Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

Looking For Quality Among the Retail Apocalypse

“Buy when there is blood in the streets,” is a common value investing truism coined by Baron Rothschild. Contrarians buy things that are cheap and out of favor when everything seems bad. The key is to separate a true value play from a value trap.

Looking outside of the United States, there are many cheap equity markets, with most emerging markets being very cheap by historical standards. In today’s rather expensive U.S. market, there are relatively few cheap sectors, and they are cheap for various rational reasons. Commodities and energy are cheap. Financials are cheap. Retail is cheap.

Retail has been an absolute bloodbath lately, and for good reason. So, let’s look through the rubble and see if we find anything interesting.

Retail Apocalypse

Online retail has been killing physical retail for years. And yet ironically, many online retailers like Amazon are opening physical stores, and many physical retailers are increasing their percentage of online sales. Everyone wants to become an omnichannel retailer now, meaning that they use a variety of mediums to reach consumers. Physical locations can make returning online items easier and allow for trying clothes and shoes on before purchase, for example.

Partly due to our fairly low population density, the United States has by far the largest amount of retail space per capita of any country:

Going forward as retail space comes under pressure, it’s not necessarily about online vs retail. It’s about omnichannel, which means it’s about competitive vs weak. Some physical retail niches, like Dollar General (DG) and Ross Stores (ROST), have been massively outperforming. Walmart (WMT), Target (TGT), and Costco (COST) have been outperforming. Amazon has been outperforming, obviously.  J.C. Penney (JCP) has been underperforming. GameStop (GME) has been underperforming. Sears lost everything.

We also need to consider brands vs distributors. Makers of clothes, shoes, and accessories used to rely on retailers to distribute their products. The internet allows brands to sell their products directly to consumers, and they can also continue to partner with retailers or manage a smallish number of physical retail locations. When deciding whether or how to invest in the retail space, be cognizant of whether a company is a middle-man (diversified distributor) or the source of the product.

The First Wave

Two years ago, in June 2017, Amazon announced its intent to purchase Whole Foods. Whenever Amazon enters an industry, investors in the industry get scared. In this case, grocery store investors got scared. This sparked a big sell-off wave in retail. 

Walmart and Target dropped by 5% that day. Costco dropped by 7%, Kroger dropped by 9%, and SuperValue dropped by 14%.

Interested by this big sell-off, I wrote at the time in my June 2017 newsletter that I considered Target to be the most interesting of the bunch.

“However, even troubled companies can become attractive investments if bought at the right price. Of all of these names, Target appears the most interesting.

https://www.lynalden.com/june-2017-newsletter/

Since then, Target stock is up over 65%. It pays to focus on quality, value, and the long term.

Paying Attention to Returns on Invested Capital

One of the most successful combinations in value investing history has been to buy companies that have high returns on capital and yet have low valuations. Companies that have high returns on capital or invested capital (ROC or ROIC) generally demonstrate themselves to have some degree of economic moat and inherent business model success. In other words, a high return on capital metric is a key quality factor and a source of wealth creation.

When digging through the wreckage of what was once retail, it’s important to have a quality filter. Let’s focus on companies with high returns on capital, rather than speculative unprofitable business models. I want to get investors familiar with some of these companies because I’ll be keeping an eye on them over the next several years, looking for opportunities. 

Walmart (WMT)

Chart Source: F.A.S.T Graphs. Blue line = stock price if at historical average P/E ratio.

Walmat has been an amazing performer over the decades, but with a blended P/E of 22, it is pricey. It was pricey back in the late 90’s and early 2000’s as well, which resulted in a lengthy period of stock price underperformance even as fundamentals continued to grow. For a few years it became cheap, but after the stock price took off, it became expensive again.

In most years the company has solid returns on invested capital of over 12%, but in recent years has been dipping into the single digits. This is not my top stock choice for forward returns.

Target (TGT)

Chart Source: F.A.S.T Graphs. Blue line = stock price if at historical average P/E ratio.

Target is one of the leading retailers in the United States, with a nice blend of groceries, home furnishings, and clothes. It is a step above Walmart in terms of the demographics it targets; slightly higher income levels, more appealing store interiors, etc. The company has over 50 years of consecutive annual dividend growth.

Returns on invested capital vary for Target but are often over 10% and currently well into the double digits. With a blended P/E ratio of 15, I consider Target to be quite reasonable as an investment with a 3% dividend yield and solid per-share growth, although no longer the strong buy I recommended it as in 2017.

Ross Stores (ROST)

Chart Source: F.A.S.T Graphs. Blue line = stock price if at historical average P/E ratio.

With increasing wealth concentration since the global financial crisis over a decade ago, discount stores like Ross have been performing well. Ross doubled its revenue in the past decade, and its closest competitor TJX Companies (TJX) has performed similarly well.

