The Rational Walk
Intelligent Investing is not a "Random Walk"

Retailers ‘Stuck in the Middle’ May Soon Face Extinction December 16, 2010

Much of what we do as investors involves studying businesses and critically evaluating the returns that are likely based on management’s competitive strategy.  The elusive search for true “moats” is often frustrated by quick technological change which can make yesterday’s incumbent firm today’s dinosaur.  Investors who pay a rich valuation for a business with a moat must be confident that the advantages leading to high returns today are not destroyed by new types of competition in the near term.

Competition has always been a threat to retailers and numerous strategies have been employed to achieve acceptable returns on investment.  Most investors are familiar with Michael Porter’s work on competitive strategy and the three “generic strategies” firms can successfully employ.  In his well known book, Competitive Strategy, Mr. Porter describes the three generic strategies:  Overall Cost Leadership, Differentiation, and Focus.  This can be translated into a retail context by observing the strategies used to appeal to mass markets, elite shoppers, and niche markets.  A business that fails to develop competitive advantages supporting one of the generic strategies is said to be “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability.  It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms.  Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall.  The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system.  Competitive Strategy, p. 41-42

It is not particularly difficult to think of companies that are neither cost leaders nor differentiators.  Usually such companies produce sub-par returns on invested capital but many have historically muddled along for years with incoherent strategies.

The days of muddling along without a clear strategy may be numbered for retailers in the age of the smart phone.  As The Wall Street Journal observed today in a front page article, shoppers are increasingly equipped with mobile phones that not only provide internet access but also often allow instant price comparisons by scanning bar codes on merchandise.  This is surely the nightmare of middling retailers that have long relied on confusion or ignorance to move uncompetitive merchandise.

Earlier this year, Nielsen projected that the smart phone market would exceed fifty percent of mobile phones in the United States by the end of 2011 as the chart below illustrates:

If it is possible to browse through the selection at Best Buy and immediately check prices at Amazon.com or Wal-Mart, pricing pressure is eventually going to drive most business to the lowest cost provider.  Even worse for “brick and mortar” retailers, most online retailers benefit from not being required to collect sales tax in jurisdictions where they lack a physical presence.  Customers who are reluctant to buy products “sight unseen” can then use the infrastructure provided by physical retailers to get comfortable with their purchase and then immediately scan the product’s bar code and order from the lowest cost online provider.

Best Buy recently reported disappointing results and the CEO made comments during the conference call related to competitive pressures.  Shares plummeted in the wake of the results as investors reconsidered the company’s strategic position and competitive strengths.  Retailers such as Best Buy have long competed for business by keeping a wide variety of merchandise in stock and promoting select products in order to bring customers into the stores and allow for cross selling higher margin merchandise.  This strategy may no longer be viable as smart phones begin to dominate consumer behavior in ways that would have been unthinkable just a few years ago.

Physical retailers will not become extinct but they will increasingly be forced to choose a coherent strategy based on a broad offering of very low prices or true differentiation.  While the threat of internet commerce has been a consideration for investors for much of the past fifteen years, the threat has become much larger with new smart phone technology.

Disclosures:  None.

Avoid Relegating Investment Errors to the “Memory Hole” January 6, 2010

No one enjoys dwelling on past errors whether we are talking about investments, career choices, or poor decisions in personal relationships.  It is far more pleasant to think about what has worked well in the past and to relegate unpleasant memories to what George Orwell referred to in 1984 as the “memory hole”.  In Orwell’s story, the “memory hole” is a chute through which all evidence of unfavorable events are sent to an incinerator by order of a totalitarian government. The attempt to erase bad memories by a government is tyranny;  doing the same in business and investments can lead to repeating the same errors again and again.

While it is never productive to endlessly dwell on mistakes, it is healthy to examine key errors to see whether any lessons can be learned.

“Pie on Face Award” for 2009 …

The Rational Walk is not an investment newsletter and does not provide investment advice.  Nevertheless, at times, we discuss specific securities and views regarding the business prospects for companies.  One such example last June involved a decision to favor shares of Wal-Mart Stores over shares of Sears Holdings.

