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Michael Kon, CFA
COVID-19 hit the retail industry like a major tsunami in a coastal community. There is no place to hide and the damage is substantial. So far, 13 retailers filed for bankruptcy in 2020 and many others are engaging with their legal and financial advisors to evaluate their alternatives. Unfortunately, for many retailers, bankruptcy is the only option left.
The Retail Apocalypse
“Software is eating the world” and the internet is consuming brick-and-mortar retailers. The rise of ecommerce has exposed the weakness of many brick-and-mortar retailers that failed to adjust to the new reality or do not have a differentiated in-store experience that attracts foot traffic. This retail apocalypse is a well-documented trend that has been in place for years and claimed many victims in the industry.
Then the pandemic happened, and most retailers were forced to close their doors to help combat the health crisis. The economic damage from such action is considerable, and we believe the recovery will be slow. To make matters worse, shoppers may have changed their habits for good during the shelter-in-place period, and some shoppers might never come back to their favorite stores. The outlook for the average brick-and-mortar retailer is not encouraging.
Investing in Retail
The stock market, not surprisingly, has very little confidence in the sector. The SPDR S&P Retail ETF (XRT), which is a good proxy for the entire retail industry, has underperformed the S&P 500 over the past five years by a wide margin.
It is, therefore, understandable that some investors avoid the retail sector altogether. On the other hand, contrarian investors might be tempted to look for bargains, or place an industry bet through an ETF, hoping to catch some upside from the low valuations. Many retail stocks have been in the penalty box for years. It is possible that some of these names are ready for a bounce.
Summitry does not subscribe to either of these approaches. We agree that the traditional brick-and-mortar model is being challenged. Many retailers will not survive e-commerce disruption, but we do not believe this alone is enough to completely avoid the sector. We find investment opportunities typically arise from change and uncertainty, and we see plenty of both in retail.
We do not have a view on sector valuations nor an appetite to pursue a business just because the stock’s price has fallen significantly. As far as we can tell, many retail stocks appear cheap, but for good reason. Their business models are under attack, and the market is baking in ugly outcomes. Bargain hunting in the most challenged corners of retail is like picking up pennies in front of a steamroller.
Our approach is to look for companies that we find have unique and differentiated business models resulting in an economic moat that protects them from competition, both physical and online. We think the retailers we own – CarMax, Lowe’s, Ross Stores, and Ulta Beauty – clear this high hurdle with flying colors. COVID-19 may pressure results in the next couple of years but longer term, we believe our retailers should benefit from the demise of their more vulnerable competitors. CarMax, Lowe’s, Ross Stores, and Ulta Beauty grew faster than most retailers during the first chapter of the retail apocalypse. We are bullish on their prospects in a post-pandemic world.
Invest in the Best
Unlike many investors who take a macro or industry view when investing in stocks, we at Summitry always look first for quality businesses. We selected our retail holdings because they exhibit certain qualities that make them stand out from the crowd. While our investment thesis for each of these names is unique, there are three attributes common to all four holdings:
Return on invested capital is a strong indicator of business quality and competitive advantages. The leverage ratio indicates whether the business will be able to survive tough economic conditions, and same-store sales growth show that the business can grow in value over time. Our thinking is that if prior to the pandemic a retailer earned high returns on capital, had no debt, and was able to grow when many others struggled, then there is a good chance it will come out of the current crisis in a stronger position.
In the table below we compare Ross Stores and Ulta Beauty to some of their peers and the top 25 names in XRT. We excluded CarMax because it has a sizable finance operation that makes this type of comparison meaningless. We also excluded Lowe’s because their stores remained open during the pandemic and sales skyrocketed on demand for essential products. Both Lowe’s and CarMax operate in unique retail niches so comparing them to the average retailer is less relevant.
This is not the case with Ulta Beauty and Ross Stores. Both companies compete directly with mall-based shops, large department stores, and big box retailers. As you can see in the table below, Ross Stores and Ulta Beauty have generated returns on invested capital that are multiples of the returns generated by their competitors, while employing no leverage and growing same store sales at a healthy clip.
And both stand out when compared to the top 25 names in the XRT:
Over the next several months, the financial media will be flooded with stories on how the retail industry is going through a purge. As investors, we always remember that industry disruptions like the one occurring in retail comes with risks, but it also creates opportunities. Our preference is to invest in the most competitively advantaged retailers we identify because we believe they have the best chance to survive the short term and thrive in the long run. By focusing on retailers with high return on invested capital, solid same-store sales growth, and low financial leverage we believe we can increase our chances of being invested only in those businesses that are best positioned for the next chapter in retail.
If you’re interested in learning more about our investment approach, please contact us now!
The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. All material of opinion reflects the judgement of Adviser at this time and are subject to change. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services.
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Advisor Group Manager