I love retailers.

Despite their shortcomings, their volatility creates opportunity. And the three companies with the highest returns can teach us three ways to use that opportunity to our advantage.

The top 3
Below is a table of cumulative returns over the past three years for the top three retailers.


3-Year Return

Guess? (NYSE:GES)


GameStop (NYSE:GME)


Big Dog Holdings (NASDAQ:BDOG)


Data from Capital IQ, a division of Standard & Poor's. Returns as of June 11, 2007.

When I started thinking about why they earned those returns, it struck me that they did it in very different ways. How lucky could I get? So let's examine how they did it so we can be ready to find the next opportunities.

Roll up your shirtsleeves and please the people
Seeing Guess? at the top of the list doesn't surprise me. That's because Seth Jayson used to constantly blab about how great it was on our daily commutes to Fool HQ, only to make me jealous of his stellar returns. Here's how it became a winner.

Since 2002, it's done nothing but improve its business. The data say that sales have been growing and margins have been improving. What caused the numbers to turn around? I think it boils down to two simple yet crucial things: merchandising and operations. To sell things at full price, a retailer -- especially a clothing retailer -- has to have what people want to buy. And, boy, did Guess? ever find what customers wanted and get it to them.

Get big in a fragmented market
One could argue that the video game industry is just starting to hit its stride. After all, with the power of the new consoles and the incredible games from companies like Electronic Arts (NASDAQ:ERTS), its future looks very bright. And that's exactly what GameStop is looking to take advantage of by positioning itself as the leader in gaming retailers.

Not only has GameStop been opening stores and creating a huge market for used games, it has been acquiring stores as well, namely through its EB Games acquisition. Size is critical in a fragmented, growing industry. Size provides buying power and the ability to attract more customers, and the company has been using that advantage to grow operating margins, even if it's done it slowly.

Milk a mature business to grow a new one
Are you familiar with Big Dog products, those T-shirts and things with the Saint Bernard logo? They were cool for a while, but they have lost their luster. The market noticed right away and pummeled the stock.

The company was still generating cash from those assets, but it was clear that the cash flow was going to start drying up. Management decided, correctly, to stop investing in the brand. Instead, Big Dog purchased The Walking Company when it was in trouble, turned it around, and acquired additional stores on the cheap. So far, the market likes the idea of allocating capital from a declining business to a growing one that should start increasing its return on invested capital as it expands. That's my thesis in CAPS (I'm TMFHumbleServant), and it has paid off with big gains over the past year.  

Who's ready to move next?
So there we have it: three ways retailers can generate big returns. (1) Better operations, starting with merchandising. (2) Get big in a fragmented industry. (3) Part improved capital allocation and part turnaround. Here are three additional businesses from my CAPS portfolio that use those ideas.

The first is Chico's (NYSE:CHS). After its merchandising miss last year that broke an unbelievable streak on same-store sales increases and crushed margins, the company's executives appear to have rolled up their sleeves and attacked the problem head-on. As such, I expect margins to continue to expand and returns on invested capital to get moving in the right direction again.

I've owned stock in outdoor sporting goods retailer Cabela's (NYSE:CAB) for well over a year. It's going through a major retail expansion, opening up large, destination stores as fast as it can negotiate incentive deals. The industry is very fragmented and Cabela's is using a multichannel strategy -- catalogs, retail, and e-commerce -- to increase its share of the market while working on improving its operations. It's not easy, and the market sees plenty of uncertainty as the price has been volatile. Still, I think the best part of Cabela's is still a way off, and I am more than willing to wait for the market to recognize this.

Finally, I think dELiA*s (NASDAQ:DLIA) fits the makeover/turnaround model. Management has been closing underperforming stores and remodeling the ones it kept. So far, the retail side of the business -- it is also a multichannel retailer -- is running with negative EBITDA, but it's about to break even. And with rapid store growth coming down the pipe, it should be able to leverage its scale if it can sell the right merchandise at the right price-points. It's not a slam dunk by any means, but at today's prices, the market is not giving much value to the retail segment that appears to be moving in the right direction.

The Foolish bottom line
Investments in retail are a bit riskier than most. That's because it's difficult for a retailer to create a competitive advantage and generate big returns on invested capital. And when mistakes happen -- and they always do -- the market is quick to punish. But if we understand the business and see these three ways to create value, those missteps can create opportunity.

For more on these retailers, check out:

Cabela's is a Motley Fool Hidden Gems recommendation and fits the model very well as an undervalued small-cap stock. To find out how these smaller companies can pack quite a punch, try Hidden Gems free for 30 days.

GameStop and Electronic Arts are Motley Fool Stock Advisor recommendations.

Retail editor and Inside Value team member David Meier surprised a Chico's assistant manager by performing a channel check. He's ranked 2,558 out of 30,211 ranked players in CAPS and owns shares of Cabela's. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.