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Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
When you can buy merchandise at 40 per cent off the last ticketed price in the weeks before Christmas, you know that the current retail environment is grim. But when even the liquidators are closing up shop, maybe the situation is worse than we realize.
Last week, Columbus, Ohio-based Big Lots Inc. announced it would be shuttering its Canadian operations, which trade under the Liquidation World banner. The 73 stores were acquired in July, 2011 – in what can only be politely described as a "takeunder" at 6 cents a share – but in spite of an experienced U.S. management team, they remain unprofitable and will be gone during the first quarter of 2014.
I must confess to some nostalgia at hearing this, as I have a history with Liquidation World. In my former life at Saxon Funds, we were big shareholders in Liquidation World, along with a number of other value investors. In fact, it was my favourite example of a Ben Graham net-net working capital stock – companies which trade below the liquidating value of their current assets. "After all," I would say, "how can you go wrong buying a liquidation company at a discount to the value of its inventory?" Alas, it was not to be. Even after changing the board and management, the company continued to drift until it was rescued from oblivion by Big Lots.
So, what went wrong and what can we learn about investing in retail stocks from this episode?
Liquidation World began life as a regional operator in Alberta with a focus on opportunistic buys of manufacturers' close-outs and overruns. With the passage of time, the company grew into a national chain and had to buy product simply to keep the shelves stocked, so both price points and the sense of adventure for the customer began to erode. Back in those early days, department stores didn't do their own liquidating and dollar stores had yet to evolve. The company floundered through various strategies and management teams until the arrival of Big Lots put it out of its misery.
The first lesson is that it is virtually impossible in the retail sector to create the defensible "moat" sought by Warren Buffett. By definition, any successful strategy will be seen, not just by your customers, but also by your competitors who will do their best to replicate it. For example, the first drugstore to place the pharmacy at the back of the store so that customers have to pass all the other products may have had a competitive advantage, but the rest of the industry could follow suit in a matter of weeks.
The second lesson is that a successful niche operation does not translate well into a national chain. Management oversight, creative flexibility and rapid response time all go out the window when a business expands over several time zones. The urge to broaden the product offering results in higher dollar revenues, but also a diluted brand image and a lower return on capital. By this time, professional management is usually on the scene, so they endorse this evolution because bigger companies pay higher salaries. Investors, however, pay a premium for high returns on capital and are less enthusiastic about growth for its own sake.
The final lesson is that although the overall economy is growing, we are buying less physical "stuff." Downloadable ringtones, personal training sessions and visits to the spa all contribute to GDP, but they don't require a trip to the store. Retailers of physical stuff are fighting a rearguard action against the purveyors of services and experiential products.
It is possible, of course, that there are retail niches offering a sustainable competitive advantage. Right now, the dollar store category seems to fill that bill in a slow growth economy. That is possible. But last week, Larry Rossy, Dollarama's chief executive, said: "It will all look great if we have nice, good weather for the next three weeks across Canada – we'll look like geniuses. If it starts snowing and we can't get to our stores, then we'll probably look like less than geniuses."
On the face of it, these are prudent words from a seasoned retail executive. They could also have come from the mouth of a farmer or a ski resort operator: In other words, we don't control our own destiny. There is nothing wrong with investing in an industry with a weather-dependent profile, but only if the valuation fully reflects that risk.
Robert Tattersall