Retail Carnage (Part 1) – Perception Vs Reality

As a value investor, it should not be surprising that I have been spending a lot of time on the retail and restaurant sector over the last year or so. The space has been pummeled by Wall Street in recent quarters, as the thesis gains steam that we have essentially reached “game over” for traditional businesses. We will buy all of our stuff from Amazon (AMZN) because it is the only rational choice when we are offered a vast selection, great prices, and fast delivery. The same goes for our dining habits; why not have our groceries and meals delivered too? That way we can binge on our favorite Netflix (NFLX) shows without ever being bothered to leave the house to run errands.

I am not going to tell you that these trends are not real. Heck, I am an Amazon Prime member who subscribes to Netflix. The only time I visit an actual pet store is when Amazon is temporarily sold out of the pet food I need. I get it.

I guess my background as a fundamental evaluator of stock prices, though, tells me that the simple “macro” call (which is to avoid investing in any business that is being “Amazoned”) is not automatically the right one. I have always followed the premise that stock prices are a function of the underlying cash flow of the business. As a result, as long as a public company is producing free cash flow, it has value. Accordingly, if the financial markets are mispricing the intrinsic value of that cash flow, there is an opportunity for investment gains. Just because the internet has changed the landscape in many sectors of the economy, it does not follow that the link between cash flow, company values, and investment returns has somehow been rendered obsolete.

But if you have been watching the stock action in these industries you can not help but realize that Wall Street is not really valuing these stocks on cash flows right now. Good luck trying to justify Amazon’s stock price with numbers. Instead, investors simply conclude (correctly, if you ask me) that they are going to take market share in any number of sectors and the end result will almost surely be a higher stock price years down the road. It is more of an “over/under” bet (the line being their existing business today) than it is a prediction about exact profit levels.

And the flip side is also true. Bricks and mortar retailers are being valued at some pretty insane levels in many cases, especially if you happen to have stores in malls. But you can justify that if you ignore the actual numbers and simply make a more general prediction that 5 or 10 years from now there will be no reason to visit a mall or open air shopping center.

For a while now I have been trying to pick and choose attractive investments in these sectors where the sentiment does not line up with the actual financial results of the businesses. It has been a frustrating endeavor with very mixed results. It has become clear to me than in many cases the stock prices are simply not going to line up with the underlying profits or asset values, unless the company takes a proactive role in narrowing the gap (e.g. through a sale or some sort of transaction that “proves” the values). As the market continues to underprice retail-related assets, I think we will see more and more companies take a proactive role, though movements on this front have been muted so far.

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Full Disclosure: Long shares of Amazon and Kohl’s at the time of writing, but positions may change at any time

Disclaimer: Peridot Capital ...

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Gary Anderson 1 month ago Contributor's comment

Online buying is way overrated. It is not the reason for much of retail's decline, only for some of that decline.

Craig Newman 4 weeks ago Member's comment

I think it depends on the person. I for one shop online more and more. And with near instant delivery times from super markets and stores like #Amazon, I hardly see any reason to go to a physical store. It's not exageration when I say that weeks (occassionly even a month or more) have gone by without my stepping foot in a physical store.

Gary Anderson 4 weeks ago Contributor's comment

That seems to be unusual, to not want to get out in public. I suppose a certain percentage of Americans will do that. Perhaps your employment is enough of the public for you. But for many, getting out is healthy. Remember, we are talking about a decline in restaurant traffic too, and online stores have noting to do with that decline. Truth is, the decline is a manifestation of economic weakness for the consumer. Online ordering only explains a part of the retail "problem".