In short, Ross is on fire. The company has a rock-solid balance sheet with more cash than debt, and sky-high ROIC of 30-40% per year or more. However, with a P/E of over 24, the stock has potentially gotten ahead of itself. I’d be more interested in the stock under $100 (fairly-valued), and certainly under $90 or $80 (undervalued). This stock should be on everyone’s watch list.

Nordstrom (JWN)

Chart Source: F.A.S.T Graphs. Blue line = stock price if at historical average P/E ratio.

Nordstrom consistently has returns on invested capital north of 12%, and after a couple bad quarters is currently sitting at 11%, which is low for the company but still okay. The stock has been pummeled and is now less than half of what it was less than a year ago, partly because many of its locations are tied to malls, which are at the epicenter of the retail apocalypse.

I initiated a small long position in Nordstrom about a month ago after its big sell-off. It’s not a core position for me; it’s an acknowledged riskier position that I am cautiously optimistic on. The stock currently has a P/E ratio of below 10 and a dividend yield of nearly 5%. While competitor Macy’s has seen declining sales over the past decade, Nordstrom has seen increasing sales. In the past five years, Nordstrom has increased its online sales from 18% of total sales to 31% of total sales and is beginning to close some underperforming stores to emphasize its better locations. They are showing competitiveness as an omnichannel semi-luxury retailer and the Nordstrom family has huge insider ownership.  

Tapestry (TPR)

Chart Source: F.A.S.T Graphs. Blue line = stock price if at historical average P/E ratio.

Tapestry used to be Coach, the maker of expensive handbags other accessories. In recent years, they acquired the Kate Spade and Stuart Weitzman brands, and rebranded their parent company as Tapestry, their new brand holding company.

These acquisitions moderately increased the company’s diversification, especially in the area of women’s footwear, but overall there is not good evidence that these were well-priced acquisitions for good returns on capital. The company would likely have been better off giving the money back to shareholders to reinvest into the core Coach brand.

Still, Tapestry historically and currently generates strong returns on invested capital, usually in the double digits. The company recently announced a $1 billion share buyback program, which is quite large for a company with an $8 billion market capitalization. The company has a strong balance sheet with net debt equal to about a year’s worth of net income, which is low. The dividend yield is 4.6%.

I am cautiously optimistic on Tapestry from this price point for a small position. Investors will get most of their returns from dividends and buybacks, with a potential boost from higher valuations in the future. The company also plans to continue to look for potential brand acquisitions, which normally I would not be thrilled about but in the current cheap retail apocalypse might be lucrative.  

When discussing Tapestry as a value play, some investors bring up Capri Holdings, which is even cheaper with a blended P/E ratio of only 7. It is one-third the price it was at in mid-2014 and less than one-half the price it was at less than a year ago in mid-2018.

However, Capri also has a net debt/income ratio of about 5, which is rather high. Its core brand, Michael Kors, is weaker than Tapestry’s core brand, Coach. While Tapestry pays a dividend, Capri does not. In other words, Capri is lower on the quality spectrum despite having high returns on capital. It is a potential deep value play, but requires even more caution, and is not my first choice.

Levi Strauss (LEVI)

Levi Strauss has been making denim for 166 years, before the U.S. Civil War. The company had a long stretch of being private but recently IPO’d earlier this year in 2019.

The company has enjoyed strong growth over the past five years, has returns on invested capital in the high-teens and sometimes over 20%, and has a blended P/E ratio below 18. The company has a lot of cash, so its net debt is equal to about a year’s worth of net income, which is quite low.

Overall, it’s not the cheapest brand, but it’s reasonably priced and high on the quality spectrum based on their investment returns. We could see a lot of downside if the economy cools off and if more store closings result in product liquidation.

People will be wearing Levi’s jeans for a long time to come. I buy mine through Zappos, which is owned by Amazon. They’re available on Amazon, on other online platforms, and in physical retail locations everywhere.  

Final Thoughts

The retail industry is a mess right now, but investors should think of it less as online vs physical retail at this point and start thinking in terms of which omnichannel retailers will survive over the next decade. Which physical retailers are showing good success at shifting their sales to online distribution, or appealing to discount physical shoppers, while maintaining decent returns on capital in a tough environment?

Brands can market themselves directly to consumers, cutting out the middlemen. A few middlemen will also succeed, but many will fail. As the wheat is separated from the chaff in coming years, and less successful retailers go bust, the remaining retails can consolidate and continue to perform.

Look for companies with a competitive edge and a strong balance sheet, keep them on your watch list, and consider buying when the stock price dips below your attractive price targets.

I consider Ross and Levi Strauss to be very high quality, but a bit on the pricey side and worth looking for dips 10% or more below their current prices. Nordstrom and Tapestry are examples of moderately high-quality that are encountering a rough period and trading at low valuations. They have risk but also significant upside potential.

Lyn Alden Schwartzer covers North American stocks and international equity ETFs with a focus on fundamental valuation. Her background is a blend of engineering and finance, and she uses a dispassionate long-term quantitative and qualitative approach to filter through the noise and find value in stocks and markets around the world.
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