Ranging from food to electronics, from luxury specialists to discounters, the retail sector is a diverse and dynamic one – and extremely susceptible to changing consumer tastes, as well. Yet the industry seems to grow every year, regardless of economic cycles or capital costs.  Investors can find a lot to like (and dislike) in retail stocks; in doing their due diligence on companies, they should focus on return on investment (ROI), in four particular areas.

The Four Rs

No matter what a store's selling, successfully managing return on investment (ROI) and other financial indicators is the key to a healthy retail business. Expansion is an important part of retail growth but only when generating positive cash flow from those capital expenditures. Without a positive ROI, retailers are throwing good money after bad. It's critical for retail managers to quantify as much as possible so that they may better understand the profitability and financial health of their business. When combined with other financial metrics like same-store sales, the four Rs of retail should paint a financial picture that's vibrant and constantly getting stronger.

1. Return on Revenues

Return on revenues (ROR) is the first R and the cornerstone of any retail operation. It tells you how much net income is made from those top line revenues. Nearly as important is gross margin return on investment, which is the gross margin profit on the cost of your inventory. The more you make per unit sold, the easier it is to produce bottom line net profits. ROR has two basic building blocks: 

  • Balance Sheet: Every retail store maintains inventory. Considered an asset on the balance sheet, when combined with the P&L statement, it can tell you a lot about how the product is selling. Dividing inventory into the trailing-12-months' revenue, you arrive at the number of inventory turns in those 12 months (the higher the number, the better). Grocery stores traditionally have lower margins, and thus need to turn inventory many more times than luxury retailers who make far more per transaction but far less in overall unit sales. Ultimately, the two retailers may deliver the same net income, but from much different volumes.
  • Cash Flow Statement: Did you know it's possible to be profitable and yet generate negative cash flow? Well, it's true and the converse happens as well. This is when a business losing money generates positive cash flow. Often it can be as simple as the payment terms you have with your suppliers. For instance, the profitable retailer might get 30 days to pay its bills while the money loser gets 60. Although this catches up with the money-losing retailer eventually, it can carry on for some time. Look for companies that make money and generate positive cash flow. Even better are those that generate free cash flow, which is the cash from operations after taking into account capital expenditures.

2. Return on Invested Capital

Moving from the big picture to a frontline individual store's operations for a moment, the second R in retail makes its appearance. Return on invested capital – sometimes referred to as "four-wall cash contribution" – is the amount of profit generated per store. The speed at which each store can return the invested capital required to open it, the faster the retailer can grow its overall profits. For example, if a new store in a home improvement chain averages $2 million in annual sales in the first year open and its four-wall contribution is $200,000, a $300,000 investment to build and open the store is repaid in 18 months. Its return on invested capital is 67%. Successful retailers look for store revenues and four-wall contribution to increase in years two and three. If not, there's a problem. 

3. Return on Total Assets

Going back to the big picture: return on total assets indicates how much operating profit is making from its assets. Here again, bigger is better. In the retail industry, this number will vary depending on the business. Specialty retailers require less retail space, fixtures, inventory and so on. Home improvement stores on the other hand operate in much larger retail footprints and thus require greater assets. Having to use more doesn't necessarily make these stores inferior. It's simply the cost of doing business in that particular industry. What's important is how a retailer's return on total assets compares with the competition. If it's generating a return on total assets of 10% and its competitor across the street does 20%, it's an indication that the competitor is operating more efficiently.

4. Return on Capital Employed

This tells us how efficiently retailers use their capital. It is defined as earnings before interest and taxes (EBIT) divided by capital employed, which generally is represented by total assets less current liabilities. However, a more appropriate definition of capital employed would be shareholders' equity plus net debt. After all, ROCE is a pretax look at its return on debt and equity, which is different from ROIC, which is an after-tax (dividends paid) look at its profitability. While ROCE is a more telling number than return on equity, it too has its limits. For instance, if a retailer in the auto parts business repurchased $1 billion of its own stock in a given year and as a result, its book value turned negative, both the ROE and ROCE are affected adversely, despite the fact it made close to $1 billion in net profit. Financial metrics can only take you so far.

Risks of Retail Investing

Economic Conditions

If there is a recession and many companies lay off workers, cut their budgets and implement a salary freeze, consumer spending tends to slow down or even decrease, which has an immediate negative effect on the retail industry. Individual retailers and specific sub-sectors can really struggle during an economic downturn; home improvement stores saw sales tank after the collapse of the housing bubble in 2007-2008, for example.

But the retail sector as a whole is largely insulated from the effects of business cycles. Consumers still shop during hard times. Obviously, they continue to need staples such as food and clothing. However, the recessions of 2000-2001 and 2007-2008 demonstrated that Americans still buy discretionary items – computers, cellphones, cars – even when the economy is not humming.

Another insulating factor: Retailers are not limited to their local areas nowadays. In fact, they tend to be among the first companies to share in the growth of emerging economies. The low labor costs and lack of existing competition make it feasible for retailers to increase margins by shipping cheap goods to the developed world. And the Internet has made it easier for low-capital, low-cost companies to service even poor nations. Goods produced in Malaysia, South Korea or India can be marketed and sold all around the world without a brick-and-mortar presence.

However, retail is a notoriously seasonal business. First-quarter performance is typically dominated by fourth-quarter numbers.

