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The landscape of retail, as we know it, has certainly changed in recent years. A changing landscape,and increased competition, has made it harder than ever for brick-and-mortar stores to turn a profit. So while traditional retailers like Bed Bath & Beyond (NASDAQ: BBBY ) , Gap (NYSE: GPS ) , and Foot Locker (NYSE: FL ) look cheap, how do we know they're not just value traps?
It's a new retail world, and we need new rules for retail value. Before you buy any retail value stock, make sure it meets these criteria.
The new rules of retail value
Rule No. 1: Choose a screening method based on both value and quality.
Most value investors use a screening method of some sort to find cheap stocks. Bed Bath & Beyond, Gap, and Foot Locker meet my criteria.
When it comes to value, I like Joel Greenblatt's "magic formula," or something similar, for individual investors. The formula aims to find cheap stocks that are also performing well, by finding the best combination of price and returns on capital.
For my screen I've used price-to-earnings and return on equity, since they're more readily accessible for most investors, and produce very similar results. Bed Bath & Beyond has a P/E of 15, and ROA of 17% versus an industry average of 10%. Foot Locker has an ROA of 12.28% and a P/E of 13, while Gap has a P/E of 15 with an ROA of 16.62%.
In each case these stocks did not have the cheapest P/E among their competitors, and that's what makes this screening vital for "new retail." It found the stocks with above-average rankings in both price-to-earnings and return on assets. That latter part, how the business is actually doing, must be accounted for.
Rule No. 2: Retailers need to exploit an "illusion of choice".
I feel that retailers with multiple businesses and product lines add value and security to your portfolio. Take Gap, for instance; it also owns the Old Navy and Banana Republic brands, among others. Still, the average consumer may very well think they're "choosing" Old Navy over Gap, but the money is all going to the same place. I like to think of this modern moat as an "illusion of choice." That's also the case with Foot Locker, which owns Champs, they seem like competitors but they're one in the same.
Foot Locker and Champs compete in the exact same space, and that's actually an advantage; it's ideal to have multiple brands in one space, because it lessens the volatility risk of consumer tastes, which is enormous in apparel.
Rule No. 3: Retail stores must offer a unique buyer experience.
Let's face it, we can buy most things online for a cheaper price than we would in person. For that reason alone, I prefer stores that offer a truly unique buyer experience, and I'm afraid to own retail businesses that compete on price alone. This is where Bed Bath & Beyond separates itself from most retailers.
Bed Bath & Beyond has always seemed to me like a place that Batman's Bruce Wayne would shop at. It has every "toy" that you could think of, from massage chairs to Icee makers, and you get to test them out in person. The novelty effect of its namesake stores, and World Market, for that matter, offers a really fun experience for most buyers.
Rule No. 4: Organic growth rules.
In their most recent quarters Bed Bath & Beyond and Foot Locker both showed comparable sales gains, of 3.7% and 1.8% respectively, and Gap's comparable-sales growth grew over 5% in its most recent showing. Same-store sales are usually a result of rules 1-3 working, but you can't have a true retail winner without them.
The most troubling red flag a retail business can show, is if they're expanding in the face of declining comparable sales. While declining comparable sales are bad alone, an ownership team that tries to placate investors with new stores and unhealthy EPS gains is flirting with disaster.
Ultimately you want retailers that are growing due to delighted customers, not reckless over-expansion.
Foolish thought: Invest in the new world
These days the retail world is tougher than ever, with stiff competition from every angle. To thrive, retailers need to offer unique experiences, exploit the "illusion of choice," and grow organically, and that's just the start. All three of these stocks shine in these areas, so intangibles will ultimately determine if you should buy or not.
These rules are the result of one thing: customer satisfaction. Comparable sales growth, and return on assets, are simply the results of many satisfied customers. So while these rules will lead you to promising stocks, you should only "buy" if a company passes the most important rule of all; if you can't imagine a "tomorrow" where people buy less of its product than "today," then you should buy the stock.
Retailers who will rule the new world
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.