A Few Bright Spots In The Retail Wreckage

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Includes: FDIS, FXD, PMR, RCD, RETL, RTH, VCR, XLY, XRT
by: Scott Fearon

As last year's holiday season was kicking off, I cautioned investors for the second year in a row to beware of the traditional retail sector. Since then, things have gone from bad to worse. This earnings season has been an unmitigated disaster, with one retailer after another turning in disappointing reports. Gap, Nordstrom (NYSE:JWN), Macy's (NYSE:M), J.C. Penney (NYSE:JCP), Kohl's (NYSE:KSS), and others have all dropped precipitously.

Some contrarian investors who buy out-of-favor stocks in out-of-favor industries have started calling a bottom for these companies, positing that the recent selloff provides an attractive entry price for long-term investors.

I disagree.

Not long ago, apparel retailing was a well-loved sector. When I was younger, I regularly attended presentations where middle-aged, often female New York brokerage analysts would fawn over CEOs at companies like Gap, the Limited, and Ann Taylor while discussing fashion trends in minute detail. Those days - and those analysts - are long gone, and they're not coming back.

According to Morgan Stanley, Amazon (NASDAQ:AMZN) now accounts for 7 percent of all apparel sales, with that number expected to grow to 9-11 percent in a few short years. Just as scary is the pricing power Amazon gives its users. American consumers almost always shop on one thing and one thing only: price. We love hunting for bargains, especially when we don't have to leave our homes to do it. Even as traditional retailers continue to implement "omnichannel" approaches, I just don't see how they can compete with Amazon's dominance.

All that being said, some players will survive this onslaught - those that sell products where Amazon cannot and will not be a meaningful competitor. An obvious niche is deep discount, "treasure hunt" chains like T.J. Maxx (NYSE:TJX) and Ross Stores (NASDAQ:ROST). Both are adept at sourcing merchandise from bankruptcies and overruns, and passing most of those savings on to their customers. Those customers are usually from a middle and lower middle class demographic, groups that are still somewhat hesitant to buy clothes over the internet. Not surprisingly, TJX and Ross are two of the best performing retail stocks of the last decade, and could continue to outperform in years ahead.

Other niche companies should survive and even thrive in this landscape. That includes Covington, LA-based Pool Corp. (NASDAQ:POOL), which - not surprisingly - distributes pool and hot tub chemicals, equipment, and related products to pool store and service operations in the US. I interviewed Pool Corp.'s management at its corporate headquarters last week, and was fascinated to learn that despite POOL being one of the ten best-performing US stocks of the last two decades, a mere eight analysts (none of whom are based in New York) write research on this world class, $2.5 billion company.

Pool's typical customer operates fewer than 10 stores. These mom-and-pops love the extensive inventory at Pool's 330+ US locations, plus the fact that the company delivers, if needed, and will extend credit. You might be wondering, doesn't Amazon sell pool supplies? Of course it does. Amazon sells everything. But guess where Amazon sources its pool-related items? Pool Corp. That's because it does not want to keep volatile chemicals in its warehouses. While POOL's stock appears pricey at 24x earnings, the company generates lots of cash and has used buybacks to shrink its outstanding shares by over 25 percent over the last ten years.

Retail has always been an inherently risky, failure-prone space for investors. In my career, I have shorted more retailers that have eventually filed for bankruptcy than companies in any other sector. That list includes Bombay, Circuit City, Edison Brothers, Factory 2-U, Gadzooks, Garden Botanika, Kmart, Stage Stores, Ultimate Electronics, Value Merchants, and Wilson Leather. The only thing that surprised me about any of these names wasn't that they went broke, but how long they managed to hold out in the meantime. Anyone tempted by some of the downtrodden retailers in today's market would be wise to study the history of the sector before they buy. Turnarounds are exceedingly rare and bargain stocks often wind up costing a good deal.

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