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Investing in the stock market is a difficult process, and success often comes with a good dose of risk. Throw in the hundreds of sectors and the overload of information available out there, and it’s easy to see how one can get bogged down, and ultimately make an ill-advised investment decision. Here, we focus on the retail sector, and discuss what’s important to know when evaluating these types of equities. Indeed, understanding the retail business and certain key terms specific to the sector can make a world of a difference.

On a broad scale, the performance of retailers—from specialty merchants that make and sell their own line of goods to large department stores and discount chains—is often influenced by a variety of economic factors. One such factor is consumer confidence, a key barometer of the public’s sentiment on the economy and its direction. The statistic essentially provides insight into future spending activity. Equally important are consumer spending (consumption) trends, given their substantial impact on virtually the entire industry.

There are other elements investors should be mindful of when assessing retail equities. Same-store sales, comparable-store sales or comps (used interchangeably) are perhaps among the most significant terms to become familiar with. Unlike total sales, which include all receipts generated from new and established stores, comp-store sales refer to sales from shops open for at least one year, and are typically released on a monthly or quarterly basis. The metric helps to determine what portion of sales growth comes from existing locations as opposed to newly opened units.

Observers pay close attention to this number and its year-over-year trend (expressed as a percentage), as it can move the needle on a stock, quite drastically at times. Although factors such as shifts in the timing of a holiday and weather-related issues can skew year-over-year comparisons, a consistent upward or downward pattern speaks volumes about how well a retailer is faring. Keep in mind, though, that it’s not unusual to see comps moderate as retailers mature. Of course, having trend-right fashions in place also has a direct impact on comp trends.

The Gap (GPS), for instance, saw its shares soar through the 1990s, as the company’s line of denim and preppy casual apparel grew popular among young adults. But the stock has gradually lost steam over the past decade, or so, largely reflecting a saturated domestic market and fashion misses along the way. Similarly, both Quiksilver (ZQK) and Pacific Sunwear (PSUN) have experienced sharp share-price declines in recent years after successfully riding the wave of board-sports inspired fashion for some time. Indeed, these teen retailers enjoyed hearty top- and bottom-line gains as their store bases grew rapidly and their fashions took off. But fundamentals have since weakened amid a market filled with such apparel.

Gross margins can be telling of a retailer’s health, too, as they provide clues on the efficiency of operations and on the effectiveness of a company’s pricing strategy. A healthy retailer will strike a balance between full-priced selling and discounting (promotional pricing) to keep inventories moving and the gross margin in sound shape. Rising inventory levels and a narrowing gross margin are red flags, though. In general, the higher the gross margin, the better a retailer can cover such fixed expenses as SG&A and interest costs, which benefits profits.

A merchant’s store count ought not to be ignored either. That goes hand in hand with square footage, which is used to calculate the sales per square foot, a measure of the success of store selling space. In fact, from these numbers, an investor can learn about the size of a retailer’s market position and where it is headed. A rising trend indicates growth of the business.

Consider Chico’s (CHS). Shares of the Florida-based women’s apparel retailer peaked during 2005 and 2006, as the business flourished. But Wall Street eventually punished the stock, after a series of fashion missteps and aggressive store expansion gave way to weak sales and profit declines. Management changes and adjustments to the business strategy have since enabled the company to recover and the stock to regain its stride.

Investing in the retail sector can surely add some excitement to a portfolio. But while there are quite a few opportunities in retail that seem rewarding, investors should realize that equities in this industry come with some degree of risk. For those interested in gaining exposure to the sector, developing a good understanding of how the retail business operates can certainly help in making wiser investments moves. With its vast coverage of retailers and in-depth analysis, the Value Line Investment Survey can indeed serve as a solid guide.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.