Let’s be clear:  The mere fact that a stock was sold that has since appreciated by nearly fifty percent does not, by itself, justify the “pie on face” award.  During any six month period, virtually anything can happen in the stock market and price movements cannot be used to evaluate the success or failure of an investment decision.  The reason this decision was a mistake was based on faulty reasoning at the time rather than subsequent short term stock price movement.  Let’s take a look at the two main factors behind the decision.

Error #1:  Excessive Fixation on Macroeconomic Factors

As described in the article, the decision to purchase Sears Holding shares was based on a belief that the underlying real estate assets far exceeded the overall market capitalization of the company.  While the book value of the real estate holdings are carried at historical cost, evidence existed to justify much higher valuations.  In fact, Bruce Berkowitz of the Fairholme Fund assigned his team to a methodical examination of property tax assessments and concluded that the real estate alone could be worth $80 to $90/share.

Throughout the spring of 2009, like most investors, I spent significant time following macroeconomic trends and thinking about the implications of the severe recession on my investments.  Since the tax assessments the Fairholme team examined were from 2008, I became concerned that the values of the real estate may have become impaired since the analysis took place, particularly due to the impact of the recession on commercial real estate such as malls.

Error #2:  Changing Investment Rationale After Initial Investment

The second error involved changing my investment rationale after the initial investment was made.  In the case of Sears Holdings, my initial investment rationale was a play on a severe undervaluation of the company’s real estate holdings rather than an investment in the retail operations of the company.  In my view, if Sears Chairman Edward Lampert could engineer a turnaround at the retail operations, that could add even more value but was not essential to the investment thesis.  In other words, the investment came with a free option on the recovery of the retail operations.

In addition to allowing my macroeconomic concerns impact my views on the value of the company’s real estate holdings, I also became worried that customers would abandon the retail stores given the weakness of Sears and Kmart relative to stronger competitors.  But it made no sense to allow this to impact the investment decision since the retail operations were not part of the original investment thesis.

Lessons Learned

Perhaps the most important lesson to learn is that paying excessive attention to the macroeconomy is generally unhelpful when making specific investment decisions.  This is why Warren Buffett always says that his investment decisions are not made with regard to macro conditions.  It was easy to justify making “exceptions” to this rule in a year like 2009 when talk of depression was widespread.  But it was an error.

The second lesson is to always remember why a security was purchased to begin with.  If the investment thesis centered on real estate value, then only a true erosion of the original thesis should justify a decision to liquidate below appraised intrinsic value.

As of today, Sears Holdings has reached my original high estimate of the intrinsic value of the real estate holdings at nearly $90 per share.  A buyer of the shares today might have to justify the purchase based on the retail operations; a buyer at $50 did not need to consider the retail operations to justify a purchase.  Based on the original investment thesis, Sears shares would be sold at current levels.  However, due to the faulty thinking discussed in this article, they were sold prematurely at $61 thereby giving up an additional 50% of upside.

It so happens that even at $61, the shares were sold at a significant profit.  The performance even exceeded the S&P 500 return over the holding period.  But that is hardly the point.

Examining this type of mistake is never pleasant but it is necessary to avoid repeat performances.  All investors should take the time to do the same to avoid the risk that the “memory hole” will extinguish such experiences and lead to future errors.

Wal-Mart’s Upscale Strategy for Growth in China December 9, 2009

Companies that attempt to expand from their home base into foreign countries must adapt their operations to suit the preferences and peculiarities of each local market.  In the “Tea with the Economist” interview shown below, Wal-Mart’s head of China operations provides some insight into how Wal-Mart has adapted the familiar model we are used to in the United States to suit local preferences in China.

According to Mr. Chan, Chinese customers place a much greater emphasis on fresh food selections and many actually visit a Wal-Mart store once or twice per day.  Wal-Mart is also considered to be a relatively upscale retailer in China in contrast with the budget conscious image the company has developed in the United States.

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Will Consumer Brands Survive the “Great Recession”? August 27, 2009

Very few Americans have experienced an economic downturn as severe as the current recession.  Although it is very possible that GDP will show a positive reading for the third quarter, hardly anyone expects the employment situation to improve significantly until 2011.  It is very possible that unemployment will soon exceed the worst levels of the 1981-82 recession.  In most economic downturns, consumers attempt to substitute cheaper private label “store brands” for brand name goods.  The key question is whether the current “great recession” will produce more lasting effects in consumer behavior.

