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Stock analysts have used the same metrics to assess retail stocks for as long as I can remember. After reading a report from a retail industry website, however, I question whether we've been looking at the wrong metrics all along.
After briefly examining the traditional retail metrics, we'll turn our attention to the one statistic that has produced market-smashing portfolio returns. I'll then provide a link to a free report detailing the handful of retailers that are growing revenue despite the ongoing economic malaise.
The old school
As I discussed in a recent column, investors traditionally rely on three metrics to make buying and selling decisions in the retail industry.
The first is same-store sales growth, sometimes referred to as "comp" sales. This compares sales from existing outlets to identical periods in the past, most often annually, allowing you to isolate revenue growth from improved operations (what's known as "organic growth") as opposed to revenue growth from new stores. In the second quarter of 2011, for example, lululemon athletica (Nasdaq: LULU ) reported same-store sales growth of an astounding 20%.
The second is gross margin, which indicates both potential profitability and brand power. It's the amount of each dollar a company keeps after paying its sales costs -- including the cost of the goods themselves. On one end of the gross margin spectrum are Apple (Nasdaq: AAPL ) and Select Comfort (Nasdaq: SCSS ) , which regularly report gross margins of 40% and 60%, respectively. And on the other end of the spectrum is Costco, an equally compelling business but with gross margins closer to 12%.
The third statistic is free cash flow, which is the difference between operating cash flow and capital expenditures. The luxury goods retailer Coach (Nasdaq: COH ) provides an example of healthy free cash flow, growing it from $638 million in 2007 to $885 million in 2011.
The new school
Although these metrics are unquestionably important, none of them address productivity, the metric I've found to be the most accurate at predicting retail stock performance. The rationale for my opinion is illustrated in the following figure, which in part replicates the results of a report by Retailsails.com.
Source: Retailsails.com and Yahoo! Finance.
As you can see, the return on an equally weighted portfolio of the 10 most productive retailers in terms of sales per square feet (32.2%) beat the returns of similar portfolios containing the 10 fastest-growing retailers over the last year (17%) and the 10 most productive retailers in terms of sales per store (11.4%).
Beyond this, it smashed the 7.9% return of the SPDR S&P Retail ETF, which seeks to replicate the performance of the overall S&P Retail Industry Index.
Consequently, the best investments according to this metric are companies like Apple and Vera Bradley (Nasdaq: VRA ) , which are both growing in size and highly productive in terms of sales per square foot, as opposed to companies such as Cabela's (NYSE: CAB ) and Under Armour (NYSE: UA ) , neither of which is in the top 10 with respect to sales per square foot.
The foolish bottom line
Although I haven't found a crystal ball to predict the future returns of retail stocks, I have found that a chain's productivity per square foot is one of the strongest indicators of past success.
If you're interested in retail stocks and want to read more about them, I urge you to check out our free report detailing the handful of retailers that are currently growing revenue despite the ongoing economic troubles. To get your copy while it's still free and available, click here.