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The current meltdown in major department-store stocks reverses what had actually been a pretty good run for names such as Macy’s Inc. and Kohl’s Corp., which had seen their shares rise robustly from the depths of pessimism in early 2016.Mark Lennihan/The Associated Press

The current meltdown in major department-store stocks reverses what had actually been a pretty good run for names such as Macy's Inc. and Kohl's Corp., which had seen their shares rise robustly from the depths of pessimism in early 2016.

Last week's disastrous sales reports, however, should be a sharp reminder of the perils of investing in brick-and-mortar retailing in what is largely becoming Amazon's world. Traditional retailing isn't dead, certainly, but chances are good that investors in the sector will feel as much pain as gain as they watch the major department stores lurch from quarter to quarter.

I wrote last May – the last time there was a major upset in the space – that department-store stocks looked like bargains, but investors should be wary that "this could be the beginning of a closeout." Alas, investors disagreed: From the publication date to last Wednesday, Kohl's rose 50 per cent, while Macy's gained almost 20 per cent and J.C. Penney Co. Inc. gained in the double-digits. There remains a lot of faith in traditional retail. (Hudson's Bay Co. doesn't trade in line with U.S. competitors, and actually saw its shares fall over this period.)

That faith was tested again last week, as Kohl's, Macy's and Penney reported declining same-store sales (revenue from locations open at least a year) for the holiday shopping season. Kohl's and Macy's posted 2.1 per cent and 2.7 per cent declines, respectively, and Penney was able to post an 0.8-per-cent decline mostly because it was starting from a lower base, as it lost $5-billion (U.S.) in sales from 2011 to 2015, Citigroup Global Markets Inc. analyst Paul Lejeuz notes. Analysts cut their estimates, and all the traditional U.S. department-store stocks are down 10 per cent to 20 per cent since last Wednesday.

The carnage underscored the thesis I had last May: Amazon continues its path to become the No. 1 retailer of apparel in the United States – perhaps as early as this year, analysts at Cowen & Co. suggest. Observers noted the pullback in the department-store stocks meant Amazon's market capitalization exceeded Macy's, Kohl's, Sears Holdings and Penney combined – and it's not even close, as investors value those four at a total of $20-billion (U.S.), and Amazon's market cap is nearly $380-billion. You can throw in Nordstrom Inc., Target Corp., "off-price" retailers TJX Cos. Inc. and Ross Stores Inc. (both of which I own), and three other smaller traditional retailers, and Amazon's valuation is still more than twice their combined $150-billion market cap.

This comparison is not entirely fair, as Amazon's valuation is also driven, significantly, by its cloud-computing business that also make it a competitor to major tech companies, as well as retailers. That said, let's take a look a particular valuation metric, enterprise value to sales.

Comparing enterprise value – market capitalization plus debt, minus cash – to sales gives some insight into how much investors value a dollar of a company's revenue. Some companies' sales are more profitable – or should become more profitable – than others', and that gets reflected in EV/EBITDA.

All of the traditional department stores, including Target, now trade at EV/EBITDAs of less than one, meaning you can pick up the companies for less money than they rack up in annual sales. TJX, Ross and Burlington Stores Inc., the off-price retailers that investors favour, trade between one and two times sales. Amazon trades at three times sales – despite the fact its margin of EBITDA, or earnings before interest, taxes, depreciation and amortization, to revenue is smaller than most retailers'.

The disparity suggests a belief that Amazon will continue to take market share, as the Cowen analysts believe. There may be limits to that: In a focus group Cowen conducted last year, shoppers gave Amazon high marks for convenience and selection, but also expressed fondness for various elements of the brick-and-mortar experience, such as the ability to touch and try on clothing, and take it home immediately, rather than wait for delivery.

That type of consumer sentiment, combined with rock-bottom pricing for department-store stocks, is catnip to value investors. Reuters reported this week that "some investors are holding out hope for a longer-term recovery," with Ken Murphy, senior vice-president and portfolio manager at Standard Life Investments, saying "there is optimism that someone will shrink the [department-store] business enough to hit that magic number and turn it around."

Think about the implications of that, however: Traditional retail stocks will likely continue to trade on quarterly sentiment, as each sales disappointment is met with news of store closings, employee cuts and other "rationalizations" as the companies try to reduce costs to match their declining sales. A multimonth run of optimism will get undone quickly when the companies' numbers fall short.

Trying to pick winners in a declining industry is notoriously difficult work for investors. Best to stick to finding bargains in the stores' aisles instead.

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