“The crowd of companies in this section [Manufacturing, Service and Retailing Operations] sells products ranging from lollipops to jet airplanes. Some of these businesses, measured by earnings on unleveraged net tangible assets, enjoy terrific economics, producing profits that run from 25% after-tax to far more than 100%. Others generate good returns in the area of 12% to 20%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operated.“
—Warren Buffett, Letter to Shareholders 2013
What Everyone Should Know Before Investing in the Retail Sector
The mantra “understand the business before you invest in it” may seem like a trivial statement. But it’s not. I have done it myself, and I guess that many of you know what I’m talking about. Sinned by buying shares in a business I didn’t understand good enough (I say enough, since you cannot know everything—at some point you have to make a buy/sell decision or just move on). It’s easy to buy shares in a business before having collected enough facts about the situation and circumstances at hand. Psychological factors and emotions often play too big a role when it comes to buying and selling shares.
Understanding why it is important to know the fundamentals of a business before investing in it most likely seems like a no-brainer to most of us—at least in theory. The hardest part, I guess, is to live as you learn. To start with, you have to understand yourself. Never fool yourself. Easier said than done, I know, but that doesn’t make it less relevant. It probably makes it even more important to repeat it time and time again. Becoming aware of the problem in situations like these is the first step. We all need to be aware of things before we can do our best to address them.
Except for the business, you need an understanding of the industry—the playing field where competitors battle each other. This is where the fight for profits takes place. The inherent industry structures will impact the way in which incumbent businesses compete, and also whether any entry and exits is likely to happen. The inherent industry characteristics differ between different industries in terms of entry barriers, number of competitors, profitability, growth, number of competitors, competitive advantages (or moats) and returns on invested capital etc. Beyond understanding the business, an understanding of the industry is highly critical since it will impact the profit and return potential.
Understanding the industry could of course be part of “understand the business.” Anyway, understanding a certain business most likely requires basic understanding the industry (or industries) in which it operates. All this talk about “understanding” has one, and only one goal in the end, to mitigate the risk of a permanent loss of capital.
Now that we’ve discussed the importance of understanding the business and the industry, a fair question to ask is; How do you obtain this understanding? As always, you have to start somewhere. You have to start building your own circle of competence. No one will do it for you.
In this post we will take a closer look at the retail industry, too learn what this industry looks like, what could be expected from a retailer, the likely returns on invested capital, the degree of competition, among other things. For now, we’ll leave the part about understanding the business. Let’s improve our understanding of retailing and the retail industry in general.
Basically, everything you read could give you hints and improve your knowledge and understanding of the things at play in a certain area. Your knowledge data base (your brain) will accumulate new facts along the way, building on the things you’ve processed earlier, hopefully replace any facts that turned out to be wrong. All this in an attempt to increase and improve your skills when it comes to industry structure, profitability, returns on invested capital. The more you learn, the better you will get at detecting differences between industries and businesses, and also understand why there are differences—what forces can explain and sometimes even predict what happens. Some industries are inherently more attractive (that is, more likely to provide sustainable above-average returns on invested capital) than others.
A few useful sources to start with are:
- Annual reports
- Shareholder letters (for example Warren Buffett’s shareholder letters)
- Earnings calls or transcripts
- Research reports (some could be found via a Google search if your lucky)
- Investor presentations or transcripts from such events
- Books (for example Competition Demystified, Competitive Strategy, The Five Rules for Successful Stock Investing, Why Moats Matter, The Little Book That Builds Wealth, Good Strategy Bad Strategy)
- Business journals
- Articles or white papers
- Lectures and other public presentations (for example Google Talks, Greenwald lectures on YouTube)
- Lecture notes
- Business and investing blogs/sites (for example CSInvesting, Value Investing World, The Manual of Ideas, Fundoo Professor—see below for excerpt from BuffettFAQ.com)
The above examples are just that, examples. There is a ton of stuff to learn from that I didn’t include.
The Oracle of Omaha on the Difficulties of Retailing
Someone who’s been in the investing game for some time is Warren Buffett. And when it comes to investing in retailer even Buffett has his fair share of, let us say less satisfactory results. Let’s see what Buffett himself has to say about the difficulties an investor could encounter in this area.
What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lambert do at bringing Kmart and Sears together?
Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.
But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.
Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1966 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.
It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.
We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.
How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.
If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins. (Source: BuffettFAQ)
Retail is a tough game to play, or as Buffett says; “Retailing is like shooting at a moving target.” Buffett’s advice? “We would rather look for easier things to do.” Let’s look at one more before we move on (emphasis added).
What economic laws have worked best for Berkshire?
