance growth, some attention must be paid to EV to EBITDA as well as Debt-to-equity ratios in order to ascertain whether or not the business can continue to support capital expenditures and other investments necessary to execute their business models.
3. Let the trend be your friend
Just as consumer interests ebb and flow, so will interest in your favorite retailers and consumer products. And, so will investor interest in their corresponding stocks. The positive benefit here is that positive headlines and other seemingly innocuous events can prove to be strong catalysts for your target investments. The negative is that the bottom can just as easily fall out of these stocks as investors lose interest for seemingly unexplained reasons.
As such, while I am not typically a market timer, I don’t make a habit of trying to average down into these types of businesses. Instead, I’d prefer to give up some early return for the security of being able to identify clear support (for me, stop loss) points and with the benefit of a long term trend. For those interested in how I do this, check out my articles on How to Draw Trendlines and Technical Analysis for Fundamental Investors.
Full Disclosure: Author is long shares of AAPL at the time of writing. No positions in any other stocks mentioned.
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