It’s no secret that the retail industry is facing challenges. While talk of the “retail apocalypse” may have subsided since annual store closings peaked in 2017 at nearly 8,000, the industry remains in flux. Pressure from e-commerce companies like Amazon.com have forced changes in the traditional way retailers do business, and with customer traffic falling in traditional strongholds like malls, brick-and-mortar chains have adapted by building their own online businesses and finding new ways to bring customers into stores. Additionally, many have resisted opening new stores or are even closing stores.
Given that environment, it’s not surprising that retail stocks have…
significantly underperformed the broader market in recent years. As the chart below shows, they’ve generally missed out on the market rally following the 2016 election. However, that’s caused much of the industry to be significantly undervalued according to conventional metrics like the price-to-earnings ratio, especially as the sector got a significant boost from last year’s tax cut. A number of retail stocks now trade at bargain prices, and many of them pay juicy dividend yields.
There are a number of reasons why investors should consider getting exposure to the retail industry. We’ll take a look at those factors in a minute but, first, let’s review some industry basics.
What is the retail industry?
Businesses in the retail industry sell goods, generally through stores or online portals, to the end consumer for personal use. Retail differs from wholesale, which is the sale of goods for resale by retailers — though some retailers that manufacture their own products also have a wholesale business. Retailers sell a broad range of products, including apparel, groceries, home goods, auto parts, electronics, appliances, sporting goods, and more.
Why invest in retail?
As the chart above shows, retail stocks have underperformed overall, but that chart does not tell the complete story. In recent years, the industry has split in two. Underperforming chains like Sears Holding, J.C. Penney, and Ascena Retail Group have shrunk their footprints and even declared bankruptcy in the case of Sears. However, stronger retailers have grabbed market share from their struggling counterparts and have put up solid sales and profit growth, benefiting from a strong economy. While the industry as a whole may be challenged, several chains are growing both online and off.
Additionally, retailers are often reliable dividend payers, and a number are even Dividend Aristocrats, having increased their payouts every year for more than 25 years, giving investors access to both income and growth. Investors can also benefit from skepticism about the industry as retail stocks are generally cheap, with some trading at single-digit P/E ratios or in the low double digits.
Finally, retail stocks are also accessible to investors. You can visit stores to learn more about the company. Consumers are also familiar with most retail brands, so talking to people about brands, especially up-and-coming ones, may give you insight that the average investor doesn’t have. Famed mutual fund manager Peter Lynch has encouraged investors to buy what they know in order to gain an edge on the market, and retail affords more opportunities for this strategy than more opaque ones like energy or banking.
What are the risks of investing in retail?
The changes in retail that we’ve seen with the rise of e-commerce aren’t over. Online retail, which continues to take share from brick-and-mortar stores, has increased by about 15% each year since the financial crisis, and now claims 10% of all U.S. retail sales. Stores aren’t going to completely disappear, but the retail experience will have to change to keep up with faster delivery and innovations like drone delivery, autonomous vehicles, and things that aren’t even on the horizon yet that will make online shopping even easier and more convenient.
In order to thrive in the future, retailers will have to either build out successful online businesses, reinvent the store experience, or combine elements of the online and offline experience to find new ways to add value in order to bring in traffic. Shopping in stores is still a pleasure or a necessity for some consumers, and physical retailers will be able to attract them, but it’s clear they will have to adapt as shopping habits change.
More immediately, those challenges have caused retailers to make investments to drive top-line growth, but those have weighed on the bottom line, meaning profits at many large retailers have been flat. If profits don’t eventually return to growth, those stocks may struggle to grow.
The biggest headwind facing the industry today is disruption from e-commerce, in particular from Amazon. Retail stocks have shuddered repeatedly as the e-commerce giant moves into a new sector of the industry, as it did when Amazon acquired Whole Foods. The growth of e-commerce has made stores less relevant for customers, causing some chains to close stores or repurpose their space by focusing on customer service, experiences, and products that aren’t easily sold online. The rise of e-commerce has accompanied a decline in mall traffic, which has pressured mall-based chains in particular, like Victoria’s Secret parent L Brands, and Gap, which also owns Banana Republic and is planning to spin off Old Navy. Within brick-and-mortar retail itself, there are other sector-specific challenges like fast-fashion retailers in apparel, including H&M, Zara, and Uniqlo, which have come from abroad and threatened the traditional American leaders.
