Shares of retail stock have staged an impressive rally over the past three months, as the S&P 500 has moved up over 30%. However, when it comes to retailing, caution should be taken before investing in this industry.

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Weak Economics
The majority of retailing businesses have very little in the way of competitive advantages and several disadvantages. First, there is inventory obsolescence. If you are in the fashion business, your products have a shelf life of a few months before they are marked down. This is a problem in any economic environment, but a disaster during a recession.

Second, there are no trade secrets in retailing. If you want to discover what your competitor is doing, you can simply visit the stores and pick up information.

Finally, you have Wal-Mart (NYSE:WMT) which is just about every retailers nightmare. The facts speak for themselves, as Wal-Mart grew from a regional department style store to a national low-price superstore. When Wal-Mart began selling toys, the once dominant Toys R Us had to go private as it could no longer meet the demands of a public company and deliver competitive results. When Wal-Mart began to seriously sell quality electronics, both Best Buy (NYSE:BBY) and Circuit City faced such intense competition that the market could no longer support the both of them, which led to Circuit City's eventual filing for bankruptcy.

Retailing is a commodity type business. As such, when you can sell a commodity for less, you get the business.

A Few Exceptions
There are retailers that have such unique characteristics as to be exceptions. The first exception is luxury products. There is no better example, in my opinion, than that of luxury retailer Tiffany (NYSE:TIF). For the past 10 years, return on equity has averaged over 15%. Since 2000, book value per share has increased every year, until a slight decline in 2008. Nonetheless, book value has gone up from $5.22 in 2000 to just under $13 in 2009. Today you are paying 1.6-times book value versus over seven in 2008

Charlie Munger once asked, "Name the one product who's price can be raised and still experience increased sales." The answer: luxury goods. There's no substitute for the feeling that she gets when she's opening a blue box from Tiffany's. Folks will pay up for that priceless moment.

Finally, you have Target (NYSE:TGT), which is the upscale version of a Wal-Mart. Considering the damage that this economy has done to people's wealth, Target and Wal-Mart should find themselves in a sweet spot for years to come. As for Tiffany's, folks will continue to get married, have birthdays, anniversary's and other memorable moments.

The Bottom Line
Retailing is a very tough business, with little in the form of competitive advantages. Unless a retailer can really demonstrate a durable advantage like low prices for Wal-Mart or a unique luxury good like a Tiffany diamond, caution should be taken before betting on this industry. (Read Analyzing Retail Stocks to learn about the most important metrics to look at when analyzing retail stocks.)

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