Wednesday, June 15, 2016

How to select winning retail stocks

While I am a buy and hold passive investor, I also try to regularly monitor the companies I own. I usually review the investments I have made once every 12 – 18 months. In addition to that, I often review past decisions I have made, in an effort to improve my investing over time. I also monitor my shareholdings, when they announce a dividend raise.

A couple of weeks ago, Lowe’s (LOW) raised its quarterly dividend for 55th consecutive year in a row. The company raised its quarterly dividend by 25%, to 35 cents/share. Lowe’s Companies, Inc. (LOW) operates as a home improvement retailer. It offers products for home maintenance, repair, remodeling, and decorating.

The latest increase extends the company’s dividend streak to 55 consecutive years. There are only 18 companies in the world, which have managed to raise dividends for over 50 years in a row. I coined the term "Dividend King" in 2010 to describe companies which have managed to grow dividends for at least 50 years in a row. This is an impressive track record, which is something that smart investors study.

Somehow, I have managed to make a lot of money on Lowe’s – the stock has almost quadrupled from my purchases at the beginning of the decade. I have had a lot of success in other retail stocks, such as Family Dollar (FDO), Casey’s (CASY), Walgreens (WBA). Other winning retail investments for dividend investors in the past have been Wal-Mart (WMT) and Target (TGT) and Home Depot (HD). I would discuss a few retail investments I believe could do well over time.

It is possible that I have been lucky beneficiary of the long bull market we have had since the Global Financial Crisis. But I am surprised that I have been making money off retails stocks, despite the common consensus that retailing is a difficult business. After researching winning retail investments I had made I uncovered a few common traits behind success. I believe that those lessons could be helpful to readers, which is the reason I am sharing them with you.

As I have analyzed certain winning retail investments I have made, I have uncovered a common trait that could explain future success. This common characteristic also works in reverse to uncover companies which may be in for a decline.

Many believe that what happens in the economy, markets, stocks is unpredictable. I agree with this assessment to a certain degree. However, after studying a lot of successful businesses, I have come to disagree on a portion of them.

For example, the winning formula for winning retail investments has always been:

1) Creation of a new and unique retail concept
2) Expansion of this concept across the US and the world
3) Making sure that the investor does not overpay dearly for the investment

The common success denominator behind a winning retail investment was growth in number of retail stores. As the company also manages to grow same-store sales, you have the power of compounding in turbo-charged mode.

The same formula by the way could be used for companies like restaurant industry too. McDonald's (MCD) is one such beneficiary of this trend.

In the case of Lowe’s, the company has been able to succeed by expanding the number of stores from 15 in the late 1950s to 1857 by 2016.

The company had less than 50 stores and roughly $100 million in revenues by the late 1960s. In 1971, the company operated 75 stores in 12 states, which generated annual revenues of $170 million, and earnings of $6.5 million. By 1979, the company had roughly $900 million in annual sales coming from 212 stores in the South Atlantic and South Central States. The company generated almost $25 million in annual profits. Ten years later, Lowe’s operated 307 retail stores in 20 states that generated $2.8 billion in sales and a net income of $71 million.

By 1999, Lowe’s had 484 stores in 27 states which generated annual sales of $12.2 billion and a profit of $484 million. Five years later, Lowe’s had 952 stores in 45 states, generating over $36 billion in annual sales. The number of stores hit 1710 by the end of 2009, and the amount of sales reached $47 billion.

The fact that the company was growing those stores in the US, and the fact that it was starting to expand in Canada and Mexico were some of the reasons I bought the stock several years ago. I liked that the company was starting a joint venture to tap into the Australian market ( Note: in 2016 it decided to exit the joint venture) I also liked the fact that DIY home owners would need to buy things from Lowe’s or Home Depot (HD) in order to renovate their homes. I especially liked the attractive  valuation at the time, and the decent entry dividend yield. Last but not least, I liked that the company was increasing the amount of dividends paid to shareholders.

When you have a store concept that works, you can copy that concept and apply it with minor tweaks in different markets. It is also important to avoid growing too quickly – you do not want to open too many new stores in an unproven location. If your concept is applied at a small test scale in a new market, and it works fine there, you need to keep opening new locations. As the number of stores increases, you also get economies of scale. The more stores you have, the higher the value of your brand.

