At least one investing strategy is to find struggling companies whose shares can be bought at bargain-basement prices and then benefit when the price surges. While in theory that could make investors rich, the obvious hole in the argument is that the price may continue to fall, the company could file for bankruptcy protection, and the investor could lose a lot of money. It's a pretty big risk, and investors should find reasons they can expect a company to improve before placing bets on a recovery.

In a standoff between lululemon athletica (LULU 0.64%) and Gap (GPS -1.44%), we have a hot, still up-and-coming athleisure retailer on one side, and a company that was once a top retailer but is now gasping for oxygen on the other. Let's evaluate.

A customer making a purchase at a Gap store.

A customer making a purchase at a Gap store. Image source: Gap.

Changing with the times

Gap has been struggling on many fronts, from trouble with changing styles to challenges with its store locations. It's gone through a succession of CEOs as it seeks to right itself, and it seemed to be on the right path in the hands of Sonia Syngal, who came over from her top perch at Old Navy. In the fourth-quarter results, which were released March 12 right before the pandemic wreaked havoc on the U.S., sales were flat at both Old Navy and Banana Republic, while they were positive at Athleta, the company's activewear brand. Gap brand sales decreased 5%, but on the whole the quarter was an improvement over earlier declines.

Just as it looked like the company was heading the right direction, COVID-19 caused stores to close, and sales decreased 43% in the 2020 first quarter, which ended May 2. During that time, Gap was teetering on the brink of insolvency, issuing debt to keep cash flowing in and refusing to pay rent on some stores. At the same time, there were strong signs of life, with a 40% digital sales increase in April and a 100% digital increase in May. Gap ended the quarter with $1.1 billion in cash, cash equivalents, and liquid assets.

Lululemon's sales also decreased during the store closure period, but to the tune of a much lower 17%. Prior to the pandemic, sales were increasing by double digits, and the company was executing on its "power of three" strategy to grow its product line through innovation, expand its omni-channel experience, and advance its international sales. The company is benefiting from the general trend toward athleisure as a common mode of dress, and it's been successful at creating a community of like-minded fitness enthusiasts living the "sweat life."

Woman running.

Image source: Getty Images.

Recovering and moving forward

With stores back in operation, Gap is working hard to pick up the pieces of its business and is going full-on into digital. It uses many of its stores for ship-from-store capabilities and launched curbside pickup at a selection of stores during the pandemic. And while a sales decline is certainly alarming, Syngal pointed out that the Old Navy, Gap, and Banana Republic brands are three out of only nine that bring in over $2 billion in annual sales in the U.S.

Its problems, however, are far from over. While Old Navy is bouncing back, the company is still dealing with how to define Gap, which has lost its panache from when it dictated cool casual back in the nineties and early 2000s. It's been moving away from malls, but it's still a mall store. The company's brightest spot is Athleta, a Lululemon challenger, which is riding the current athleisure trend and saw a mild 8% loss in the first quarter.

Despite the COVID-19 setback, Lululemon is poised for more outstanding growth. Its products aren't seasonal so there isn't a backlog of post-pandemic goods to put on promotion, and in the beginning of June, as stores reopened, sales were similarly high to holiday sales. The company is introducing new, innovative products, and it's confident that it can quadruple international sales by 2023. It also recently bought Mirror, a home fitness brand that it expects to add value to the company's community and sales.

A value move, or too high a risk?

Owning shares of Gap hasn't been beneficial for investors over the past few years, with a five-year annualized losses of 15%, and it's down almost that much year to date. Over the same five years, Lululemon stock has returned an annualized rate of almost 40%, and it's up 50% year to date.

Gap may recover, but there isn't enough evidence to say that it will start delivering better returns in the near future. Buying shares now comes with a high risk. Counter that with Lululemon's recent performance, strong headwinds in the form of general trends, and strong omni-channel community, and Lululemon is the better buy today.