The First Step to Pick Winning Retailer Stocks: Analyzing Their Business Models

One of Peter Lynch's favorite ways of finding a good stock to invest was to take his family shopping at a large shopping center and see how each store was doing. It was no wonder that he picked up Gap (NYSE: GPS) during the early stage of the franchise's nationwide expansion and captured the huge run in the company’s stock price for the investors of Magellan Fund.  So how can individual investors replicate Mr. Lynch's strategy to achieve similar results for their personal portfolios?  I believe the first step to pick up a winning retailer stock is to understand the business of the company to determine whether it has got a good or at least viable business model.  

If a company has an inferior business model, it may not survive competition from the marketplace. It is unlikely that the long-term cost arising from an inferior business model will be offset by the seemingly lower stock price you pay for the shares of such a company. That is why Mr. Warren Buffett repeatedly stated that for him to invest in a company, it must have a good economic model. He does not mind even paying a little bit of a premium for those companies.

So how can you tell whether a retailer has got a good business model? There is not a single one-size-fits-all great business model for all retailers. It depends on what a specific retailer is trying to sell.

The Informational-Physical Spectrum

Let me coin a term called "informational-physical spectrum" to describe the different categories of products that different retailers are selling. At the very left end of the spectrum are things that are purely or primarily "informational," such as books sold by Barnes & Noble (NYSE: BKS) and Amazon.com (NASDAQ: AMZN). Music CDs and DVDs are also on the left end of spectrum. They are essentially selling, at an abstract level, "content." The more content-oriented a product is (i.e., the more its physical attributes are irrelevant to its users), or the more it can be characterized as to be fungible, like commodities; the more likely it will end up on the left side of the spectrum.

At the very right end of the spectrum are products that are primarily "physical," such as fresh produce or dairy products you can find grocery stores or your local farmer's market. You buy those things because they have certain physical attributes that you need or like. For example, you buy a box of ice cream to physically eat it. So physically it had better taste good. If possible, you prefer to look at it or try it before you buy it. The more concrete, or unique or volatile a product is, the more likely that it will end up on the right side of the "information-physical spectrum."

In the middle of the spectrum are products that have some informational components and some physical components, such as the consumer electronic devices that both Amzon.com and Best Buy (NYSE: BBY) sell, or designer clothes sold by specialty stores. The "informational" components of such products are primarily their design and style, while the physical components of such products are their physical characteristics and practical functions.

Where a product falls in the spectrum will likely determine the best business model to sell it to the consumers. And the retailers that sell any product through the "wrong" business model will lose out in the long term in the competition. You do not want to invest in such retailers. Below are a few case studies to illustrate my points.

1. Bookstores

Now let's stack Barnes & Nobel up against Amazon.com. It is no wonder that Amazon.com started primarily as a book-seller because books are most suitable for sale online. A book is mostly an "informational" product. For most readers, they are buying a book not because they like the physical characteristics of the book, but the content in it. In other words, I do not need to see the book, or touch it, especially if it is a new book, before I feel comfortable to click the "Place the Order" button in Amazon's website. An online bookstore can give me a good preview to help me make up my mind. So I do not need to flip the pages in a brick-and-mortar bookstore. Better yet, I do not even need the content of the book to be delivered in paper nowadays. That is where Kindle came in.

Since a War and Peace from any bookstore, online or offline, is the same for the reader, the reader only cares about one thing: the price tag. So the bookstore that has got a cost advantage prevails in the competition because it could afford to lower the price for any book it sells.

Compared to Amazon.com, Brick-and-mortar bookstores such as Barnes and Noble have an inferior cost structure because they have to pay a lot of money to lease huge store space in each mall or city center and hire customer services staff to sell books. Amazon.com, however, can store the books in the cheapest and most highly automated warehouse in the middle of nowhere and deliver the books to its customers by UPS. Better yet, Amazon.com can store millions of different books in its warehouse, but a brick-and-mortar bookstore is limited by its physical size and frankly, its rental budget. So the cost to operate Amazon.com's book business is much lower but the wider selection of the books it sells makes it a more desirable destination for the consumers. This explains why Barnes and Noble, as well as the street-corner independent bookstores, have lost so much of their market shares to Amazon.com. In other words, it is an inferior business model to sell books in brick-and-mortar stores.

      2. Grocery Stores

This does not necessarily mean that the centralized, automated, lean and efficient warehouse operation of Amazon.com represents the better or even desirable business model for retailers that sell other products, such as fresh groceries.

