Many of the best investors agree that checklists can help you identify the most attractive profit opportunities and -- maybe even more importantly -- avoid costly mistakes. In that spirit, here is a 10-point checklist that can help you uncover the retail stocks that are most likely to deliver handsome rewards in the years ahead and help you stay well clear of the companies liable to cause painful losses.
1: Is this business Amazon-proof?
If the answer to this question is no, I urge you to run -- don't walk -- away from the retailer in which you're considering investing.
Amazon.com (AMZN -1.89%) is a juggernaut; an annihilator of less-competitively advantaged retailers both large and small. With the philosophy that "Your margin is my opportunity," CEO Jeff Bezos is relentless in the pressure that he puts on Amazon's rivals via his company's low prices, unmatched selection of goods, fast and often free shipping, and excellent customer service. It's a value proposition Amazon's competitors can't match -- and a powerful competitive moat that Bezos continues to widen as he expands Amazon's reach into more and more areas of the retail industry.
So if the retail stock you're considering competes with Amazon or is likely to do so in the future, you may wish to steer clear and move on to another investment with a less dominant competitor.
2. Market opportunity
How large an industry does the retail stock you're evaluating reside in? How much market share can it legitimately hope to obtain? And how far along its growth curve is the company? These are some of the questions that can help you estimate the current and future growth potential of a retail stock.
In addition, the managers of retail businesses will often share a long-term store count goal with investors. Do you believe that goal is attainable? Is it attainable in the time frame that management has suggested? If not, you may wish to avoid investing in the company, because if management's growth forecasts are overly optimistic, the stock could be headed for a fall.
On the other hand, if you find a young business with a large market opportunity and a long runway for growth still ahead of it, you may have found an investment opportunity that will allow you to profit for years -- and even decades -- to come.
3. Unit economics
In order for a business to be sustainable, it must posses strong unit, or store-level, economics. For example, investors can sometimes be blinded by the tantalizing growth of a hot new franchise concept. But if the parent company is earning the majority of its revenue and profits from selling new franchises, equipment, and/or supplies to its franchisees -- and those franchisees themselves are failing to see strong returns on their investments -- the whole business will ultimately collapse. The franchisees will flee the concept for greener pastures, and the company's growth and financial situation will deteriorate rapidly. As such, the profitability of individual retail stores is of paramount importance.
4. Same-store sales growth
If the company is growing its unit count, but same-store sales are flat -- or even worse, have turned negative -- it could be a sign that a retailer has saturated its market and has begun to cannibalize sales of its own existing locations. If the market is pricing in years of steady growth when this occurs, look out, because the stocks of retailers that disappoint Wall Street in regards to comp growth are often crushed as investors reset their expectations.
5. Disciplined growth
If a retailer has a large market opportunity, attractive unit economics, and is reporting solid increases in same-store sales, the company should be producing respectable revenue growth. But is it disciplined growth?
Overeager management can sometimes place their foot on the pedal too hard and expand too quickly. Examples include opening stores more rapidly than can be supported by the business's operational staff or taking on too much debt.
Far better is a management team and company culture that supports disciplined growth. For instance, a retailer that chooses to fund its store count expansion via its operational cash flow is in a much stronger financial position than an overleveraged competitor should a severe recession take hold. The disciplined retailer can usually choose to simply slow its expansion if its cash flow decreases during the downturn. The highly indebted rival, however, may not be able to meet its interest payments and could be forced into bankruptcy by its debtholders.
6. Margin expansion
Growing retail businesses often benefit from operating leverage. Basically this means that as these companies' sales rise, their profitability improves. That's because as these businesses increase their store counts, they're able to spread their fixed costs over a larger revenue base. Improving operating margins are therefore a key metric to watch when it comes to a growing retail company. Contracting margins should be investigated; an explainable, temporary dip may not be cause for concern, but a long-term trend of declining margins is a major red flag and could be a sign of a deteriorating business.
7 & 8. Happy employees & quality leadership
These two go hand in hand, as great leaders understand the importance of taking care of their employees. Happy employees tend to treat customers well, which can boost sales. And low employee turnover can reduce hiring and training costs, thereby improving profits.
A great resource that can help you gain insights in these areas is anonymous-rating site Glassdoor.com. The website allows current and former employees to rate management and offer feedback on the company's culture and future outlook. It's this type of qualitative analysis that can often give you an advantage over strictly quantitative-focused investors.
9. Ability to innovate and adapt
Does this retailer constantly strive to improve its customers' shopping experience? Is the company delivering creative new products and improved versions of existing goods and services? Has the business demonstrated an ability to anticipate new trends and adapt successfully to changing consumer preferences? If the answers to these questions are no, then it's likely only a matter of time before this retailer is disrupted -- and ultimately eradicated -- by more innovative competitors.
10. Do you want to shop there?
Some investors may say this is an unnecessary question, and that it's possible to find attractive investments in areas outside of our personal interests. That may be true, but "buying what you know" can give you an edge.
If a retailer sells goods and services that you use and enjoy personally, it will make it much easier to monitor the company's performance. You'll know -- potentially even before Wall Street -- whether the quality of a company's offerings is improving or deteriorating.
And if the business operates in an area that's a passion of yours, you may see important industry trends before other investors. That's highly valuable information that can help you identify opportunities and protect you from sizable losses.
So is making this question -- whether or not you shop at a retailer -- a part of your investment checklist necessary? That's for you to decide. But I urge you to consider the advantages and disadvantages of doing so.
10 signs of a great retail investment
If you find a stock that matches up well to these 10 criteria, you may have a potential winner on your hands. Additionally, perhaps an even more valuable use of this checklist is to help you stay clear of retail businesses that are on a path to oblivion, thereby preserving your hard-earned capital for more lucrative opportunities.