Retail stocks have been annihilated recently, despite the economy eking out growth. The fundamentals of the retail business look horrible: Sales are stagnating and profitability is getting worse with every passing quarter.
Jeff Bezos and Amazon get most of the credit, but this credit is misplaced. Today, online sales represent only 8.5 per cent of total retail sales. Amazon, at $80-billion (U.S.) in sales, accounts only for 1.5 per cent of total U.S. retail sales, which at the end of 2016 were around $5.5-trillion. Although it is human nature to look for the simplest explanation, in truth, the confluence of a half-dozen unrelated developments is responsible for weak retail sales.
Consumption needs and preferences have changed significantly. Ten years ago, people spent a pittance on cellphones. Today, Apple sells about $100-billion worth of i-goods in the United States, and about two-thirds of those sales are iPhones. Apple's U.S. market share is about 44 per cent, thus the total market for smart mobile phones in the United States is $150-billion a year. Add spending on smartphone accessories (cases, cables, glass protectors, etc.) and we are probably looking at $200-billion total spending a year on smartphones and accessories.
Ten years ago (before the introduction of the iPhone), smartphone sales were close to zero. Nokia was the king of dumb phones, with U.S. sales of $4-billion in 2006. The total dumb-cellphone-handset market in the United States in 2006 was probably closer to $10-billion.
Consumer income has not changed much since 2006, thus over the past 10 years, $190-billion in consumer spending was diverted toward mobile phones.
It gets more interesting. In 2006, a cellphone was a luxury only affordable by adults, but today 7-year-olds have iPhones. Phone bills per household more than doubled over the past decade. Not to bore you with too many data points, but Verizon Wireless' revenue in 2006 was $38-billion. Fast-forward 10 years and it is $89-billion – a $51-billion increase. Verizon's market share is about 30 per cent, thus the total spending increase on wireless services is close to $150-billion.
Between phones and their services, this is $340-billion that will not be spent on T-shirts and shoes.
But we are not done. In the United States, the combination of health-care inflation in the mid-single digits and the proliferation of high-deductible plans has increased consumers' direct health-care costs and further chipped away at discretionary dollars. U.S. health-care spending is $3.3-trillion, and just 3 per cent of that figure is almost $100-billion.
Then there are soft, hard-to-quantify factors. Millennials and millennial-want-to-be generations (speaking for myself here) do not really care about clothes as much as people may have 10 years ago. After all, high-tech billionaires wear hoodies and flip-flops to work. Lack of fashion sense did not hinder their success, so why should the rest of us care about the dress code?
In the 1990s, casual Fridays were a big deal – yippee, we could wear jeans to work! Fast-forward 20 years, and every day is casual. Suits? They are worn to job interviews or to impress old-fashioned clients. Consumer habits have slowly changed, and we now put less value on clothes (and thus spend less money on them) and more value on having the latest iThing.
All this brings us to a hard and sad reality: The United States is over-retailed. It simply has too many stores. Americans have four or five times more square footage per capita than other developed countries. This bloated square footage was created for a different consumer, the one who, in the 1990s and 2000s, was borrowing money against the house and spending it at the local shopping mall.
Today's post-Great Recession consumer is deleveraging, paying off debt, spending money on new necessities such as mobile phones and paying more for the old ones such as health care.
Yes, Amazon and online sales do matter. Ten years ago, only 2.5 per cent of retail sales took place online, and today that number is 8.5 per cent – about a $300-billion change. Some of these were captured by bricks-and-mortar online sales, some by e-commerce giants like Amazon and some by brands selling directly to consumers.
But as you can see, online sales are just one piece of a very complex retail puzzle. All the aforementioned factors combined explain why, when gasoline prices declined by almost 50 per cent (gifting consumers with hundreds of dollars of discretionary spending a month), retailers' profitability and consumer spending did not flinch – those savings were more than absorbed by other expenses.
Understanding that online sales (when we say this we really mean Amazon) are not the only culprit responsible for horrible retail numbers is crucial in the analysis of retail stocks. If you are only looking at "who can fight back the best against Amazon?" you are solving only one variable in a multivariable problem: Consumers' habits have changed; the United States is over-retailed; and consumer spending is being diverted to different parts of the economy.
As value investors, we are naturally attracted to hated sectors. However, we demand a much greater margin of safety from retail stocks, because estimating their future cash flows (and thus fair value) is becoming increasingly difficult. Warren Buffett has said that you want to own a business that can be run by an idiot, because one day it will be. A successful retail business in today's world cannot be run by by an idiot. It requires Bezos-like qualities: being totally consumer-focused, taking risks, thinking long term.
Vitaliy Katsenelson, CFA, is chief investment officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing and The Little Book of Sideways Markets. His strategy for investing in an overvalued stock market is spelled out in this article.
The author does not own or hold short positions in Amazon. His firm owns a position in Apple.