It is all a matter of trying to find businesses with wide moats protecting a large castle occupied by an honest lord. Moats might be a natural franchise, brand loyalty, or being a low-cost producer. In a capitalistic society, all moats are subject to attack: if you have a good castle, others will want it. What we want to figure out is what keeps the castle standing and how smart is the lord. [Charlie Munger: We also like to look for low agency costs on that lord, economies of scale and “economies of intelligence.”]
Buffett elaborated on the “economies of intelligence”: the idea is to find businesses where you have to be smart only once instead of being smart forever. Retailing is a business where you have to be smart forever: your competitors will always copy your innovations. Buying a network TV station in the early days of television required you to be smart only once. In that kind of business, a terrible manager can still make a fortune. Given the choice between the two (a business where you have to be smart forever or one where you have to be smart once), Buffett advised, pick the great business – be smart once. (Source: BuffettFAQ)
A Closer Look at Retail
One of the books mentioned above is a book written by Pat Dorsey—The Five Rules for Successful Stock Investing. There is a section in this book that discusses and goes through a number of different industries, of which one is retail (as part of consumer services). The remaining part of this post will focus on the consumer services sector, and more specifically retail. We will do this by reading the part about retail.
Below is an excerpt from the Five Rules of Successful Investing, explaining and discussing the industry fundamentals and some of the pros and cons of retailing (emphasis added).
NOT SURPRISINGLY, WE generally don’t find a ton of great long-term stock ideas in retail and consumer services because most economic moats for the sector are extremely narrow, if they exist at all. The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors’. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever. It’s rare to find a retailer or consumer service firm that maintains any kind of economic moat for more than a few years.
The retail game has undergone a major facelift over the past two decades. First came the development of category killers, with specialized merchandise and service. Chains such as Home Depot and Lowe’s put many smaller, regional players out of business in the home improvement area. In 1992, the two firms posted combined sales of $8 billion; in 2002, they sold more than $80 billion worth of nails, hammers, and appliances. Office Depot, Office Max, and Staples did the same thing to the office supply business in the late 1980s and 1990s.
The second major shift has been the move off the mall. Once upon a time, department stores were infallible in the world of retailing. Well-known chains such as Sears that were once destinations in their own right became the anchor tenants for malls. The stores aimed to provide customers with a one-stop shopping experience, and some even housed full-service restaurants. Customers had more time to shop and placed more value on the personal attention these stores provided.
Over the past 20 years, however, traditional department stores have become dinosaurs. Nowadays, companies such as Sears and JC Penney are struggling to remain relevant—a battle that chains such as Montgomery Ward and Woolworth have already lost. Changing consumer trends are largely, but not totally, to blame. In this era of dual-income households, shoppers want selection, quality, and reasonable prices, and they want it fast. And they’ve shown a willingness to shift their spending to stores that can provide this experience.
Firms such as Wal-Mart, Target, and Kohl’s have stolen the thunder of the traditional department stores with innovation and efficiency. These are the firms that developed everyday low prices, pioneered centralized checkouts at the front of stores, and set up shop in freestanding locations with more convenient parking. Whereas, Sears and Penney averaged 0 percent and 1 percent annual sales growth, respectively, from 1998 to 2002, Wal-Mart, Target, and Kohl’s averaged 15 percent, 10 percent, and 24 percent, respectively. Over the next several years, we expect this divergence to continue.
Investing in Retail: Understanding the Cash Conversion Cycle
One of the best ways to distinguish excellent retailers from average or below-average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables). Figure 15.1 illustrates the cash conversion cycle, and Figure 15.2 shows the conversion cycle for Home Depot.
Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns). The best-case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier. Wal-Mart is one of the best in the business at this: 70 percent of its sales are rung up and paid for before the firm even pays its suppliers.
Looking at the components of a retailer’s cash cycle tells us a great deal. A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favor. This leads to excess inventory, clearance sales, and, usually, declining sales and stock prices.
Days in receivables is the least important part of the cash conversion cycle for retailers because most stores either collect cash directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price. Retailers don’t really control this part of the cycle too much. However, some stores, such as Sears and Target, have brought attention to the receivables line because they’ve opted to offer customers credit and manage the receivables themselves. The credit card business is a profitable way to make a buck, but it’s also very complicated, and it’s a completely different business from retail. We’re wary of retailers that try to boost profits by taking on risk in their credit card business because it’s generally not something they’re very good at.
If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows haw well a retailer negotiates with suppliers. It’s also a great gauge for the strength of a retailer. Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they’re one of the few (if not the only) games in town. For example, 17 percent of P&G’s 2002 sales came from Wal-Mart. The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retail has a huge advantage when ordering inventory: it can push for low prices and extended payment terms.
