Want to Invest in Retail? Read This First

Growing up, I was lucky to have a parent who was knowledgeable about investing and wanted to share that knowledge with me -- who, at the age of 13, was not concerned with same-store sales figures. My father warned me often about investing in retail businesses. He said it was just a tough business to make any money in. Of course, many have figured out winning formulas when it comes to shopkeeping, but his words rang true overall: Retail is a tough business to run, and maybe even tougher to invest in. In today's retail landscape, riddled with technological disruption and shifting demographics, it's more important than ever to know the industry before taking a position. Here are some quick pointers for being a better retail investor.

The return aisle
Returns may be your least favorite part of the shopping experience, but it means everything if you are buying a piece of a retail company. Sure, same-stores sales and revenue per square foot are very important metrics, but let's look at the absolutes first.

They certainly aren't foreign terms to the stock picker -- return on invested capital, for instance. In retail, ROIC lets you know how much cash each store contributes to the company's bottom line. Obviously, you want your stores to cover the cost of creating them in as short a time as possible. Companies typically provide ROIC numbers for total stores and new stores opened, but be careful -- these numbers have the potential to be manipulated. Activist investor and CEO of Biglari Holdings Sardar Biglari has been in a drawn-out battle with Cracker Barrel (NASDAQ: CBRL  ) management over its ROIC numbers. In the company's last earnings statement, new stores were reportedly earning more than 16% ROIC. Biglari believes that number is actually around 3% after depreciation and administrative costs.

Usually you can trust the numbers provided, but you may want to do your own math just to make sure.

For new stores, investors want to see ROIC increasing in years following the opening year. If a store isn't adding more to the company's bottom line a year or two after it opened, there could be something wrong and you'll want to figure it out -- especially if the company is expanding. A bad ROIC can destroy shareholder value.

If you want a number that not only tells you a return on equity, but with debt factored in as well, look up the return on capital employed (capital employed being total assets minus current liabilities). ROCE  is a pre-tax measurement (ROIC is after-tax) of the performance of both equity and debt. It helps you look at the business from the owners' perspective.

So what other lovely metrics are there for measuring the strength of a retail business?

Asse(t)ss the situation 
Retailers are not typically the most asset-heavy businesses -- leave that to the industrials. But depending on what kind of store you are running, it could require some major square footage and equipment. For that reason, investors should be taking a look at the company's return on assets. The return on assets figure lets us know how much operating profit is coming from the company's assets, which in this case is mainly buildings, real estate, fixtures, etc. You can use the return on assets figure when comparing one company to another -- just make sure it's apples to apples. Michael Kors' ROA should not be the same as Home Depot's.

Return on assets gives you an idea of whether those stores are really worth all that shiny signage and floor space. Making a good impression on customers is crucial to keep them coming back, so having a nice store is great. But a store made of gold won't earn you the same.

Usual suspects
The numbers many people cite when evaluating a retail company -- same-store sales and sales per square foot -- are obviously very important. Naturally, stores need to keep growing if you want the overall company to rise in tandem. Sales per square foot are also telling, but need to be kept in check. Big Lots isn't ever going to have anything comparable to Apple's numbers -- it doesn't sell big-ticket items. You are better off using that figure internally rather than comparatively. For instance, J.C. Penney (NYSE: JCP  ) CEO Ron Johnson has been very encouraging regarding the company's new stores, which are limited in number at the moment but showing promising trends. The old J.C. Penney stores earn $134 per square foot. The new ones earn twice as much -- $269. If we extrapolate that number and hold all else constant, we are looking at a very appealing stock given the basement-level valuation.

See how easy that was?

In conclusion 
Financial metrics are a crucial part of any reasonable stock analysis, but they all have their drawbacks. Use these metrics as part of a balanced analytical diet. Don't forget to do the less pencil-pushy stuff: listening to management, talking to customer service representatives, or counting how many people walk in the store every day. All together, these elements will help you build your case for or against a company.

The best part is, it requires nothing greater than some eighth-grade-level math. Take that, H.B.S. students!

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