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Retail & Luxury Investment Guide: Opportunities and Traps


Caption text "Retail & Luxury Investment" "your Guide to Smart Investment" logo of wealthor with background picture of luxury watch and jewelries


Introduction

The retail sector is a goldmine for investors, especially when you delve into the luxury segment. In 2019, global retail sales surpassed $25 trillion, with $319 billion attributed to luxury goods alone. So clearly, understanding retail is key to unlocking some of the most lucrative returns the stock market has to offer. Just look at Amazon: the world’s most valuable retail stock has delivered 2000% returns over the past 20 years. Chinese counterpart Alibaba, meanwhile, has doubled in value in just five.

This article aims to provide a comprehensive understanding of the retail and luxury sectors, focusing on consumer discretionary products—items we desire but don't necessarily need. We'll explore the importance of brands, the evolution of retail strategies, and how e-commerce is reshaping the landscape and evaluation of retail stocks.


The Consumer Discretionary: A Brief Overview

The retail sector is broadly divided into two categories: consumer staples and consumer discretionary. While staples are essential items like groceries and cleaning supplies, discretionary are the 'goodies' we desire but don't necessarily need—think clothes, gadgets, and luxury handbags. Companies in this sector can be manufacturers like Nike and Apple or retailers like Amazon and Walmart.


The takeaway: Consumer discretionary products are the things we want but don’t need, and the sector is made up of both brands and retailers.


The Power of Branding

Branding has been around since ancient times, but its importance has never waned. A strong brand can evoke emotions and drive sales. Brands like Hermès use their long history to justify their high prices, while others like Nike make you feel like a pro athlete. Goldman Sachs even considers a strong brand as one that can capture a niche, scale geographically, and fend off competition.


The takeaway: Consumer discretionary products are the things we want but don’t need, and the sector is made up of both brands and retailers.


The Luxury Paradox

Luxury brands defy traditional economic logic. Normally, as the price of a product increases, its demand decreases. However, in the luxury goods market, higher prices often lead to higher demand. This is especially true among the emerging middle class in countries like China, who view luxury goods as a status symbol. That might be why China is a major driver of the 3% annual growth in the luxury goods market.


The takeaway: Brands are valuable because they make people buy things they otherwise wouldn’t – and for luxury brands, higher prices can lead to higher demand.


The Retail Business Model: The Trade-offs and Risks

The retail business is fairly simple but involves significant trade-offs. Brands sell their products to retailers, who then sell them to consumers at a markup, often three times the cost of goods sold. Brands don't have to worry about distribution but lose a chunk of their revenue. Retailers don't have to manufacture products but only get to keep part of the revenue. Some brands, like LVMH, are going "direct to consumer" (D2C), increasing their store count from 2,300 in 2008 to over 4,500. However, physical stores come with high rent costs and long leases, making them a risky venture.


The takeaway: Brands have traditionally sold their product at a discount to retailers, who then handle distribution. But they’re increasingly going direct to consumers, while retailers build their own brands.


The Rise of E-commerce and Its Impact

E-commerce has revolutionized the retail landscape. It offers higher margins and has led to a drop in-store footfall. This has given rise to "omnichannel" retailing, where the physical and online shopping experiences are integrated. Brands like Warby Parker, which started online, are even opening physical stores to enhance customer experience. The shift to digital has made exclusive products more important and put pressure on physical stores to offer more than just products, like Apple's Genius Bar or art installations at France's Galeries Lafayette.


The takeaway: E-commerce has made brands more important, increased margins for those that can get those brands right, and put pressure on physical stores to change tactics.


Evaluating Retail Stocks: Metrics and More

When it comes to evaluating retail stocks, there's more to consider than just glancing at a company's balance sheet. The retail sector has its own set of metrics and considerations that investors need to be aware of. Let's delve into the nitty-gritty details.


Year-over-Year Comparison

Firstly, when assessing a retailer, it's common practice to compare figures like revenue and profit to the same period the year before, not the quarter before. This is because retail has a seasonal business model; for instance, around a third of sales are made in the fourth quarter alone, thanks to the holiday period.


Inventory Levels

Another crucial metric is inventory levels. If inventory is rising faster than revenue, it's a red flag that the company might be struggling to sell its products. This could indicate poor demand or overproduction, both of which are not good signs for investors.


Same-Store Sales

If the retailer has physical stores, you'll want to look at same-store sales. This metric excludes recently opened or closed stores, allowing you to compare like for like. For example, a retailer's revenue might have increased because it opened ten new stores, but if same-store sales are down, there could be cause for concern.


Sales Per Square Foot

Another useful metric is sales per square foot, which helps you compare how efficiently different companies use their physical space. If one retailer has much higher sales per square foot than another but has equivalent rent costs, it could be a better investment. However, in an omnichannel market, brick-and-mortar locations also contribute to digital sales, something they may not get credit for, as pointed out by Goldman Sachs


Financial Modeling

For those who like to get technical, you can build a financial model to make future predictions about a retail business. By finding out how much cash the average store brings in and the total number of stores, you can estimate the overall "sustainable cash flow." You can then use a discounted cash flow model to determine what that cash is worth today and how much you should be willing to pay for the stock. However, be cautious; many companies are closing stores, making it challenging to predict the sustainability of the cash flow.


Price-to-Earnings and EV/EBITDAR

If you prefer a simpler approach, you can use price-to-earnings multiples to compare retail stocks. However, this metric has its limitations as it ignores how companies use debt and leases. A more comprehensive metric is EV/EBITDAR, which divides a company's enterprise value by its earnings before interest, tax, depreciation, amortization, and rent. This multiple allows you to compare stocks more effectively.


Brand Value and Qualitative Analysis

Don't underestimate the power of brand value. Companies like Hermès trade at higher multiples partly because of their strong brand value. If numbers aren't your thing, you can always opt for qualitative analysis. Visiting stores and observing customer engagement can offer insights that lagging indicators like published sales data cannot.


Conclusion: The Cyclical Nature of Retail

Lastly, it's essential to remember that consumer discretionary firms are cyclical. Their performance is tied to the broader economy, and they are often the first to suffer during an economic downturn. Factors like wage growth, interest rates, and inflation can all impact your investment. Timing is everything, and while you could benefit if you time it right, you could also face losses if the economic conditions are unfavorable.


By understanding these metrics and considerations, you'll be better equipped to make informed decisions in the retail sector. Whether you're a numbers person or prefer the hands-on approach, there's a strategy for everyone. Happy investing!

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