Regulation

Federal and state regulations pose another significant risk to the retail sector. As many retailers rely on labor that earns hourly salaries close to minimum wage rate, any increases in the minimum wage can adversely affect profitability in the retail sector.

Competition and Consolidation

High competition and consolidation in the retail sector is another big risk that investors should consider. Because of proliferation of e-commerce, a person does not necessarily need a brick-and-mortar store to start a retail business. As certain retailers have been slow in embracing e-commerce, their sales and profitability have suffered as a result of consumers shifting away towards competitors that offer goods through the Internet that can be shipped anywhere. Also, as the retail sector consolidates, there are more concentrated companies with very large resources and increased competitive advantages.

Channel Disruption

Disruption or failure of the supply channel represents another important risk in the retail sector. For example, the labor strikes of 2014-2015 at the U.S. West Coast ports disrupted the supply of inventory for many retailers, negatively affecting their sales.

What Type of Investor?

Retail may not be the best bet for the value investor. If there is one area where the Berkshire Hathaway boys, Warren Buffett and Charlie Munger, have struggled, it's in retail. The Omaha, Nebraska-based duo famously avoided the trappings of the Internet bubble in the late 1990s, but their aversion to technical disruption has also kept them from accurately assessing retail successes. When it comes to retailers, Buffett specifically identifies a lack of "economic moats" (competitive advantages that keep other businesses at bay and protects margins).

On the other hand, retail is an attractive sector for a growth investor due to its propensity for turning in bigger-than-average gains when the market is rising. Retail securities are divided into seven discrete segments: automotive; building supply; distributors;grocery and food; online; general;
and special line or specialty retailers. All of them tend to track the market as a whole, but with a degree of greater volatility, which means stronger gains during bull runs, but larger losses when the bears roar.

More specifically, retail's seven sectors carry betas that range from 1.03, indicating 3% greater volatility than the market, to 1.44, a whopping 44% more volatile than the market as a whole. That means when a bull market is on, a retail investor can expect gains that beat the market by anywhere from 3% to 44%, depending on how he divides his investment dollars between the sector's various segments. The potential for such aggressive gains makes retail a sector that is closely monitored by growth investors.

Price-to-Book Ratio

Before selecting which retail sub-sector or company to invest in, one important calculation used to understand a sector's or company's value is the price-to-book ratio, or P/B ratio. According to data published by the NYU Leonard N. Stern School of Business, as of January 2018, the average P/B ratio of the retail sector is 8.82.  The average is calculated using an arithmetic mean of all the retail segments' P/B ratios. By sub-sector, it breaks down like this:

     
Retail (Automotive) 5.22        
Retail (Building Supply) 32.98        
Retail (Distributors) 3.47        
Retail (General) 4.00        
Retail (Grocery and Food) 3.30        
Retail (Online) 9.37        
Retail (Special Lines) 3.43  

Companies with P/B ratios greater than 1 are typically thought to be overvalued, while companies with P/B ratios less than 1 are thought to be undervalued. This is why value-investment gurus like Buffett tend to shy away from the sector.

Factors that Affect Stock Prices

The primary drivers for retail share prices tend to be consistent: higher earnings, better cost management, new-market growth and brand name recognition.

Retail companies have to match their products with their consumer demographics and tastes. If you are looking at a multinational retailer, for example, check its exposure and direct investment in emerging markets, such as Mexico, Indonesia, Brazil, India and China. This is where the most aggressive growth is likely to take place.

Online retail is the fastest-growing segment in the industry, but it also has the lowest profit margins of any sub-sector, retail or otherwise. Internet companies aren't necessarily valued more highly, but businesses that ignore the Internet do so at their own risk.

Many retailers offer credit for purchases. One dramatic example is the retail car market. Most American and Japanese car manufacturers make most of their money through financing and not from making cars. Accounts receivable can be extra important for these companies.

Inventory is often the largest investment for retailers, so look at inventory efficiency as a key differentiator among similar companies.

Retail Investing Strategies

Growth investors who are especially savvy employ a strategy called sector rotation. This technique enables them to make the most of retail's gains while mitigating its risks. Sector rotation requires an investor to monitor the economic cycle closely. The investor puts his money in retail and other volatile sectors during the expansionary phase. When he projects a transition to a period of contraction, he shifts out of retail and into more stable sectors, such as utilities, that are known for holding their value during bear markets.

Other retail investors employ options strategies that take advantage of the sector's volatility by rewarding big market moves, regardless of direction. Two popular ones are the long straddle and the long strangle.

The Bottom Line

Although customer service is an important component of successful retail, it's just one of the many things that must be executed flawlessly in order to continue growing. At the top of the list should be financial discipline. If a retail business doesn't possess this trait, it likely won't be around very long. The strongest retailers understand that every store should be profitable. Otherwise, there is no justification for tying up the capital required to open them. The faster a store is able to recover the initial investment, the faster it's able to please the four R's of retail. (See also: Analyzing Retail Stocks.)

The retail sector is divided into seven segments, all of which confer greater risk than the broader market. Retail securities tend to track the market as a whole but with a greater degree of volatility, resulting in stronger gains during bull markets but larger losses during bear markets. For this reason, savvy investors hedge exposure to the retail sector by investing in noncyclical or countercyclical sectors that outperform the broader market during periods of decline.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.