The Long and Short of Retail Investing
When investing in retail, it’s paramount to evaluate not only the prospective investment return but the value the retailer provides its customer. The value can be tangible or perceived but it’s important to empathize and observe the core customer in order to properly assess the business’ intrinsic value. As illustrated in the graphic below, I evaluate the customer value proposition on three dimensions: price, differentiation, and convenience.
In addition to evaluating a retailer on each dimension, I also consider the symphony of these factors and assess the sustainability over the long run. In my experience, three qualities that excellent retail businesses share are: positive traffic, ample investment opportunities (new stores or e-commerce), and stable returns on invested capital (ROIC). Additionally, given the secular shift toward e-commerce distribution, I evaluate the company’s e-commerce strategy through the lens of the key product it sells. Products that are sold at a low price, possess a low value-to-weight ratio, rely on olfactory or tactile senses, or are perishable in nature are well suited for bricks and mortar retail distribution but not easily distributed by an online retailer such as Amazon.
For example, TJX Companies, Inc. (TJX) offers its customers incredible deals on branded merchandise in a convenient location. To some degree, TJX is the equivalent of a local miniature outlet mall. TJX’s talented merchant team, combined with vast brand relationships, creates the “treasure hunt” that generates surprise, excitement, and most importantly, traffic. In the case of Dollar General Corp. (DG), customers on limited budgets are provided a convenient shop at value price points. Given the financially stretched nature of Dollar General’s core customer, the absolute dollar cost—not the per-unit cost—is the key consideration. As illustrated in the graph below, items with prices below $5 generate over three quarters of DG’s sales.
Dollar General: Emphasis on Price Point of $5 or Less
Source: Dollar General 2016 Investor Day presentation
On the short side, I identify businesses that rely heavily on price increases to grow sales, have few reinvestment opportunities, exhibit declining returns on capital, and sell product that can be easily distributed online.
The nature of retail—fragmented and highly competitive—makes it difficult to increase prices year in and year out1. For example, current short investments such as American Eagle Outfitters, Inc. (AEO) and Big Lots, Inc. (BIG) appear to owe most sales growth to price increases. Additionally, each company is closing stores and places a large emphasis on share repurchases. Store closings and share repurchases are not necessarily good or bad in and of themselves, but the wisdom and long-term results of such decisions can vary greatly over time.
In terms of declining ROIC, Wal-Mart Stores, Inc. (WMT) ticks the box. As illustrated in the table below, Wal-Mart’s ROIC and return on assets (ROA) have been primarily flat or in decline since 2007.
Wal-Mart: Return on Invested Capital and Return on Assets
Source: Wal-Mart annual reports
Best Buy Co., Inc. (BBY) sells ubiquitous product that can be easily distributed online. The lack of traffic driving product such as packaged media (CD, DVD) makes each customer visit more important to convert into a sale, which creates a higher pressure store environment and a worse customer experience. In order to verify my claim, I recommend visiting your local Best Buy on a Saturday afternoon to observe customers’ body language—particularly hunched shoulders and crossed arms—while upgrading their smart phone. And while management deserves credit for delivering solid fiscal 2017 results, I remain skeptical that Best Buy will continue to produce consistent profits over the long run.
A final consideration on the short side is the risk of a leveraged buyout or permanent impairment of capital. In addition to calculating the intrinsic value of a potential short, I calculate an approximate private equity valuation to minimize the risk of my short investment being taken private. As recent articles in the Wall Street Journal and Bloomberg indicate, results of various retail leverage buyout companies have been poor, thus reducing the probability of a permanent impairment of capital via a leveraged buyout.
The long and short of retail is that it’s a tough business and investing in retail businesses requires the flexibility to think long and short.
1Purveyors of luxury goods such as Louis Vuitton (LVMH) are an exception given the affluent customer profile. Please refer to our October 2013 Industry Perspective for more detail.
As of January 31, 2017, Diamond Hill owned shares of TJX, DG, and LVMH. As of January 31, 2017, Diamond Hill held short positions in BIG, AEO, WMT, and BBY.
Originally published on February 15, 2017.
The views expressed are those of the research analyst as of February 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.