It has been one disturbing year for retailers. There is nothing optimistic about this list of retailers that have significantly underperformed the S&P 500 over the past year:


1-Year Return



Pacific Sunwear (NASDAQ:PSUN)


Urban Outfitters (NASDAQ:URBN)




Nordstrom (NYSE:JWN)




S&P 500


As if things couldn't get worse, further bad news is likely on the horizon for the industry, as the most important quarter of the year is shaping up to be hellish for most retailers. I don't suggest disregarding retail altogether; however, you must proceed with extreme care in this sector.

Don't fall for the value trap
Too often, I see investors focusing too heavily on the value proposition of retailers while spending too little time actually analyzing the qualitative aspects of a company. The recent tumble of retailers across the board has opened up a lengthy list of companies that look like great bargains. A large portion of the sector has averaged P/E ratios in the high teens to low 20s over the last several years. Today, many stand in the single digits.

But it's never been more imperative for investors to step back and really look at the fundamentals, longevity, and brand power of particular retailers. In good times, when cash is freely flowing from consumer wallets, it's easy for retailers to disguise themselves as success stories. But the scene dramatically changes when consumers have to tighten their purse strings and start making hard choices about what they purchase.

What to look for
The tougher environment is actually a great thing for stronger players in the industry, because it lets them excel further while simultaneously whittling away at weaker competitors. So with that, here are the four must-have characteristics I'm looking for in retailers that will survive and thrive in the upcoming year:

  • Don't rely on a single concept for success.
  • Have a strong brand concept now.
  • Don't be dependent on debt.
  • Rapidly adapt to changing conditions.

The world of retail is a very fickle business. Very few concepts can flourish for more than several years. Often, companies get caught up in what made them so successful in the beginning and never change -- or they change after it's far too late. But consumers quickly move from one fad to another, and retailers that don't move in tandem fall behind and find their brands end up tarnished.

Even in good times, regaining brand strength in the retail sector may be one of the most difficult turnaround processes. Attempting to do so in an environment when even the "in" companies are struggling over limited consumer dollars seems near impossible to me. In some cases, as with Gap (NYSE:GPS), this probably just means several more years of investors watching their "value" stock endlessly struggle to revive a dead brand. In other cases, it means watching companies bring their businesses to a close. This is why one of my golden rules for investing in retail is that the brand must have spunk now, even if it means paying a small premium over some of the deep discounted retailers.

The best dressed balance sheet
Yet sustaining a retailer's success takes more than just fashion sense and an ability to stock shelves with what consumers want. The retail sector closely follows the general peaks and troughs of our economy, and as we've seen this past year, even the most popular retailers struggle in recessions.

Companies must be financially positioned to ride out a full economic cycle, meaning their business models need to be structured so that fixed costs and interest payments can easily be paid even when sales are on a downswing. Thus, companies like Buckle (NYSE:BKE) that have little or no debt are much safer when times get tough.

Bottom line
I don't expect our economy to emerge from the recession in 2009, so I predict another harsh year for retailers. But for long-term investors, there are many opportunities to pick up really great retailers at bargain prices. Just proceed with caution and don't forget to carefully study the qualitative and operational aspects of these companies rather than relying solely on cheap valuations.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.