Investing in the Retail Sector

The retail sector -- which includes all types of stores that sell goods directly to consumers -- has been through some major upheaval over the past few years. The internet, specifically (but not only), Amazon (AMZN +0.55%), has changed consumer behavior and led to what many have called the "retail apocalypse."

Whether or not you agree with the theory of a "retail apocalypse," it's tough to argue that the emergence of the internet didn't create a retail shakeout. Traditional retailers that refused to address changing consumer demands spurred by the internet -- including ordering, low-cost or even free shipping, and easy returns -- have generally suffered or went out of business, while chains willing to adapt and emerging digital innovators have found success.

Investing in retail offers significant opportunity even though many retailers continue to struggle. In 2017, Consumer Discretionary spending stocks returned 22.7%, which was good for the fourth-highest sector return, and better than the S&P 500 (21.83%) and an all-sector (18.27%) investing strategy. Though, the second sector that includes retail spending, Consumer Staples -- which are essential products including food and other household goods -- came in well below those numbers at a 12.92% return, according to data from Sectrspdr.com. 

Within the sector, there are emerging players with room to grow, established brands that have adapted well to changing market, and struggling veterans that may still be able to right their ship. Retail has most certainly changed. Consumers no longer have to go to a store to buy something, and the existence of the internet, along with the growth of fast shipping, has reset expectations. If a store does not offer reasons beyond merchandise for people to visit, in many cases, they won't. Although the shake-up has been tumultuous for the industry, opportunities abound for investors.

Amazon has changed everything

You can't discuss retail investing without talking about how Amazon has shaped the marketplace. The online leader raised the bar when it comes to pricing and convenience. The "always-on" nature of the internet -- where a consumer can order at 3 a.m. or 3 p.m. and have the item in a day or two -- has forced major retailers to follow suit by offering the same level of service on their own e-commerce channels.

Amazon created the expectation of two-day shipping on nearly every item imaginable, and at a good price through its Prime membership. Prime, which offers two-day shipping as well as other perks for $99 a year, ties customers to the online leader. Once someone signs up for Prime, they become more likely to order from Amazon both because of the free shipping and in order to make their outlay of the $99 annual subscription worth it. The added perks of Prime -- including Prime TV, Prime Music, Prime Day (a day of sales that only Prime members can access) -- help to create a "sticky ecosystem" that is hard for customers to leave.

Brick-and-mortar chains were initially slow to adapt, leading to an unprecedented amount of bankruptcies, store closures, and many retail stalwarts saw their market value drop precipitously. Over the past three years, J.C. Penney has lost nearly 65% of its market value and Nordstrom almost 50%.  That is beginning to change, however, as chains are finding ways to adapt and even thrive.

In order to remain viable, veteran retail operations are migrating to an omnichannel model.

The omnichannel model

An omnichannel is the idea that a store and its digital operations will essentially operate as one sales channel. That means consumers can order online and pick up in store, buy online and return in the store, or any combination that works for the customer.

It's a customer-friendly model that has been successfully adopted by a number of retailers. Chains such as J.C. Penney's, Nordstrom, and even Dicks Sporting Goods, have embraced this approach so that they can leverage their brick-and-mortar presence to support their digital offerings and vice versa.

The logistics

Operating an omnichannel market involves huge changes in operational logistics. Traditional retailers have needed to change their supply lines to go from exclusively supplying stores to being able to ship individual orders as well. That's not a small shift and it's not an easy one to pull off in a cost-effective manner.

Big-box retailers such as Walmart and Target have led the way in doing this. Both have invested heavily in logistics and have made acquisitions to aid in the transition. Often, they use stores as distribution points to ship individual orders and are beginning to train in-store staff to offer support for online orders.

Delivery, of course, is a huge expense, and retailers have had to work to make their process as efficient as possible. This has included making in-store pickup attractive and easy, with methods like Target's curbside pickup and Walmart's in-store pickup kiosks, as well as working to maximize warehouse efficiency.

The most challenging part of the logistics puzzle is what's known as "last-mile delivery." That's a more-or-less literal term that describes the challenge of getting orders from a truck or shipping facility to a consumer's home. The cost benefits of grouping shipments together diminish the closer you get to the consumer's house as the number of packages you can group gets smaller. A number of services exist to facilitate last-mile delivery -- including Instacart and Shipt, which Target owns -- and new technology continues to be tested to solve the problem, such as Amazon's foray into drones.

It takes more to bring consumers to stores

Perhaps the biggest change the rise in e-commerce has brought about is reducing retail traffic. It used to be that stores were a destination in themselves. When you can order most things -- everything from clothes and groceries to furniture -- from your phone through platforms that are open 24/7, you have less of a reason to leave the house.

That led to a general decline in mall traffic, and it also forced retailers to make their stores destinations. For example, you may not go to Best Buy to buy a cable, but you may buy a cable at Best Buy when you go there to consult with Geek Squad, its home-services division.

In order to stand out, some chains have mixed in services that can't be purchased online, for instance, Ulta, the beauty retailer, includes salons in its stores. Others have added store-within-a-store concepts like J.C. Penney bringing in Sephora shops or featured brands through pop-up (temporary) displays that only last a limited time.

