Love the Loser? Or Say Goodbye?

New York Story
Every investor has lost money at some point. We all make mistakes. We all make bad buys. It's an inevitable part of the game.

It's vital to learn when to cut your losers loose. As I watch the action in New York & Co. (NYSE:NWY), I'm reminded of the tough lesson it taught me, one that could have been much tougher. I originally bought this Motley Fool Hidden Gems pick in the $19 range. As it flew up into the low $20s, I took a look at the numbers. I felt like the valuation might be a little rich; the firm's sales growth was fitful, and profitability whipsawed wildly every time the revenue came in too light. I nearly hit the sell button one day, but decided I should hold out for a quarter or two, to see whether things got better.

They didn't. Eventually, those crummy sales caused the market to lose faith in New York & Co. I finally stepped off the roller coaster somewhere in the mid- to high teens, taking a 25%-ish loss. Today, the company trades for just more than $6 a stub.

Leaving the Big Apple
When I finally sold my shares, it wasn't because the stock was down, or, strictly speaking, because sales were sloppy. Fashion retailing is a tough business. Trends are missed. Weather can spike important seasons and promotions. But at New York & Co, poor performance quickly became the rule, rather than the exception. When that happens to a retailer, month after month, quarter after quarter, I usually head for the door. To me, it indicates a lack of resonance, a squishy, touchy-feely, completely made-up metric in my head that attempts to understand whether or not consumers care enough about a brand to return to it again and again. I didn't think New York & Co. had it.

Watch your step
I've written before that I consider it dangerous to trust too much in what you see with your own eyes at the mall. It's too easy to misconstrue reality, too dangerous to make illogical extrapolations from a very limited set of observations. My fashion sense is confined to the Gap (NYSE:GPS) sales rack, or when I'm feeling extra cheap, TJX (NYSE:TJX).

That said, I've been paying close attention to the New York & Co. nearest me. For months now, it's seemed like an unmitigated disaster: There were two clumsy moves to a huge new store that was by turns empty and packed. When it was packed, there were sales signs promising huge discounts, but not enough staff to serve customers. On a recent trip, my wife gave up after 10 minutes in a frozen queue. We haven't been back since.

What looks like a specific case of klutzy management seemed to me to reflect management's failure higher up the food chain.

Here's the big problem for New York & Co. investors: I think they need to believe that a big change is coming. Current management's dismal record with sales and profitability hasn't stopped the company from expanding rather aggressively, trashing its returns on investor capital during the process. After adjusting the annual figures for operating leases, here's my estimate of returns on invested capital over the past few fiscal years.

Not a pretty picture at all. It suggests to me that the folks running the show just aren't allocating capital in a profitable way. Nothing personal; I just see value being destroyed, rather than created.

Is it time to go back?
But even the worst business in the world -- and New York & Co. surely isn't that -- is worth something. Today's Q2 earnings report, the one that sent the stock down more than 20%, actually looks decent to me. Maybe I need to check the chain of custody on my coffee, but I see a net sales increase of 11.2% on a comp increase of 4.7%. That seems like a sign of hope to me, especially given the dismal stats I've seen in past reports. Mr. Market is obviously pretty upset about the full-year guidance, which cuts about 50% off previous EPS targets. Those prior expectations were pretty much flat with the actual results for the prior fiscal year.

At this level, I'll grant that it's very tough to know whether New York & Co. is a value. The "forward" P/E, based on the midrange of the guidance, is about 16, which seems high for a retailer that looks dead in the water. But New York & Co. sells for a mere 0.37 times trailing 12 months' sales. Top-notch retailers currently fetch enterprise value-to-revenue multiples closer to two. At Abercrombie & Fitch (NYSE:ANF), the EV/R ratio is 1.9. Hot growth story Zumiez (NASDAQ:ZUMZ) goes for four times revenue. Even at struggling Ann Taylor (NYSE:ANN), the ratio's still 0.73, and perennial stagnator Gap gets 0.75 times sales.

Somebody ought to be able to do something with this brand. But until we see a new game plan, I'll stand by my decision to say goodbye to NYC. There's easier money in the retail space.

New York & Co. is a Motley Fool Hidden Gems recommendation, as is Zumiez, which has fared much better. Hey, there's a reason we recommend diversification in your small-cap investing. For the full slate of market-beating small caps, you can take a free trial.

At the time of publication, it was about a decade since Seth Jayson, a top-10 CAPS player, said "See yuh!" to Manhattan. He had no shares of any company mentioned here. See his latest CAPS blog commentary here. Gap is an Inside Value and a Stock Advisor recommendation. View Seth's stock holdings and Fool profile here. Fool rules are here.