Retailers going cheap

We’re not fans of the sector, but after some spectacular falls, we’re beginning to sift through the retailer rubble.

I’m not a fan of investing in retailers. Period. My aversion doesn’t come from a personal bias, either. I've bought a few over the years and haven’t had any crippling disasters. But they remain, on the whole, mediocre and challenging businesses, both from a management and analytical point of view.

My first gripe is that they lack any durable competitive advantage. Take Lovisa (ASX:LOV) for example. It appears to have a unique retail offer today, and generates high returns, but what will prevent this from eventually being eroded by copycats? A low-cost model might be more defensible, but except for JB Hi-Fi (ASX:JBH), few retailers have institutionalised this successfully over the long term.

Intense competition means slim margins, and with high fixed costs from store lease liabilities, the probability of bankruptcy is heightened. We all remember Dick Smith, but a string of recent bankruptcies, including Herringbone, Rhodes & Beckett, Marcs, David Lawrence and now TopShop, suggest the industry is a minefield.

Retailers often lack substantial growth potential, too. Their model is linear, in that five times as many stores are needed to increase earnings fivefold. Contrast that to an exponential model, such as a software business, that can achieve the same growth by selling the same intellectual property many times over.

Granted, investors can achieve fantastic growth by being early into successful roll-outs, but there's an element of survivorship bias to all the success stories and it's hard to achieve in any case. By the time a retailer is ready for an IPO the concept is already validated and the store network expansion is well underway. This means in a low population country like Australia, the runway for successful store roll-outs is short. From there, acquisitions or overseas expansions become more likely, and those rarely end well.

The level of consumer debt is also a worry, because it's easy to envisage an environment of belt-tightening with higher interest rates.

An investor could be excused for avoiding the sector entirely. But with discretionary retailers plummeting, it might pay to examine the sector for opportunities rather than run away from it altogether. Just look at the price falls: RCG Corporation (ASX:RCG), Godfrey's (ASX:GFY) and Oroton (ASX:ORL), have halved in the past 12 months. The Reject Shop (ASX:TRS) is down by 72% and Surfstitch (ASX:SRF) by 85%.

With the media fanatical about the risk Amazon’s entry poses, and the prospect of tax loss selling up until June 30, these and other retail stocks could fall even further.

That's why we've started combing the sector in search of strong balance sheets and big margins of safety. It's likely that we will see more bankruptcies but there could also be some multi-baggers.

We're picky shoppers so there's no guarantee we will make any purchases but it's a good time to peruse the aisles. We'll keep you posted.

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