There’s no area of the market where you’d say stock picking was ‘easy’, but some sectors tend to offer fewer challenges than others.
For Luke Winchester (aka Wini), whom we spoke with last week (see below), the preferred hunting ground is in the B2B industrials space. One of the key reasons being that these types of companies tend to offer better visibility in terms of revenues — the coordination needed for CAPEX programs and utilization schedules means the order book is generally a reliable predictor of what’s to come, at least in the next year or so.
Contrast that with retailers, who each day open their doors without really having any sense of what demand will be like. They deal with fickle consumers, who are heavily influenced by a fast-moving economic backdrop, and who often have a wide choice of competing products/services to choose from. And, on top of that, you’ve got all the challenges of managing inventory and carrying a large fixed costs base.
It’s tough going. And it’s why Luke tends to stay away.
Of course, when it’s done right, there are spectacular gains to be made. Just look at Lovisa (ASX:LOV) and Nick Scali (ASX:NCK).
If you’re considering this sector, keep the following in mind:
Beware leverage
High fixed costs mean even a small dip in revenues can significantly impact earnings. This is common in retail and not usually a big issue for long-term investors who expect volatility.
But lenders often lack this patience.
Value traps
Trailing PEs and the like can often make retailers seem cheaper than they really are. If you’re basing your perception of value on what the company did last year, which may have been a very different retail environment, you can easily be wrongfooted.
Beware of anchoring to ‘top of the cycle’ (or ‘bottom of the cycle) earnings.
Mind the macro
No company is entirely immune from the ups and downs of the economic cycle, but retailers are especially sensitive to it.
Discretionary goods and services are easily cut from people’s budgets when times get tough.
Management matters
Well, this point is always true. But it nevertheless warrants a mention here.
Retailing is a dark art, so if you find a team that has delivered growth across many cycles and in the face of evolving consumer preferences, it’s noteworthy to say the least.
Be bold when others are fearful
It’s usually darkest just before the dawn. The best time to buy into a retailer is often when sentiment has cratered — it’s at these times you tend to have low multiples on bottom-of-the-cycle earnings, so as you come out the other side you see a recovery in profits AND an expansion of market multiples.
Just be sure the current malaise is due to cyclical, and not structural factors.
Growth can be expensive
Opening new stores isn’t cheap. And once the doors are open, it tends to take time for a new premises to hit its stride.
As such, retailers that are aggressively expanding their footprint can find their operating margins deteriorate for a time — so you want to make some allowances for that.
That being said, if new stores don’t ever prove successful, which is often the case when a retailer moves into an unfamiliar geography, it can be a difficult dalliance to recover from.
Brand matters
A good brand provides pricing power. Without one, you’re essentially dealing with commodity-like products and it can be very cut-throat at that end of the market.
Some businesses still do well here, but it takes a huge amount of operational excellence (and that’s rather rare).
What else?
What other factors do you think are important when considering investing in retail? Be sure to share your thoughts on our forums — and maybe even suggest a few ASX-listed retailers that are looking interesting right now!
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