Home Depot finally started taking advantage of its competitive position by squeezing suppliers in 2001 and 2002. Days payable outstanding for the home improvement titan has historically been around 25. In 2001, the figure hit 33 days, and by 2002, it exceeded 40 days. By holding on to its cash longer and reducing short-term borrowing needs, Home Depot increased its operating cash flow from an average of $2.4 billion from 1998 to 2000 to $5.6 billion from 2002 to 2003.
Hallmarks of Successful Retailers
• Sometimes you never get a second chance to make a good first impression. Retail is a fickle business, and shoppers have plenty of alternatives, so companies have to make a concerted effort to keep stores clean and fresh. Lowe’s has benefited mightily in its battle with Home Depot because its stores are widely perceived to be more aesthetically pleasing and easier to navigate. Home Depot is reinvesting in its stores, but as we mentioned in the restaurant section, maintenance and renovation is easier than reinvention.
• Keep an eye out for store traffic. You don’t want to see a traffic bottleneck at the checkout aisles, but you don’t want to see empty parking lots on weekends either. This is particularly true for specialty retail companies such as clothing stores that cater to a particular demographic. Traffic to teen hot spot Abercrombie & Fitch and women’s outfitter Chicos FAS has remained relatively robust even in times of lax consumer spending. These stores have carved out a brand identity and won customer loyalty, and their stock prices held up during the tough market conditions in 2001 and 2002. Remember, though, specialty retailers have a much shorter shelf life than traditional retailers do, so these investments have to be monitored much more closely.
• Successful retailers have a positive employee culture. After all, retail is about customer service—period. Sam Walton helped build Wal-Mart into the largest retailer (and largest company) in the world based on sales using the premise that the customer is always right. During its growth heyday in the 1990s, Home Depot’s employees were always visible and customers usually walked away satisfied. In 2001 and 2002, Home Depot’s service waned noticeably, largely due to an influx of part-time employees who didn’t have the same connection to the company.
As we’ve mentioned numerous times in earlier chapters, great companies in attractive industries generate returns on invested capital that far exceed the cost of capital. However, retail is generally a very low-return business with low or no barriers to entry. Retail bellwethers Wal-Mart and Walgreen earn little more than 3 cents profit for every dollar of sales, so store management is critical. The problem is that many retailers don’t execute as flawlessly as these two and flame out as soon as trouble hits.
The sector is rampant with competition. Think of all the specialty apparel shops that try to imitate Abercrombie &2 Fitch and Gap. A few succeed; most fail, but the point is that nothing exists to prevent new concepts and stores from being launched. There are few, if any, barriers to entry. Customers may be swayed to buy a cool $50 sweater, but they’ll quickly go to the store next door if the same sweater can be had for $40.
The primary way a firm can build an economic moat in the sector is to be the low-cost leader. Wal-Mart sells items that can be purchased just about anywhere, but it sells it all for less than the competition, and consumers keep coming back for the bargains. Others may try to imitate Wal-Mart’s strategy in the short run but lack the economies of scale to remain profitable employing the strategy in the long run.
Investor’s Checklist: Consumer Services
• Most consumer services concepts fall in the long run, so any investment in a company in the speculative or aggressive growth stage of the business life cycle needs to be monitored more closely than the average stock investment.
• Beware of stocks that have already priced in lofty growth expectations. You can make money if you get in early enough, but you can also lose your shirt on the stock’s rapid downslide.
• The sector is rife with low switching costs. Companies that establish store loyalty or store dependence are very attractive. Tiffany’s is a good example; it faces limited competition in the retail jewelry market.
• Make sure to compare inventory and payables turns to determine which retailers are superior operators. Companies that know what their customers want and how to exploit their negotiating power are more likely to make solid bets in the sector.
• Keep an eye on those off-balance sheet obligations. Many retailers have little or no debt on the books, but their overall financial health might not be that good.
• Look for a buying opportunity when a solid company releases poor monthly or quarterly sales numbers. Many investors overreact to one month’s worth of bad same-store sales results, and the reason might just be bad weather or an overly difficult comparison to the prior-year period. Focus on the fundamentals of the business and not the emotion of the stock.
• Companies also tend to move in tandem when news comes out about the entire sector falls—keep that watch list handy.
Learn Something New Each Day
Charlie Munger once said that “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.”
I hope that reading through this post, and reflecting on the content, made you a little wiser.
Wish you all a great weekend.
Additional Weekend Reading
- S&P CAPTIAL IQ, Industry Surveys Retailing: General (October, 2014)
- S&P CAPTIAL IQ, Industry Surveys Retailing: Specialty (September, 2014)
- S&P CAPITAL IQ, Not All Retailers Are Created Equal
- Harris Williams & Co., Consumer and retail industry update (February, 2015)