Retailers have also sought to step up their in-store expertise. When you visit a Home Depot or a Lowe's the staff can assist you in person in a way websites can't.

Retailers and malls are also getting clever in adding dining and entertainment options. Everything from trampoline parks to gyms and destination restaurants have appeared in vacant mall spaces -- backed partly by the idea that having non-retail options will bring people to shopping centers and drive store traffic.

What metric matters most?

Traditionally, retailers have been judged largely on whether they can increase profits and if comparable-store sales have grown. Profit, of course, remains a cornerstone of success, but heavy investment in infrastructure can drag down short-term earnings in order to maintain long-term viability.

Comparable-store sales measures sales growth from a company's stores that have been open for at least a year. That allows investors to track the performance of brick-and-mortar locations over time. 

It's an important number because overall revenue across a company can be deceptive. Let's say a chain had 100 locations and opened 10 more. Sales from the new stores may push the total revenue number higher, but if sales at existing stores fall, the chain may be cannibalizing its own sales or the company has a product line that has gotten less successful in existing locations.

Comp sales remain important in the digital age, but it has become more nuanced. For example, if Walmart or Target post flat same-store sales, but grow overall revenue by increasing digital sales, that's still a success because stores maintained their overall sales rate while overall revenue grew.

As an investor, same-store sales can be important but that doesn't mean you shouldn't look at the overall revenue and expense picture. In an omnichannel market, brick-and-mortar locations participate in digital sales in a way they may not get credit for -- either as distribution points or showrooms. 

The market is not always logical

It's important to realize that the stock market doesn't always react logically to earnings results, especially when industries have -- for a long time -- been measured against a particular metric. Sometimes, at least in the short-term, a chain will see its stock suffer if it under-performs in same-store sales, even if digital growth has more than made up for that.

Conversely, Wall Street analysts are now laser-focused on traditional retailer's reinvention into omnichannel operators. Walmart recently saw its stock punished when it posted a slower-than-expected rate of digital growth. It did not matter that the chain had grown comparable-store sales, increased traffic or that it remains on track with its omnichannel transformation. As a long-term retail investor, it's important to look at the underlying numbers and ignore any short-term reactions.

Amazon-proof stocks

So far there is one area of the retail market that has not been impacted by Amazon and the rise of online shopping. Heavy discounters, specifically companies like Dollar General have thrived. This chain has been growing by about 1,000 stores a year, and its clientele and merchandise mix give it protection from digital retailers.

Dollar General is also an example of a retailer that is not benchmarked by same-store sales increases. Each store serves a local market and that gives it a ceiling for sales, but the company has opportunity for growth in the future by expanding into new markets.

Discounters have succeeded for two reasons. People generally don't want to wait two days for certain items. (If you need paper towels, you probably need them now.) Second, chains like Dollar General or even a warehouse club like Costco have ever-changing merchandise.

That makes a store a destination. You go to a discount store or a warehouse club partly because you need something, and partly to see what they might have.

Lowe's and Home Depot, as mentioned above, have been Amazon-proof largely due to the service they provide and the nature of the merchandise they sell. If you are buying a lighting fixture, for example, you may need help knowing what to buy and you might want to see it in person.

Who should invest in retail?

The retail sector offers an opportunity to invest in companies that you might buy things from regularly.

Retail is a segment where both novice and experienced investors can participate. It's a market that's easy to understand, and while there are some nuances, this is a space where you can follow the "invest in what you know" credo.

In addition, the retail market has both emerging companies for growth investors and stable brands that would appeal to income investors.

Growth investors might like...

Growth investing is investing in companies that you expect will grow a lot in the future, and you often pay a premium for them. These stocks often have attention from analysts that sometimes belies the size of the company.

These type of stocks tend to be companies that are not yet making a profit but they are building scale. Amazon certainly would have qualified. Essentially, investors of this type are betting on potential and that fast growth will eventually lead to a scale where profits follow.

An example of a top retail growth stock would be Shopify, which isn't a retailer but rather a company that offers a digital platform for retailers to conduct their digital business. It's a fast-growing business that delivered $673.3 million in revenue in 2017, a 73% increase over the previous year. On the flip side, the company also lost $40 million during 2017.

Shopify's business is based on a subscription model, and as it builds out more features for its customer base it becomes increasingly difficult for them to leave. It's a daunting task to move your entire digital presence, as well as all the back-end services Shopify offers, to another provider. The company forecasts that its fast growth will continue coming in at $970 million to $990 million, though it also expects losses to more than double to $95 to $100 million.

Income investors might like...

In addition to growth opportunities, retail also offers a chance to invest in well-established companies that offer income in the form of dividends -- a distribution of a portion of a company's earnings to shareholders. In fact, the sector houses a number of dividend aristocrats, members of the S&P 500 index that have had a minimum of one dividend increase annually for at least the last 25 consecutive years.

The future of retail

Retail is becoming an area where you can indirectly invest in technology. Retailers, at least the big ones, are practically as much tech companies as they are retailers.

