I don't like retail stocks, I don't own any, and the recent performance of Lululemon provides an excellent example of why this is the case.
Whether we're talking Krispy Kreme Doughnuts Inc., Crocs Inc., Lululemon Athletica Inc. or hula hoops in the 1950s, the pattern is always the same. In the end, it means retail stocks are for traders, not investors.
This week's chart shows the stock performance of three faddish retail companies in the weeks after they began trading – indexed to 100 at time of initial public offering. It's a bit facetious to suggest that investors should sell any specialized retailer when it gets to five times its IPO price, but it's also true that strategy would have worked nicely in each case.
Investors are prone to blame management after the inevitable collapse of these stocks to avoid admitting their own culpability. In each case, management merely attempted to exploit the explosion in popularity of their product by expanding supply to meet demand.
Short of warning investors not to buy their stocks because it was too expensive, what exactly investors expected management to do remains a mystery. Investors that bought Krispy Kreme at 121 times trailing earnings in September of 2000 have only themselves to blame.
Importantly, the finance industry makes a lot of money from this mania and, through perfectly legitimate means, is more likely to stoke the hype than warn of investment risk. Temporarily high growth rates get extrapolated into huge stock price targets that spur investor buying activity and broker commissions.
For some lucky dealer firms, the expanding retail company will continually issue new shares (or debt) to fund expansion, generating big cheques for the investment banking department as investors swarm to the new stock at inflated valuation levels.
Again, though, investors should know better and shouldn’t spend too much timing blaming analysts. Consumers are fickle, fads burn out. At some point, the new stores hurriedly added by expanding companies are largely empty for the grand opening.
None of this is to suggest Lululemon is doomed as a company or a stock. Valuations never reached the obscene levels of Krispy Kreme’s heyday and at 20.2 times trailing earnings, Lululemon is now valued much more attractively than Nike Inc. at 25.4 times or Under Armour Inc. at 72 times earnings.
Lululemon appears, however, to have reached a more mature, hype-free stage where future profits will depend on successful marketing and other boring management blocking and tackling rather than explosive popularity growth.
If you want to trade them go ahead, but specialized retail stocks are not for long-term investment. Lululemon is only the latest in a series of painful market lessons about consumer fads. Investors should keep this in mind when the next “must own” trend hits.