MARKET COMMENTARY

Retail Stocks: Behind-The-Scenes Race Underway

Amid the fast-changing mix of retailers, how do you pick the “right” stocks? Andrew Buntain in Toronto and Grant Bowers in San Mateo share their insights.

12.20.2019

Andrew Buntain, CFA
Vice President, Institutional Portfolio Manager
Franklin Bissett Investment Management
Toronto, Ontario, Canada

Grant B. Bowers, CFA
Vice President, Portfolio Manager
US Growth, Franklin Equity Group
Franklin Advisers, Inc.
San Mateo, California, USA

Shoppers have never had so many places, or so many ways to buy just the right thing and have it in their hands at just the right time. Amid the rich, fast-changing mix of old retail stars, new stars and overnight shooting stars, how do you pick the “right” stocks? Andrew Buntain and Grant Bowers take us into the highly competitive world of general merchandise retail, where the race between winners and losers is unfolding on many fronts.

Q: What’s the retail investment landscape like these days?

Grant Bowers: US consumer spending remains strong, so investors still have an appetite for some exposure to the retail space. We’re seeing a few themes at play. For instance, as lower-end consumers have benefited from wage increases, Walmart Inc., Target Corporation, other discounters, dollar stores and the off-price (discount) segment have been delivering good results. There’s still some hesitation around investing in traditional brick-and-mortar players (especially mall-based retailers). There’s more appetite for e-commerce companies, or traditional retailers who are making strides on the digital side, offering consumers multiple methods for purchasing their goods.

The US/China trade war is a significant theme for this sector and is prompting volatility due to fears that overall margin pressures could drive price increases, which would be passed on to consumers and that could ultimately affect demand and volume.

Q: How are such tensions influencing the retail companies in which you invest?

Grant Bowers: We have a small direct exposure to specific Chinese manufacturing in our retail sector companies. It amounts to less than 10% exposure for brand companies that we own, who manufacture goods outside of the United States.

Q: How do you approach investing in the retail sector?

Andrew Buntain: We prefer durable business models that can weather downturns, or ideally use cycles to enhance their competitive position. Those companies, trading at reasonable valuations—that are relatively impervious to discounting competition, have an “Amazon-proof” model or who can launch e-commerce initiatives without major disruption, can strengthen their customer base or take market share—get our attention. We think domestic firms, such as Dollarama Inc., have resilience built into their business model. Alternatively, specialty retailer Sleep Country Canada Holdings Inc. has capitalized on Sears’ demise and we expect the company to reap more market share gains going forward. Their acquisition of Endy Sleep—the country’s “largest direct online mattress store”—is a good example of a brick-and-mortar retailer embracing change and enhancing their online proposition.

We emphasize the importance of strong and experienced management teams, effective execution strategies and capital allocation policies with which we agree.

Grant Bowers: Off the top, we view Amazon.com, Inc. as one of the winners in the US retail landscape. Even though some traditional retailers are catching up, there’s still significant market share to be gained through digital commerce in this country. Amazon continues to stay a step ahead of the competition. For instance, as some brick-and-mortar companies have caught up on two-day shipping, Amazon is introducing one-day delivery.

Our approach also includes investing in categories where there are secular growth opportunities, such as athletic footwear and apparel. We prefer brands that use a multi-channel distribution model. We also focus on areas where e-commerce players are less disruptive, such as the athletic and off-price categories. We’re always monitoring the retail space for potential winners that are either new e-commerce business models or traditional players that will survive and thrive in the evolving marketplace.

A big part of the story this past year has been about which companies have been making the right technology investments and quickly embracing digital transformation."
Q: How much of the retail investment story is occurring “behind the scenes”?

Grant Bowers: A big part of the story this past year has been about which companies have been making the right technology investments and quickly embracing digital transformation. The focus has been on delivering goods to customers when and where they want them and the race to achieve such capabilities is underway. The next chapter will likely see retailers further embracing the data-centric digital world to drive more targeted marketing. This would help better align product assortment with demand, improve inventory management efficiencies, and reduce markdowns. All these steps can positively affect profitability and that’s critical.

We also invest in firms indirectly benefiting from the shift to digital commerce, such as payment companies like Visa Inc., MasterCard Incorporated and PayPal Holdings Inc. We believe consumers will continue to use credit cards and mobile wallets to shop online.

Andrew Buntain: A digital evolution is underway and the heightened competitive pressures it brings are palpable. We note the potential it offers Canadian companies, such as platform/service provider Shopify Inc. It was also interesting to see Amazon take a small ownership position in homegrown Cargojet Inc. earlier this year. Canadian multinational, Descartes Systems Group Inc., is a great example of a behind-the-scenes beneficiary of the current change. It’s an established business that assists customers (i.e., retail, wholesale, air, ocean, trucking) with cross-border shipping logistics. Their track record is a good match for our bottom-up criteria.

Q: Over the past several years, new competitors have entered the Canadian market with varying success. What do you think about the idea of there being more to come?

Andrew Buntain: It’s already a competitive marketplace and Canada remains very challenging given its massive size, sparse population and unforgiving weather. Operating here is difficult. Canadian consumers are creatures of habit, so inroads from new competitors tend to be more gradual, which is more manageable for incumbent retailers. However, you can’t ignore the world of opportunity digital commerce creates. From our perspective, we continue to have conversations with management teams about their strategies. We think existing retailers need to continue to “up their game,” providing better customer service and increasing the agility of their inventory management. While Canadian retailers may benefit from outside competitors facing barriers to entry, companies like Amazon are handily proving such obstacles are surmountable. 

Q: What traps or potentially shiny dead ends are you avoiding?

Andrew Buntain: It’s crucial to be mindful of valuations in this space. Stocks that are appreciating more on investor enthusiasm about earnings potential (versus actual), or high-concept offerings that are not yet fully proven, are less appealing to us.

Grant Bowers: We also avoid fad-based brands where growth is unsustainable over the longer term. We’re wary of some traditional brick-and-mortar companies that show short-term sales success, but ultimately fall short in flowing those increases through to the bottom line. Some department stores and traditional mall-based retailers fall into that category.  

Q: Looking ahead, what should readers consider in terms of retail sector investing?

Andrew Buntain: We have a bottom-up approach focused on company fundamentals, strong financial and capital positions and good management teams. Occasionally it’s tempting to go beyond those fundamentals when a stock price is advancing on little more than investor enthusiasm. That’s when it’s most important to maintain our discipline. Particularly in today’s environment, we believe discipline is key for readers and us alike.

 

 

 

 

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