Speaking of economies of scale, and chain stores expanding, you may like the following Charlie Munger quote from a speech he made a few years ago:

On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power—which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.

If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he’s going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.

The reverse is demonstrated by the little store where one guy is doing all the buying. It’s like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, “You must sell a lot of salt.” And he replies, “No, I don’t. But you should see the guy who sells me salt.”

So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise.”

In his book "One Up on Wall Street", Peter Lynch had similar observations:

"The same thing happened to Taco Bell in the fast-food business, Walmart in the general store business, and The Gap in the retail clothing business. These upstart enterprises learned to succeed in one place, and then to duplicate the winning formula over and over, mall by mall, city by city. The expansion into new markets results in the phenomenal acceleration in earnings that drives the stock price to giddy heights."

So as you can see, when a retailer is expanding from a few stores to a lot of stores, it can grow revenues, and earnings by a lot. There are efficiencies realized, scale, which decreases per unit cost and increases profit.

In the case of Lowe’s the rate of store growth has slowed down considerably. The number of stores grew from 1710 in 2009 to 1857 stores in 2016. But earnings per share have tripled since I first profiled the company in 2010. The company has been spending a considerable amount of money on share buybacks, as the market in the US may be saturated at the time. The company is also exiting its joint venture in Australia, and hasn’t really expanded as quickly as in the past. So unfortunately, future returns may not be as stellar as in the past. I will continue holding on, and monitoring onto the investment.

They do have the opportunity of expanding internationally, and utilizing a strategy of growing online, with the store infrastructure supporting the receipt of those items by customers. However, once Lowe's stops growing the store base and even starts announcing closing of certain locations, it is quite possible that we may be starting to witnessthe decline of the retailer.

I have noticed that retailers that stop growing retail stores in the past, are essentially showing you they are in decline.

Kmart was a retailer which was growing quickly for several decades, until it stopped growing and started reducing the number of stores. The original company was S.S Kresge, which started the Kmart discount chain in 1962. By 1980, there 2069 stores (KM and Kresge names) with $12.9 billion sales and $358M in net income. In 1990 we had 4176 stores ( 2351 gen merchandise and 1825 specialty retail) with $32 billion in sales and $756 million in net income. By 1995, the company had been able to grow dividends for 31 years in a row. There were problems on the horizon however, as Wal-Mart was eating Kmart’s lunch.

The company had sold its interests in Office Max and Sports Authority in 1995, and also had an IPO of Borders that same year. It sold its Mexican joint venture and Canadian operations in 1997. It also has sold Pa yLess Drug Stores and PACE Warehouse club. In addition, it had closed 214 retail stores in 1995 that were underperforming. The company eliminated its dividend in 1996 – which was when investors should have sold out.

By 1998 Kmart had $33.7 billion sales, $518M in net income and 2161 retail outlets. In 2001, the company filed for bankruptcy protection, wiping out its shareholders in the process. This story is one of the reasons why I sell after a dividend cut - in order to preserve my hard earned capital and to make sure I do not make irrational decisions because I have fallen in love with a company.

As an investor in Target, I have noticed that the number of stores has not been growing by much since reaching 1740 locations in 2009. Currently Target has 1792 locations. A couple of years ago the company also had 124 stores in Canada. Unfortunately, this expansion failed. This is an interesting example on the point I was making above that a concept has to be rolled out slowly at first, in order to determine the tasted of the new segment. Only after the concept is perfected in the new territory, should the company start rolling out new locations and grow that number more aggressively.

Now the number of stores seems to be decreasing. While the retailer should likely do fine over time, I am monitoring the number of stores closely. If they cannot grow the number of stores, Target stock would most likely be a hold. This means that unless I find it selling at very low valuation, I would not consider adding to my position in the stock. I would also be monitoring if they start cutting the number of “underperforming stores”. Without new stores, future revenue and earnings growth would be more difficult to achieve. This would mean that the high dividend growth in the past may not be repeatable. As we know, dividend growth is dependent on growth in earnings per share.

