Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

3 Reasons To Avoid Retail Store Stocks

|Includes: Amazon.com, Inc. (AMZN), DLTR, TJX, W
Summary

Inconvenient for shoppers.

Expensive to operate and scale.

No moats.

There's more in the article!

So far as part of the great industries for investment series, we've taken a look at two "green dot" industries that are generally attractive for investment, and two "red dot" industries that are probably best to stay away from:

"Red Dot" Industries

  1. Airlines
  2. Restaurants
  3. This Article!
  4. Coming Soon!
  5. Coming Soon!

"Green Dot" Industries

  1. Payment Processing
  2. Social Networks
  3. Coming Soon!
  4. Coming Soon!
  5. Coming Soon!

In this article, we are going to continue to build out our list of "red dot" industries, usually best avoided when talking about "buy-to-hold" investments.

To that list, we add an industry that pretty much everyone is familiar with: "brick-and-mortar" physical retail stores.

Just like print media, music, video, and countless other industries, the retail selling model has been almost completely upended by the rise of the Internet. Old-school retailers that rely on the store model and remain behind-the-curve with respect to e-commerce are in big trouble. And even if they have embraced e-commerce, expense to build out a presence is high, there are no location advantages as with physical stores, price competition is more intense online, and they face perhaps the most intimidating competitor in business today: AmazonĀ (AMZN).

While there are some exceptions discussed in the last part, in general the physical retail space is one best avoided when looking for longer-term investments. Here are the reasons why.

Physical Retail Shopping Is Inconvenient for Consumers

By far the biggest advantage of e-commerce over physical shopping for consumers is convenience.

If you think about it, it takes a fair amount of effort for a shopper to buy something at retail. They have to drive or ride to the store, take the time to walk around and find what they are looking for, wait in line to pay for it, and then drive/ride home.

That makes even a short trip up the street time-consuming. And consider the complications. What if there is no parking? What if it is raining, or snowing, or really cold, or windy? What if the person in front of you in line to pay has a lot of stuff? What if the car is low on gas? What if you haven't showered yet today? What if you want to do your shopping late at night after all the day's chores are done?

The pain doesn't end there. Physical stores can only carry so much inventory. What if what you went to buy was sold out, or not carried anymore, or not available in your size? Is there anyone reading this who hasn't experienced these pains? It is very common.

Almost every single inconvenience listed here is addressed by e-commerce. Shopping can be done right from the sofa, in your pajamas, 24/7, with no worries about parking, gas, or the person in front of you in line paying in pennies. Online retailers carry far more stock, both in quantity and variety, and if one retailer is out, going to another one requires very little effort.

For some time, the cost of this convenience was shipping, but even that is beginning to go away with nearly ubiquitous free shipping deals. Amazon has even used free shipping to build out a recurring revenue model in Amazon Prime, an impressive accomplishment in this space.

History has proven that a business model that makes accomplishing goals convenient for consumers is one that will win over time. It is absolutely clear that e-commerce accomplishes just that over the traditional physical retail model. It is the single biggest reason that "brick-and-mortar" retailers have struggled so mightily.

Physical Retail Is Expensive To Operate And Scale

Compared to a purely e-commerce operation, physical stores are pretty expensive to operate and even more expensive to build out a presence with.

Think of all the expenses every individual store has to deal with. There are facility costs, like rent and utilities. There are operating costs, like wall fixtures, shelving, flooring, displays, in-store advertising, check-out counters, etc., all of which must be updated and refreshed on a regular basis. They have to staff their stores with employees, which requires not only labor costs, but also search and training costs (which are important as retail has very high turnover).

Inventory management is also more difficult for physical retail stores than it is for e-commerce operations. Since there is limited space, management has to carefully decide the appropriate mix of merchandise for that particular store's clientele. Additionally, physical stores have to deal with things like "breakage" - a nice way of saying shoplifting, or the ruining of merchandise by employees or customers.

Each individual store can only service a fairly limited number of potential customers - usually no more than a 30 mile radius (often less). That means to address the maximum number of customers, a whole network of locations has to be built out, each one of them facing the expensive challenges outlined above.