What are the tailwinds for retail stocks?
Despite those challenges, several forces support the retail industry. Overall retail sales continue to grow, and that pattern seems almost guaranteed to persist in nonrecession years as long as the U.S. population continues to grow. Historically, American discretionary and consumption spending has tended to increase over the long term, and consumers will always need to buy items like clothes, food, and furniture. The big question remains: From what companies will consumers buy these necessities?
Though e-commerce presents a challenge, it’s also an opportunity. and some retailers have managed the shift better than others. Walmart, for example, has capitalized on the digital channel, with new omnichannel programs, or those that take advantage of online and offline resources. Walmart grocery pickup is now available in more than 2,000 stores; customers can shop online for groceries, then drive up to their local Walmart later that day to get their order placed into their vehicle by a store employee. Walmart also has Pickup Towers in hundreds of stores that allow for easy retrieval of online orders. Target has also been implementing similar innovations.
Who should invest in retail stocks?
Today, the retail sector is most likely to appeal to dividend and value investors, given the sector’s generally low valuations. With a few exceptions, like lululemon athletica, there aren’t many fast-growing brick-and-mortar retailers on the market. Instead, the opportunity in the sector mostly lies in undervalued stocks that have been ignored or left behind by the market, as well as strong dividend payers that offer yields of 5% or more.
How should I analyze retail stocks?
Like any other industry, retail stocks contain their own set of key metrics that investors in the sector should get to know:
- Comparable sales measure the sales growth or decline of a retailer without the impact of new or closed stores. This metric, which usually includes e-commerce sales, gives retail investors a clear window into the performance of a company as healthy retailers should see steady same-store sales growth, at least in the low single digits. Adding new stores is an easy way for retailers to grow revenue, but it’s not always in their best interest as deriving sales growth from new stores rather than the current base is more expensive. By increasing comparable sales, they avoid the costs of building new stores.
- Gross margin measures the percentage of revenue that retailers keep after accounting for the cost of goods sold, which includes merchandise, labor, and occupancy costs. Gross margin gives the clearest picture of how efficiently a retailer is turning over its inventory. If comparable sales rose but were largely due to markdowns, then gross margin will likely fall, showing that the increase in sales did not lead to rising profits. Like comparable sales, rising gross margin is preferable, though a dip isn’t necessarily a warning sign as retailers can be contending with issues out of their control like rising minimum wages or higher merchandise costs due to tariffs on China.
- Protection from e-commerce is also important. While this is a not a number that investors can easily look up, it’s important for investors to consider. Retail models like off-price, bulk sales, home improvement and others have been particularly durable in the e-commerce era because they are hard to replicate online. Other retailers have found success with omnichannel tactics that combine elements from e-commerce and in-store retail, or have invested in things like customer service and a more personalized experience that can be difficult to do online. Sectors like department stores, which have struggled to offer customers a benefit over e-commerce, have been among the biggest losers in the modern retail era.
- Competitive advantages are important in any industry, but in today’s retail environment, it’s especially important that retailers have some way of standing out from the pack, whether that be a brand, low prices, a unique model, or customer service. Paired with e-commerce protection, the most successful retailers will also demonstrate sustainable competitive advantages.
What are the best retail stocks to buy in 2019?
Investors will want to find retail stocks that demonstrate at least some of the following: positive comparable sales, stable gross margins, barriers to entry from e-commerce competitors, and competitive advantages against other retailers or online or off. In addition to that, investors will want to look at stocks trading at a good value as the retail industry has been under pressure, and a relatively low price should help these stocks withstand any challenges ahead.
The chart below shows five such stocks that look poised to outperform the retail industry and the broader market in 2019 and beyond…
To see chart and continue reading at THE MOTLEY FOOL