It looks like Target (TGT) and Wal-Mart (WMT) have slowed down at the rate at which they growing their number of stores. It makes sense that a company like Wal-Mart with over 11,527 locations worldwide may have difficulty growing, relative to a company with a lower number of stores. As a long-term investor, this means that future growth in earnings and dividends may not be as robust as in the past. However, it is quite possible that online sales changes things a little bit. That being said, investors need to be on the lookout for the changes in number of retail stores, for the companies they own. If the number stalls for too many years, further net income gains may be limited. A company can still try to squeeze in some extra profit over time even with a fixed number of locations of course, and same store sales could grow a little over time as well. A company could also repurchase shares in order to boost earnings per share as well. However, it could be easier to grow earnings per share if the company does all those items listed above, and grows the number of stores.

Of course, the company with the lower number of store locations may still be an untested concept which has a higher failure rate. As we mentioned above however, the development and proliferation of online sales could allow retailers to expand the level of sales without growing the number of retail locations available. On the other hand, online sales are feared to be destroying the traditional retail business model. I personally believe that the companies which survive will adopt a blended approach to retail, where you have sales at a physical location, coupled with sales at an online one ( which also increases the convenience factor for customers who can order online and pick up at the store)

I still think it is possible to see companies expanding at this day and age however. There are some stores which keep expanding. However, it is important to avoid overpaying for them, since this could reduce forward returns and future yields on cost. A few companies I am monitoring include:

The TJX Companies, Inc. (TJX) operates as an off-price apparel and home fashions retailer in the United States and internationally. It operates through four segments: Marmaxx, HomeGoods, TJX Canada, and TJX International. The company has 3661 stores as of fiscal year 2016. TJX Companies expects that the number of stores under its umbrella could eventually reach 5600. While store saturation in the US is a potential risk, international expansion could bring a source of growth for years ahead. The company has raised dividends for 20 years in a row. Currently, it is overvalued at 22.10 times earnings and yields 1.40%. I would consider adding to the stock on dips below $70/share. Check my analysis of TJX for more details about the company.

Ross Stores, Inc. (ROST), together with its subsidiaries, operates off-price retail apparel and home fashion stores under the Ross Dress for Less and dds DISCOUNTS brand names in the United States. Ross Stores has managed to grow operations rapidly, and still has room to expand its geographic reach. Of those stores, 1295 are under the Ross Stores brand and 178 are dd’s Discounts brand. The company expects that it would ultimately be able almost double stores in the US ( 2000 Ross Stores and 500 DD discount Stores) The company has raised dividends for 22 years in a row. The stock is selling at 19.80 times earnings and yields 1%. Check my analysis of Ross Stores for more details about the company.

Casey’s General Stores, Inc. (CASY), together with its subsidiaries, operates convenience stores under the Casey’s General Store name in 14 Midwestern states, primarily Iowa, Missouri, and Illinois. The company has raised dividends for 17 years in a row. It tries to open between 75 – 100 stores per year, either by building them or acquiring them. This is from a base of roughly 1931 locations throughout the US. The stock sells at 20.50 times forward earnings and yields 0.80%.

Starbucks Corporation (SBUX) operates as a roaster, marketer, and retailer of specialty coffee worldwide. The company operates in four segments: Americas; Europe, Middle East, and Africa; China/Asia Pacific; and Channel Development. The company would likely be able to open approximately a net number of 1,500 stores annually over the next decade, which is a high level of growth of the 23,000 stores it has worldwide.

The company has raised dividends for 6 years in a row. The stock is overvalued at 29 times forward earnings and yields 1.50%. If Starbucks ever stumbles upon some short-term problems, this could be the time to initiate a position in the company. Check my analysis of Starbucks for more details about the company.

Costco Wholesale Corporation (COST), together with its subsidiaries, operates membership warehouses. The company offers branded and private-label products in a range of merchandise categories. The company has raised dividends for 13 years in a row. It is expanding at a rate of 20 – 30 stores per year. There were 698 stores at the end of 2015. Of course, everyone knows about Costco today - the stock is overvalued at 29 times earnings and a yield of 1.20%. If this company ever stumbles, and sells below 20 times earnings, this would be a good time to initiate a position.

Full Disclosure: Long CASY, TJX, ROST, TGT, WMT, LOW, WBA, MCD

Relevant Articles:

Buying Quality Companies at a Reasonable Price is Very Important
How to value dividend stocks
The most important metric for dividend investing
The advantages of being a long-term dividend investor

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