This pales in comparison to the e-commerce model. Here, a handful of warehouses or distribution centers are built out that can service a much wider area (Walmart's service a 200 mile radius each). Employee costs are much lower, as many of these centers are largely automated. Warehouses don't need to look nice for customers. Inventory management is much more generalized, and breakage is less of a concern.

It is just a far more efficient way to get merchandise to customers. And it is a second major reason why e-commerce has continued to gain ground on physical retail over the last decade-and-a-half.

Physical Retail Has No Moat

The most common long-term, structural competitive advantages ("moats") we encounter are: HIGH SWITCHING COSTS, NETWORK EFFECTS, CONSUMER BRAND ADVANTAGE, and ECONOMIES OF SCALE.

Do physical retailers have any of these?

HIGH SWITCHING COSTS: Years ago, you might argue that this was the case. For many towns and cities, residents relied on one large, general store for a lot of needs. That store had a major location advantage, as the next similar store could be a several hour drive away. But this is no longer the case. Denser urban development has led to more physical competition, and buying online is just a laptop away. It is very easy for consumers to cross-shop. Switching costs are nil.

NETWORK EFFECTS: There are no network effects in retail. Let's move on.

CONSUMER BRAND ADVANTAGE: Several consumer goods brands have made the move to physical retail stores over the past 20 years (Apple, Nike, etc.), but we look at these companies as just that - consumer goods brands with a small retail presence. When talking about pure retailers, the number that have built meaningful brands are very small. Most folks simply don't care where they buy their Levi's or printer ink at.

ECONOMIES OF SCALE: Again, except in very rare cases (like Walmart), building large enough economies of scale in retail to have a price advantage is extraordinarily difficult, simply because there are so many outlets to sell products now.

For all intents and purposes, very few retailers can ever achieve any kind of long-term competitive moat. It is just not a business model that lends itself well to them.

The Exceptions

Throughout the previous sections, we've made some generalizations - but ones that apply to the vast majority of "brick-and-mortar" retail stocks you will encounter in the market.

However, there are a few exceptions - retailers that have done well over the long term, while still being based in physical stores.

One important category here are "need-it-now" items. It is unlikely you will choose the Internet to get those headache pills you need NOW, or the buns for the hamburgers you are making tonight, or that mulch you need to fix up the flower beds today. This is the reason that e-commerce has had limited impact on retailers like drug stores, grocery stores, and home improvement chains - despite a lot of dollars and effort to break into the space.

Another type of retailer protected from e-commerce are discount or clearance retailers, like TJ Maxx (TJX) or Dollar Tree (DLTR). This kind of bargain hunting is a physical act ("treasure hunting"). Nobody has been able to successfully duplicate it online.

A final one to mention are large-item retailers, like furniture or appliance stores. Up until pretty recently, the shipping costs on these were so prohibitive that e-commerce didn't make sense for them. However, we are starting to see a new generation of "e-tailers" begin to overcome these obstacles and see a lot of success moving them online. Wayfair (W) is a prime example of this.

CNBC did a write up not too long ago, making a judgment on how protected against e-commerce 13 different retail segments are. I definitely recommend giving it a read.

Conclusion

Overall, the "brick-and-mortar" retail chain model is no longer that attractive for investment. The rise of e-commerce has led to far more convenient shopping experiences for customers, along with lower costs and easier logistics for the company itself. The retail model has never been a very good one for building durable competitive advantages, outside of a very few unique cases.

We've already seen e-commerce basically wipe out physical book stores (bye bye Borders), eliminate numerous electronic chains (so long Circuit City), slap several sporting goods chains (see ya Sports Authority), take down toy stores (Toys R Us), maul music and video stores (Blockbuster, Tower Records), and close more clothing and fashion retailers than we could begin to list here. New Internet-based companies are starting to make way into areas traditionally protected from e-commerce, like large items and grocery.

For these reasons, we think that store retailing as a whole is an industry sector to avoid when looking for investments.

Store retail is one to avoid, but what are some good "green dot" stocks to consider? Our green dot stocks are outperforming the market by an AVERAGE of 21% per pick! See them all by trying out our low-cost membership! Not ready to join yet? You can always follow the latest content through our FREE newsletter, and get a free report as well!