The late Polish economist Michal Kalecki once quipped that economics is the science of confusing stocks with flows. Investors often commit a similar blunder when they misjudge a firm’s future cash flows and focus too much on the present valuation.
For several years now, value investors have been enticed by low valuations at several prominent retailers such as GameStop (GME) and Bed, Bath, & Beyond (BBBY). The same bull theses have been bandied about for at least seven years, all containing similar arguments about rock-bottom earnings multiples, high dividend yield, and the possibility of a buyout. None of these predictions have come to pass.
A few key elements distinguish a true value play from a value trap.
For all of its history, 'value investing' has been understood to mean buying an asset for less than what it is worth. The concept is simple, but the application has varied over the years.
Ben Graham, the father of value investing and Warren Buffett's mentor, is best remembered for advancing a strategy that involved buying stocks below per-share liquidation value. Eventually, the concept of 'value' expanded to include companies selling for less than the present value of future cash flows.
For going concerns, valuation is primarily based on the discounted present value of future cash. P/E ratios carry no inherent usefulness, other than serving as potential indicators of an undervalued asset. A high P/E can indicate an overvalued asset, but it may also imply that investors expect cash flows to increase in the future. Conversely, a low P/E can either point to an undervalued asset or an expectation that future cash flow will shrink.
Between 2013 and 2018, Bed, Bath, & Beyond's P/E ratio shriveled from 16.8 to 4.5 as net income shrank from $1.03 billion to $425 million. GameStop's P/E similarly fell from 15.8 to 5.3 in 2018 as its operating income dropped precipitously. When the cash flows come in lighter year after year, the market's willingness to pay a higher multiple for that cash flow evaporates.
Many bargain hunters ignored the uncertainty of future cash, instead fixating on the present cheapness of the stock. In many cases, earnings estimates proved far too optimistic. Some GameStop and BBBY watchers still believe that these companies will get taken over by private equity at higher valuations. This may yet happen, but buying stock based on that scenario is speculating, not investing.
In the end, there is little intrinsic value to these specialty retailers except the value of present and future cash. Both chains follow a capital-light model, so there are few underlying tangible assets. As long as cash flows are shrinking, investors can expect the P/E ratio to remain depressed. Although management could theoretically return more capital to shareholders, there is not much incentive to essentially liquidate the company. This is the definition of a value trap.
Value plays within the retail sector possess additional assets nested within the parent company. A person who bought Sears (OTCPK:SHLDQ) stock in 1989 would have made a sizable return due to the company's many spinoffs, including Dean Witter (now Morgan Stanley (MS)), Discover Financial (DFS), and Allstate Insurance (ALL).
Today, activist investors often target aging retailers for their vast real estate holdings. Like many specialty retailers, the department store business is fading. However, these companies come from an era when it was considered prudent to hold real estate. Macy's (M) still owns many of its stores outright, including prime real estate located in the downtown centers of major cities.
Estimates for the value of Macy's real estate range from $16 to $21 billion, far higher than the company's market capitalization of $7.6 billion. The underlying assets provide a floor on the stock price, should the business environment turn sour. Despite activist fund Starboard Value's attempt to pry away properties several years ago, Macy's rebuffed suggestions to spin off or sell its real estate holdings.
Even so, it seems management got the message. Over the last three years, Macy's has sold $1.1 billion worth of property. Investors would especially like to see the company monetize its flagship Herald Square store in New York City, worth as much as $4 billion. Macy's plans to move employees out of the store's upper floor offices could portend a sale of that space, as occurred with the Chicago Loop store last year.
To be clear, I would not be a buyer of Macy's at today's price. The $21 billion valuation for its portfolio seems rather high, and in any case, management has made it known that the company will hang on to much of its real estate.
The point is that there is solid theoretical case for Macy's as a value play because there are underlying assets aside from the core retailing business. Similar arguments have been made for restaurant chains such as Cracker Barrel (CBRL) and Darden Restaurants (DRI), which both own a lot of property.
The likes of GameStop and BBBY do not have this advantage. The only hope left for these companies is that they pull off a turnaround of the core retailing business. But to quote Warren Buffett, "turning around a retailer that has been slipping for a long time [is] very difficult." Best Buy (BBY) is the only chain in recent memory that managed its way back from the dead. Readers often point to the electronics retailer as the exception to the rule, yet how many companies ever find leaders as brilliant as CEO Hubert Joly?
By and large, slipping specialty retailers are value traps that will continue consuming investor capital as they circle the drain - slowly but surely.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.