Amazon is pushing certain innovations like eliminating cashiers in stores and potential drone delivery. Walmart and Target have followed with investments in those spaces as well as technology to improve both the in-store and online shopping experience.

In fact, most, if not all retailers, have to be invested in technology in some manner. For the bigger players that means investing in their own advancements. For smaller retailers that can involve using services like Shopify or Instacart to provide the technology, they could not develop on their own.

Top retail stocks to consider

The past few years have created clear winners and losers in the retail space, as well as some chains that could still go in either direction. To find the losers, you simply need to look at the list of companies that have declared bankruptcy or are teetering on the edge.

One-time giants including Sears may not survive the year, while the list companies that ended operations in 2017 alone is a long one. Among the companies that could go either way are J.C. Penney and Macy's, which have shown some positive results in recent quarters but have not yet fully established their turnaround.

The top stocks are more obvious. These are the clear winners in retail which look well-positioned for continued success.

All data as of 9:50 a.m. EDT April 10.

Amazon

The 800-pound gorilla in the retail world, Amazon has created the market where every other player in this space must compete. The online giant also has a massive advantage with its Prime membership program. 

As noted above, once consumers have paid to join Prime, they tend to look to Amazon first when it comes to ordering anything in order to make their membership worth it. That's a huge edge that has not dissipated even after Walmart began offering free, two-day shipping on qualified orders over $35.

Amazon also has an emerging advantage with its base of Alexa-powered Echo home-speaker devices. These smart assistants -- essentially, artificial intelligence you can talk to that answer you back -- make it possible to order from the retailer in just a few words and the company is constantly adding new functionality.

Unlike many retailers, Amazon has eschewed the traditional public company approach of making sure to show an increased profit each quarter. Instead, the online leader has been willing to invest in its future, pushing profits off at times in order to achieve even higher returns in the future.

Walmart

The retail giant may have been a bit slow to respond to the true scope of Amazon, but it has corrected that. Since buying Jet.com for $3.3 billion and putting that company's CEO, Marc Lore, in charge of its digital operation, Walmart has been making massive strides toward becoming a truly omnichannel retailer.

Walmart has been leveraging its biggest asset, its stores, to compete with its rivals by testing in-store kiosks for picking up online orders and making changes to its app to support in-store shopping. With the backing of CEO Doug McMillon, Lore has turned Walmart from a stores-first operation into an omnichannel, whatever-the-customer-wants operation.

Target

For a while, Target looked like it might go the way of Sears rather than following Walmart down the omnichannel path and becoming a legitimate player. CEO Brian Cornell has since corrected course and undergone a major effort to recast his company by making changes that acknowledge people need an extra incentive to leave their homes.

The chain has revamped its merchandise by creating numerous private label brands aimed at rekindling the chain's reputation for being hip to younger customers. It plans to remodel at least 1,000 of its stores by 2020 while it is also launching smaller-format locations in urban markets where a full-size store would be impractical and unnecessary. In addition, Target has purchased Shipt, a delivery logistics company, and that will serve as the backbone of its efforts to offer same-day delivery.

Costco

The warehouse club uses a membership model and that has proven especially resilient when it comes to competing with Amazon. Since the chain makes roughly 75% of its revenue from memberships, its biggest task is keeping members happy. 

It has been able to do that maintaining a nearly 90% renewal rate even though it raised its membership prices (albeit modestly) in June 2017. Costco has succeeded partly because its stores have always been about more than low prices. Yes, the chain offers excellent value, but it has always been a destination due to its free samples, cheap food court, and ever-changing merchandise mix.

Best Buy

In many ways, Best Buy was the first, or at least among the first, retail chain to come up against Amazon. The company suffered because of a practice called "showrooming." Basically, consumers would come to Best Buy, do their research, maybe get some sales help, and then buy the item online from Amazon.

The electronics retailer stopped that by being aggressive in pricing and shipping. It also made its stores destinations by adding store-within-a-store concepts with leading electronics companies, cable/internet providers, and wireless carriers. Best Buy also built out its service business under the Geek Squad banner giving consumers even more reason to engage with the brand.

Home Depot and Lowe's 

These two rival retail chains have thrived largely because items that fall under the home improvement umbrella lend themselves to in-store shopping. Both chains have robust websites and offer an omnichannel experience, but shoppers tend to want to evaluate items like tools, hardware, and plumbing fixtures before buying them. In addition, both chains benefit from selling items like drywall, lumber and other building supplies that don't lend themselves to traditional shipping methods.

Home Depot and Lowe's have also had success allowing customers to buy online and pick up in store. That works well with items that are challenging to ship, and which Amazon has largely avoided.

Evolve or die

What's clear in the retail space is that companies that operate as if nothing has changed tend to have very short shelf lives. Amazon has pushed innovation and its move into brick-and-mortar with its own stores and its purchase of Whole Foods only increases the pressure.

The companies that make the most sense for a retail investor are the ones that have on eye on today and one on tomorrow. It's not necessarily important to be first when it comes to a new innovation, but the chains above are the ones that can adapt quickly to an evolving market.