The Smart Investor’s 5-Step Test To Find The Next Wal-Mart

For several years, we’ve read about the deep level of distress among consumers. A tough job market, coupled with the need to pay off debts incurred during the last housing bubble means that few have the spare cash to shop with abandon.

Yet signs are emerging that a steady thaw in consumer spending is now under way. Retailers such as department stores, restaurants, auto dealers and hotel chains have taken note of stable sales trends in 2012. And 2013 may look better: A monthly survey of “Economic Optimism” jointly conducted by TechnoMetrica Market Intelligence and Investors Business Daily, saw a notable uptick to 54.0 in early October 2012 from 51.8 in September. That’s the highest reading in more than five years.

It’s noteworthy as any reading above 50 indicates optimism, and clearly Americans are feeling a bit better about the future. The index is a blend of three readings: the six-month economic outlook (59.1), the personal financial outlook (60.5) and confidence in federal economic policies (42.4).

So if consumers feel better about their personal financial picture, might that portend a coming rise in retail sales and a rally for retail stocks? The answer is a qualified yes. Many retail stocks have already traded up in anticipation of a perkier consumer. The Dow Jones U.S. Retail Index, for example, is already back up above pre-recession levels.

That means the typical retail stock is no longer the deep bargain that you might have suspected in these economically constrained times. So before you decide to buy any retail stocks, we’ve created a handy guide to help you find the industry gems, and avoid the industry duds.

Here are five questions to ask as you seek the perfect retail stock…

1. What kind of growth?
Retailers like to expand sales and profits by opening more stores. They open just enough stores in any given market to reap the benefits of local advertising and more efficient distribution costs. But too much expansion in any given market spells trouble. That’s what the fast-food burger joints such as Wendy’s (NYSE: WEN) and Burger King (NYSE: BKW) found out when they tried to place too many stores in any given region. New stores began to cannibalize traffic from nearby locations and these folks have spent the past few years culling their herds of stores.

That’s a question now dogging Chipotle Mexican Grill (NYSE: CMG). The fast casual dining chain flourished by identifying the perfect locations for new restaurants, helping to boost sales from under $500 million in 2004 to a projected $2.7 billion this year. Yet investors are starting to take note of slowing growth in terms of foot traffic at Chipotle’s restaurants, which may mean that the newest stores are sopping traffic from nearby ones.

Action to Take –> You can’t simply focus on a retailer’s track record. Instead, look at how growth will be in the quarters and years ahead by measuring how the most newly opened stores are performing.

2. How are the margins?
In the middle of the past decade, clothing retailer American Apparel (NYSE: APP) had a strong merchandising touch and was able to get full price for its clothes. But in recent years, the retailer no longer has the same cachet, and has increasingly been relying on big markdowns to lure in customers. You can see a clear impact on gross margins, which moved steadily higher until 2009, peaking at 57.2%. (Gross margins are the direct profit made from selling goods and services, prior to other costs such a rent, management’s salaries and other forms of overhead). Gross margins have fallen about 5 percentage points since then — thanks to those markdowns. And it’s hard to make money when margins are weak. American Apparel hasn’t turned a profit since 2009 and analysts expect further losses this year.

Conversely, look for retailers with rising gross margins, which tells you the goods for sale are highly coveted, and rarely need to be marked down. Retailer Saks (NYSE: SKS) has managed to boost gross margins in each of the past three years, which has fueled ever-rising profits.

Action to Take –> Gross margins should be the first thing you look at when assessing a retailer’s quarterly report. If they are falling, you should probably avoid the stock.

3. Where do the inventories stand?
Retailers face a constant challenge when it comes to ordering from suppliers. If they don’t order enough, then popular items will disappear from the shelf. And if they order too much, they’ll end up marking down prices to clear out the bloated stock rooms, crushing profit margins as noted above.

As an investor, you can spot any eventual markdowns before they come by monitoring the level of inventory a retailer carries. Just use this simple ratio: Divide the amount of inventory by the most recent quarter’s sales. If you see inventory has $600 million and $400 million in quarterly sales, that ratio is 1.5. Now, compare that ratio to the same quarter a year ago (to avoid seasonal fluctuations such as pre-holiday season investments in inventory). Did that ratio go up or down? If it went up, then it’s likely the retailer will soon need to kick off profit-sapping sales to move the merchandise — at least until inventories are back at normal levels.

Action to Take –> If you already own a particular retail stock, keep tracking the inventory ratio every quarter for early warning signs of trouble ahead.

4. How are the competitors doing?
Sales trends often impact an entire group of retailers. For example, whenever teen-focused retailer Abercrombie & Fitch (NYSE: ANF) has spoken of slowing store traffic, you usually end up hearing a similar refrain from rivals like Aeropostale (NYSE: ARO).  

Action to Take –> Many investors fail to track the activity across an entire retail niche, only following the comments and actions of the one retailer they own.

5. What are the cash levels?
A number of retailers keep enough cash on hand to handle a tough quarter or two, but are ill-prepared to hold their ground if sales trends are weak for an extended period, which can often lead to operating losses. From Bombay to Circuit City to Linens & Things to Sbarro, many retailers fiddled while their cash burned, and all ended up in bankruptcy court. More recently, Coldwater Creek (NYSE: CWTR) flirted with bankruptcy before securing a five-year loan.

Risks to Consider: It’s unwise to invest in any retailer with more debt than cash, unless the company is posting rising profits (which will help pay down that debt).

Action to Take –> Investing in retail stocks can be a challenge, as these firms must wrestle with economic and spending trends, moves by their rivals, and their own financial management strategies. As you research a retail stock, look at all of these factors before investing.

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The Smart Investor’s 5-Step Test To Find The Next Wal-Mart