During the heydays of the Internet bubble, there was this now-defunct company called Webvan. Webvan promised to deliver groceries that you ordered online to your home. How did that business fail? It failed because no one would want to go online to place an order and wait for a UPS delivery when they are hungry for a slice of pizza or crave for some ice-cream. How could online grocery stores such as Webvan ensure the food from their warehouse will be fresh and safe upon delivery to the doorsteps of their customers? How could the consumers be confident that the food they order online will be fresh and safe without first looking at the food? For one thing, the ice-cream might melt on the way! Webvan could have fancy refrigerated trucks to ensure the quality of the food and rent/build a warehouse in every town to ensure timely delivery, but then it no longer enjoys any cost advantage over the traditional grocery stores.

Products that are more "physical," therefore, are less likely to be suitable for online retailers. This is also probably why Webvan failed miserably and we still see Costco, Whole Food and farmer's market in American suburbs and cities.

You may point out that Amazon has been engaged in the online grocery business since 2007. However, in this year's shareholders meeting, its CEO Jeff Bezos said that the online giant is "still tinkering" with the economic model of the online grocery business, the Amazon Fresh to try to come up with a workable formula. At least it seems that Amazon cannot simply leverage all of its e-commerce expertise and experience to rapidly replicate its online grocery business nationwide. After five years, CEO Jeff Bezos admitted that "Amazon Fresh is a test. It's only in Seattle." How long did it for Amazon to set up its online book store and sell books to consumers in every single block of America's cities and suburbs? FreshDirect, another online grocery store, started its operation in 2002, and after almost a decade of trials and errors, its delivery is still limited to the offices and homes in the metropolitan New York area.

   3. Electronic Stores

It is a more difficult to analyze retailers that sell products that are in the middle of the spectrum. For example, where do the things Best Buy sells stand in the spectrum?

I would argue electronic devices are not too far away from books or music CDs in the spectrum and as a result Best Buy has an uphill battle with Amazon.com.

People still need the physical components of washing machines to wash clothes, a physical cell phone to make calls, and a physical screen to watch TV, etc. So Best Buy is not in the exactly same boat as the brick-and-mortar bookstores. In other words, people might need to look at and touch the washing machines, the TV screens and the cell phones before they go home to place an online order from Amazon.com, or hopefully bestbuy.com. So BBY, as the clichés goes, has become the showroom of Amazon.com.

Best Buy is, however, in a worse position than other brick-and-mortar companies such as Abercrombie & Fitch (NYSE: ANF). Each specialty retailer purports to sell something unique due to its style and design. An Abercrombie & Fitch T-shirt is arguably different than a T-shirt you will find at Wal-Mart or Amazon.com. Simply put, Amazon.com cannot compete directly with Abercrombie & Fitch or Deckers because the latter can simply refuse to supply their merchandises to Amazon.com. Best Buy does not have that kind of leverage. Best Buy does not make anything it sells, nor does it have the right to affix its own label to the merchandises it sells. SONY, Apple or Samsung can sell their products through Amazon.com or Best Buy, or anybody else they like. Best Buy has no say in that.

Also just like the business of selling books, the business of selling electronic devices is cost-driven competition. The GE dishwasher from Best Buy is the same GE dishwasher from Amazon.com. The buyer will go to whichever store that charges the least for the same dishwasher. So the most cost-efficient company in the business of selling dishwashers will prevail in the competition.

So what should Best Buy do? It could sell something that Amazon does not sell, such as installation services, etc. But it seems that Best Buy is not particularly successful there. It can also become more like Amazon.com by expanding its online presence.

Best Buy could also try to cut its operational cost. However, Best Buy is stuck with many long term leases for its existing stores. A lot of people argue that once the government starts to force Amazon.com and other online stores to collect sales tax, the play field might be leveled. However, the sales tax is not the most critical cost factor that puts Amazon.com ahead of Best Buy. It is the centralized, automated, lean and efficient warehouses of Amazon.com that set it apart from Best Buy, which is burdened by the expensive, sales-people-dominated, big and fat stores. Simply put, Best Buy is not only stuck with the obligations arising from its long term store leases, the cost of staffing such stores, but also an inferior, if not "wrong" business model.

Conclusion: To sum it up, to pick up a good retailer stock, you should understand the business of the company and then ask yourself: Is this the best business model to sell the products the company carries? If it is not, you should avoid the stock.  If it is, then you can move on to the second step, which is to analyze the company's financial conditions. If you are satisfied with what you find out in the second step, you can move on to the third step, which is to analyze the valuation of the stock.