The Rise of Private Labels

According to The Economist, private label sales have grown by 9% in the United States and 5% in Europe over the past year and have seen gains from branded goods in many categories.  This has been driven by consumers seeking to save money but also by large retailers attracted by higher margins on their own private label merchandise.  For example, the estimated share of private label goods is now 20% at Wal-Mart and 35% at Kroger.  In many cases, it is easy to trim a shopping bill by 20 to 30% simply by substituting private label brands without suffering any discernible impact when it comes to quality.

Owners of Economic Moats Beware …

The presence of an economic moat can often translate to the bulk of market capitalization for consumer product firms.  Such moats are often built over a period of many decades and investors are normally willing to assign much higher valuations to companies demonstrating the presence of durable economic moats.

This is entirely logical in cases where such a moat can produce high returns on equity over time and are considered durable.  However, if the moat is impaired, much of the goodwill embedded in the market value of a company can quickly disappear.  Therefore, it is critical for investors to carefully evaluate the implied presence of a moat when considering whether a company is fairly valued.

Visible vs. Invisible Consumption

One quick test that is useful to apply to any consumer product company where the market valuation implies the presence of a moat is to consider whether the branded product represents an item that brings status to the consumer.  Most individuals care deeply about how they are viewed by family, neighbors, and co-workers and wish to appear successful.  Items that are consumed in a visible manner, such as soft drinks, beer, or packaged food tend to be items that enjoy a durable economic moat compared to items such as laundry detergent or paper towels which are consumed in private.

For example, consider the decision making process of a consumer who is at his local supermarket for a weekly shopping trip and needs to purchase items for a dinner party or barbecue over the coming weekend.  Will this consumer want to purchase generic soda and discounted beer for the party?  Probably not.  Assuming that the consumer does not perceive a major quality difference in the private label paper towels or detergent, he may choose to purchase those items in order to pay more for the branded soda and beer.

Buyer Beware

An investor who pays a significant premium for a business based on the presence of an economic moat needs to carefully examine the durability of the moat.  This must go beyond whether the moat has worked well in the past and consider the scarring impact of the current economic recession on many consumers who have never experienced anything like it in the past.  Such consumers may adopt a more thrifty attitude toward spending even when the economy improves.  In general, since consumers care deeply about the opinion of their peers, branded consumer products that represent “visible consumption” should logically be more durable than products that are mainly consumed in private.

Clearly there will be major exceptions to this generalization and many brands of “invisible consumption” products will survive this recession fully intact.  However, the combination of large retailers with an economic interest in pushing private labels with the lingering psychological impact of a major recession on consumers must force investors to critically examine each moat for durability and refuse to pay for moats that appear vulnerable to impairment in the future.

Will the “Great Recession” Change Long Term Consumer Behavior? August 4, 2009

The Great Depression of the 1930s changed consumer behavior for decades among those who experienced the downturn firsthand.  Although the vast majority of consumers today have no direct recollection of the Great Depression, most everyone remembers relatives who were frugal into their old age even decades after their economic fortunes improved.

With consumer spending in the United States averaging over two thirds of GDP, figuring out whether consumer behavior will ever return to pre-recession levels is a critical question for economists.  The consumer has reliably returned after each of the prior post war recessions, but the current “Great Recession” is much more severe than any downturn since the late 1930s.  The longer the recession persists, the more scarred consumers will be over the long run.

Those who follow reports on consumer spending in the United States have seen no shortage of forecasts on this question.  It is sometimes interesting to see how our experience compares with that of other countries even though cultural patterns have much to do with consumption vs. savings decisions.  ASDA is a British supermarket chain and a subsidiary of Wal-Mart.  In the video shown below, ASDA CEO Andy Bond talks about consumer spending and his views of whether consumer behavior is likely to revert to pre-recession levels.

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Disclosure:  The author owns shares of Wal-Mart, the parent company of ASDA.