Smart Money

June 25, 2014 2:31 pm

Laggard retailers remain a horror story

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Even after recent losses retail stocks are not cheap

This is a horrendous market in which to try to make money, with retailing stocks as exhibit A.

Globally and virtually without exception, retail stocks have fallen brutally so far this year. They are obvious laggards around the world. This even includes internet retailers. Many large retailers have specific problems, and there are well-known and much-hyped structural shifts within the industry itself, but this is plainly a sharp and unified turn in market sentiment against the sector as a whole.

Such indiscriminate moves generally spell opportunity to contrarians, as they suggest that trends have been taken too far. And an obvious rationale for punishing retailers would appear to be lacking. As this column pointed out last week, a sell-off of consumer cyclical stocks usually only occurs when the economy is slowing and the market as a whole is down. This is not the case – US stocks keep setting fresh records, while economic recovery in the US, the UK and much of the eurozone continues to be intact, albeit far less robust than most would wish.

Despite all this, it is hard to argue that the sell-off of retailers is overdone. They were badly overpriced before and do not offer compelling value now.

The bald figures do not lie. Of the 19 sectors in the FTSE-Eurofirst 300 index, retail is easily the worst performer so far this year, down 3.8 per cent. Within the sector, laggards are the UK supermarket Wm Morrison (down 28 per cent), along with Jerónimo Martins, Tesco, Sainsbury, Metro, Carrefour and Inditex, all of which have fallen more than 5 per cent.

In the US, the consumer discretionary sector lags behind all others within the S&P 500, while the S&P’s worst performing stocks this year read like a list of big retailers: Coach, Whole Foods Market, Staples, Best Buy and Bed Bath & Beyond are the only stocks to have fallen 20 per cent or more. Even Amazon is down 18 per cent, so this is not the familiar story of high street retailers losing out to the internet.

Stocks overpriced

So retailers have fallen in a strengthening economy. Is this unreasonable?

No. Results for US retailers for the first quarter were disappointing as shops complained that bad weather had affected revenues. There are also doubts over their profitability. Using the MSCI All-Countries world index, retailing has a return on equity of 20.1 per cent, thanks to margins that look hard to sustain.

Globally, the sector trades at a multiple of almost 5 times its book value (only consumer services is more expensive), and at 24.1 times earnings – higher than any other sector bar real estate and consumer and professional services. This is after retail stocks had been sold off.

Retail is the only sector to be down for the year, on a global basis. But the sector is still only about 6 per cent below its high. Other more popular sectors, such as utilities, are down far more than this.

There is no reason from technical positioning to expect a bounce. According to Goldman Sachs, consumer discretionary remains the most popular overweight for hedge funds, while utilities is the most popular underweight. There is no risk of a “short squeeze” to push retailers back up.

Further, there are reasons to fear for any retailer, as the sector is going through a secular transition. Retailers can survive with online competition, but they must develop an “omni-channel” approach, selling both online and in bricks and mortar branches. This requires investment and entails many execution risks.

Customers are used to seeing lower prices online, putting pressure on prices on offer in stores. The risk is that online media does not transfer profits from the likes of Barnes & Noble and Borders to Amazon, but rather that it ultimately drives a permanent reduction in profits.

‘Smart beta’ strategy

The retailing sell-off looks like a sensible response to news, in line with a “random walk” by the market, rather than the kind of overblown sentiment that might offer an opportunity to contrarians.

This is good to know for believers in free markets. It is lousy news for anyone attempting to make money by beating the market. At present Mr Market is refusing to offer any straightforward, clear-cut options to make money. Momentum as a strategy has ceased to work, at least for now. High “beta” stocks (like retailers) that are most sensitive to the market around them have also stopped delivering. And there are few obvious bargains.

It is small wonder that long-short equity hedge fund managers, who make paired bets for and against different stocks, complain that the last two months have been among the hardest in history. And it is also no surprise that big asset managers are looking to “smart beta” strategies – which systematically screen stocks for specific factors such as valuation – that can plausibly promise to outperform the market in the long term.

Spotting short-term winners looks harder than ever. Strategies that seek to eke out smaller victories over the longer term look far more appealing.

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