Retailers: How A Lying Groundhog Destroyed Their Profits

Includes: DKS, KSS, LB, M, TGT, WMT
by: Mike the PhD

Most people view Punxsutawney Phil as a friendly denizen of Pennsylvania whose job every February is to look for a signal of spring's arrival. This year though, the nation's furriest weather man declared that spring was just around the corner, and combined with a warmer than normal winter, many retailers and investors likely took him at his word. Unfortunately, it looks like Phil played all of us for fools in a very early April 1st prank - spring was not right around the corner, and the warmer spring weather of the last few years has not materialized at all.

Even now, the first week in April looks set to bring a renewed cold front to the southeast, and with it, a further delay of the spring shopping season by parents everywhere. And that's the rub really - retailers across the country from Kohl's (NYSE:KSS) and Macy's (NYSE:M) to Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) rely on the spring clothes shopping season to draw in traffic. In the last few months though, these retailers and many others have been hit with a 1-2-3 punch combination that looks set to potentially floor first quarter profits.

First, early winter was unseasonably warm leading to reduced winter sales at the likes of Dick's (NYSE:DKS) as retailers were forced to heavily discount their winter apparel to move it out the door. Next, the helpful politicians in Washington dickered about so much on the fiscal cliff that the IRS had to send out income tax refund checks late, leading to the now famous Wal-Mart exec email declaring February sales to be a "disaster". Finally, it turned out that winter hadn't been cancelled, it was merely delayed this year, and Phil lied to all of us. Winter got under way with a vengeance with nearly weekly blizzards in many parts of the nation including the normally warm southeast. The result is that, while retailers still have a few more weeks before they begin reporting spring earnings, it is likely that sales in February and March were hurt by stores holding the wrong kind of inventory for the weather at hand.

As an investor who holds several retailer stocks, I hope I'm wrong here, but it looks like earnings may disappoint. This view is reinforced by the lackluster consumer confidence figures that have been coming out lately, and by past research showing that abnormal weather like what most of the country is experiencing can put a damper on sales and lead to greater markdowns. Again, I hope I am wrong, but either way, the March same store sales numbers should be particularly important this month.

Now assuming I'm correct, does this make retailers a bad investment?

Normally, maybe. But given the valuation being placed on the rest of the market, for medium- and long-term investors, I would argue that retailers are in fact a good buy right now. From a valuation standpoint, retailers look cheap compared with their history, especially if the improved jobless figures in recent weeks lead to better job growth and stronger consumer spending as the year continues.

Let's look at a few basic valuation numbers for a few representative stocks; Macy's has a P/E ratio of 12.8 and a Return on Equity of 15.3% for the last 3 years. Kohl's has a P/E ratio of 11.0 and a Return on Equity of 15.23%. Both fall into the top quintile for valuation on a P/E basis. Limited Brands (LTD) has a P/E of 17.5 and an earnings growth rate of 12%, while Ross Stores has a P/E of 17.2 and a growth rate of 15%. Both fall into the middle quintile on valuation and the second to top quintile on growth rate. There are many similar retailers out there with similar valuation levels.

By and large, the market has not been impressed with same store sales for the retailers thus far this year. It is likely that investors will be even less impressed with the spring quarter earnings numbers in a few weeks. Eventually however, the weather will get better and that should result in improved sales going forward.

Now, I generally don't believe in trying to time the markets, I tend to focus my investment efforts much more on what past research by myself and others have shown to be the successful long run investment strategies. In this case, I am looking at retailers because they represent an out of favor sector with low levels of positive market sentiment (see my blog for more details on measurement of sentiment). In a 2006 study, Baker and Wurgler showed that in out of favor sectors, subsequent returns are better for small stocks and growth stocks after using a four factor pricing model (again see my blog for more details on factor pricing models).

However, not all retailers are created equal right now. In particular, retailers that are underperforming right now due to concerns about their same store sales (which are probably being disproportionately impacted by the cold winter and spring), may be well positioned to bounce back as the weather gets warmer. A famous study by two financial economists, (Jegadeesh and Titman) showed that underperforming stocks eventually reverse course and begin to outperform, which is exactly what the longer term investor is looking for.

As such, investments in retail stocks look attractive right now, especially for firms that fall into the top deciles for growth and bottom deciles for size criteria based on an ordering of all retailers. Baker and Wurgler's results seem applicable to the retail category and given the level of pessimism surround the sector, the stocks look like a good value at these levels.

So in summary, Phil lied and misled those who rely on him and it looks likely that retailers' profits will tank in the near term. However, for those looking for longer-term investments, and who are willing to bide their time, retailers will probably offer a ride to better earnings eventually. And for the record, I do like groundhogs, and I don't hold Phil's mistake against him though apparently the folks in Ohio do.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KSS, LTD, DKS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.