Finding Retail Buys in the Age of Amazon

By Adem Tahiri - November 28, 2012 | Tickers: AMZN, BBY, RL, SBUX, TRLG | 0 Comments

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Are any retailers, aside from Amazon.com (NASDAQ: AMZN), a buy these days? It's a question that's been on the mind of many worried retail investors and investors looking for holiday plays alike.

The worried crowd has reason to be these days, amid the incredible falls of some once very proud names in retail, such as J.C. Penney and Best Buy (NYSE: BBY). Many people are saying these brick-and-mortar stores just can't compete in the age of Amazon. I tend to agree.

If you're going to invest your hard-earned money in retail stocks, you need to know what you're looking for, and why -- particularly in this Amazon of a market (obvious pun intended). As Joel Greenblatt famously stated: "Buying individual stocks without any idea of what you're looking for, is like running through a dynamite factory with a lit match. You may live, but you're still an idiot."

Today, I'm going to show you the best way to keep from blowing up.

Traditional Retail is Not Dead--But It May Never Be the Same

"If you can't explain how you're different, you'd better charge less."

That's the best business advice I ever received, and you can use it to analyze the very real businesses you own--your stocks. Ask yourself: Is the retail stock I'm about to buy offering consumers something drastically different than its competitors? If not, what will keep it from fending them off?

When I think about what hurt companies like Best Buy and J.C. Penney over the past few years, the first thing that comes to mind is that they have no differentiators. They sell other companies' products -- not their own. Just as troubling, they don't have the lowest prices; that title belongs to Amazon and Wal-Mart.

Stay Away From the Low Price Leaders

As successful as Wal-Mart and Amazon have been, they've exhausted their respective markets on low prices; you're not going to find the "next" Wal-Mart or Amazon in this regard. Furthermore, one of the most important  financial metrics to follow is ROIC (the business's returns, divided by the capital it needed to get those returns), and you won't find any low cost leaders with a high ROIC. Thus, you won't find those "different" businesses you want in this niche.

Even Amazon has admitted to taking on low-margin business to expand its scale. This works for Amazon because of its size and reputation; good luck finding the next such company.

I only stress the need for a high return as such an important metric for you, because the companies that don't have it have such little room for error and probably aren't delighting customers. For further proof that this low-price space can only carry one or two leaders, one needs to look no further than Best Buy and RadioShack.

As I've mentioned time and again, Best Buy's demise came only in part because of cheaper competitors (a la Amazon). The company's glory days took place about five years ago, when tech innovation was leading us all to switch from large "boxy" TV's to flat-screens and from XBOX's to XBOX 360's. These products, particularly flatscreens, were Best Buy's golden goose, with really fat margins. Unfortunately, the firm overexpanded to satisfy demand, and once everyone had a flat screen--well, they had one.

The idea that somehow in the past few years, we've all decided to buy every product online, (leading Best Buy to tank) is just patently false. In fact, even as Best Buy's profits increased, the warnings of margin contraction due to product mix have been a concern of the street since at least 2009.

Now, like Radio Shack, Best Buy hopes to reinvent itself by selling low-margin products like phones while having high overhead, leaving nearly no room for error. Again, good luck with that.

I've Got a Fever

If we're looking for retailers in the "Age of Amazon," let's find ones that can explain why they're different, and don't charge less. That won't be easy, but we'll be on the right track if we specifically keep an eye out for retailers that have the three following characteristics:

1). They have a loyal or even rabid following, devoted to either their products or their customer experience.

2). They make their own products. (No resellers!)

3). They have a niche or specialty in their product offering. We want companies with focused targets, rather than those with a wide array of products sold to multiple demographics.

In short, you should want retailers (if we're going to invest in any) that aren't a commodity, and are, well, special. I firmly believe the "new retail" will be the "anti-big box;" specialty stores with a unique customer experience and feverish fan base will be the ones to buy. They'll be smaller, more focused and able to offer something you can't get online. That's means our "niche" from item 3 above has to be a bit subjective, but all investing involves a bit of soothsaying.

Based on these criteria and the financial metrics that matter to me -- return on equity, the P/E-to-growth ratio, and revenue growth -- I came up with the following short list of retailers.

"Amazon Age" Retailers

Choosing retailers today, is not as easy as it once was. The Big Lots of the worlds offer no reasonable differentiator from Amazon or Wal-Mart. To succeed, you need to find businesses that do. Return on equity makes a good starting point, because it indicates that a company is doing something special operationally to fend off its competitors. The companies above have rabid fan bases; people will pay up for all three brands because they either feel they're getting a special experience (SBUX) or a luxury product (TRLG or RL).

The Takeaway--What to add to Your Shopping List

These metrics are just a starting point toward finding a company that is relatively cheap while still growing its revenue. Even better, we're finding a company (through ROE) with a high return on equity that likely has some kind of moat, an edge that keeps competitors from eating into returns. But alas, these criteria are just a starting point for additional homework.

What you'll find though, is that the metrics more often than not lead you to some winners. Do the three companies listed fit the characteristics we want in a retailer? Loyal fan base and niche? Check. Do they make their own product to avoid re-selling and becoming a commodity? Check. This should matter immensely to you because these companies (through their metrics that prove their moats) are showing that they can charge more, they can be different and survive. That's where you want to put you're money.

If you can't explain why you're different you better charge less. Through this screening process we found three companies that can explain why their different. Ralph Lauren is synonymous with "Classic American Brand" and True Religion's brand is that of celebrity, that's not a commodity and you can't simply replicate that cache at a cheaper price. That's where you want to put your money, that's why being "different" matters.

Some may say that Starbucks doesn't fit into the traditional "retail" category that we've examined, I disagree. Starbucks sells many products (cd's, etc.) in addition to coffee and more importantly it has that unique customer experience previously mentioned; mocha half calf whip, anyone?

I firmly believe the future of retail will not belong to big box, brick and mortars. Rather, firms will need to be able to show why they offer something different, so they can charge more. This will means smaller specialty retailers that, again:

1). have a loyal following and unique customer experience

2). make their own product (no resellers!) and

3). have their own niche.

If you can find a retailer with those three qualities, regardless of what financial metrics you abide by, go ahead and add them to your shopping list.

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