Reflection on a Great Retail Investor

On Friday, I posted notes on an investor’s talk at the Special Situations class at the Columbia Business School. I believe that the class is taught by Joel Greenblatt. The guest speaker specializes in retail store investments. The talk is worth studying and contains many valuable lessons.

Focus Pays Off

So much of investing is trying to get an edge. You want to be like the guy Munger describes who makes a living at the horse track by only betting when the odds line up in his favor. Too many investors are all over map, often veering outside of their circle of competency. One way to get an edge is to pick a few industries you understand and then study them until you really penetrate how they work. You do this by reading the filings of the companies in that industry and following them over a number of years.

The good news is that making money is not so much a function of how many industries you follow but how well you know the ones that you do. The retail investor made annual returns in the high 20’s by focusing on one industry. She has a real edge because she has a knowledge advantage.

By operating in one sector over a long period of time, she understands the patterns of how the stocks in that group trade.

The primary pattern is simple. The market focuses on the short term. Inevitably even the best retailer will stumble on a short term basis. The market – being unduly focused on the short term – then takes the stock down. This volatility creates opportunity.

“The best time to get in is when they missed a season of merchandise because if you look at the fundamentals of the company and it is well-run and the stock gets crushed because they miss a season of merchandise, then it is an opportunity to own for the long term. It is really irrelevant if they pick the hot trends or not.”

Normalized Earnings Power

The key is to figure out what the normalized earnings power is going to be in three to five years after the company moves beyond the current set of problems. You can then set your own price target based on your projection of normalized earnings.

She does her own work. The market may miss a stock because it’s selling at 8.5 Enterprise Value/EBIT as a result of depressed margins because management made some short-term merchandising mistakes. If her own numbers show normalized EV/EBIT of only 6x, she may have a real opportunity. She then does more research.

To value retail stocks, she tries to determine what the company will earn over a five year period and then she uses a very conservative terminal value. She does not simply make a linear projection based on past data, but actually looks at the business at the store and square-foot level. How many stores can they open? How close to saturation are they? Are current margins depressed? Can they improve? Why will they improve? Does this store have a reason to exist? What is it and why will people continue to shop there?

Greenblatt stressed how important it is to actually model the build-out of the store base using conservative assumptions instead of just picking a growth rate and future P/E ratio out of the sky. The bottom line is that you need to understand the business.

How to Research a Retail Stock

Determine how much growth is left in the concept. To determine the saturation of a concept, you need to know who they cater to. There are A malls, B malls and C malls.

“You could see an AEOS (American Eagle Outfitters) in an A or B or C mall. A 1000 to 1200 is max saturation for a retailer to go into all three mall types. An ANF (Abercrombie & Fitch) will max out at 400 malls because they are only in A type malls. You won’t see them in a C mall. That is why they launched the Hollister concept which was for lower quality malls: B and C.”

Do primary research. She approaches research with a thesis. It’s not just an open ended field trip. She wants to know why a stock is cheap and whether it’s a temporary or permanent problem.

Talk with anyone who will talk with you: store managers, senior managers, merchandising managers, people who come out of the store with or without bags, store employees. “Are customers coming in and not buying? What do they think of the merchandise?”

Spend a lot of time in the malls and check out the stores.

Macro Economics

She does not spend time trying to figure out the macro issues. She thinks they are already priced into the market. The primary question is, “Whether this is a cheap stock today and do I think over the next two years there will there be a normal environment.”

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8 thoughts on “Reflection on a Great Retail Investor

  1. kungfu panda

    Thanks for this post. And I truly enjoyed the presentation Ms. Greenblatt did with regard to retail stock investing. One question has been lingering in my mind is

    -how do we know if the company will bounce back after missing a season’s numbers? what are the characteristics of such retailers exhibit? what happens if the company miss another season and another season?

    Reply
  2. Greg Speicher Post author

    I think the key is being able to recognize the difference between a short-term fixable problem – for example, not ordering the right merchandising mix for back-to-school – and a permanent structural problem – for example, the collapse of Circuit City when the big box retailers such as Walmart and Costco aggressively moved into electronics.

    When Aeropostale’s stock was off the investor concluded that the company was still highly relevant because they continued to be the value leader in providing on-trend teen basics (jeans, t-shirts, hoodies, etc.). Being able to make these judgments is a function of experience and good research.

    It also explains why focusing on a one or a small number of industries can give you an edge.

    Reply
  3. kungfu panda

    thanks much for your quick reply!

    I’ve traditionally tried to avoid fashion companies as I think they possess a certain degree of ‘fashion risk’. In other words, if you use the strict Buffett rule, I don’t know if the company will still be relevant in 10 years. I almost say I have a mental blockage in this area. In China, I’ve seen apparel companies come and go all the time. But I also missed some huge opportunities in the space. That is why I’m very glad to listen to a different perspective in this area.

    Now, in Aeropostale’s case, it is a value leader in providing teen basics. Should we try to stick with something more basics when it comes to investing in apparel because they are more likely to come back? If the stuff is basics, why would they be out of trend? If it’s basics and value, now there are all these fast retailing companies (forever 21, H&M, etc, etc), would they pose threats in case you are betting the turn around of the company? I apologize for all the dumb questions… =(

    In the Circuit City case, I think I can understand because it is a structural change.

    Reply
  4. Greg Speicher Post author

    I think a company that sells higher priced discretionary products is inherently riskier than a company that provides basic items like teen essentials. Teens need jeans, polos, t-shirts. Since they are growing, there is built-in obsolescence in what’s in their closet. Fashion trends help drive new sales. Add in a relevant brand with a touch of style (makes the kids happy) along with a price tag that makes mom and dad happy (prices similar to Tarket, Kohl’s, Walmart, etc.) and you have a winning combination. ARO is a good business; if you back out growth capex, it has returns on tangible capital employed of over 100%.

    Regarding your question of why they would get off trend, I am not a fashion expert, but I suspect in any season – back-to-school, Christmas, etc. – a judgment must be made about what to order and in what quantities. Even a good management team can get this wrong from time to time. Then, margins are impacted as the company has to discount and work-off the slow-moving inventory. The market is totally focused on the short-term and downgrades the stock, even though nothing has changed in the business and its long-term prospects remain unchanged. ARO has very good systems and can quickly respond to this type of mistake.

    Although it’s not totally black and white, I think we can say that there are two types of turnarounds: 1) the structural kind such as the Circuit City case that rarely work because the basic economics are broken (this is the type that Buffett says rarely turns) and 2) a short term problem that can be corrected. It is the latter where opportunity lies.

    Reply

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