TCS Daily


What's In Store?

By James K. Glassman - October 29, 2002 12:00 AM

Celebrating its 30th anniversary, Money magazine recently crunched the numbers and found the 30 stocks that had returned the most, in price and dividends, since the magazine's founding in August 1972. The No.1 stock was, of all things, an airline - Southwest (LUV) - whose value had increased at an annual average rate of 26 percent. If you had invested $1,000 in Southwest 30 years ago, your stake would be worth $1.02 million today.

The list was downright weird. For example, there were just as many steel companies as drug companies (two), and, in a revolutionary period for both finance and technology, the 30 winners included just four financials and two high-tech firms.

But, strangest of all, the leading sector turned out to be retailing - with four stocks in the top 10 and six overall: Wal-Mart Stores (WMT), which finished second, just two one-hundredths of a percentage point behind Southwest; Walgreen (WAG) third; Circuit City Group (CC) sixth; Kroger (KR) ninth; Albertson's (ABS) 18th; and Dollar General (DG) 19th.

Why retailing? It's a sector with two strikes against it. First, it's widely seen as cyclical, at the mercy of the ups and downs of the economy. And, second, it's old-fashioned and unsexy - not an industry that traditionally pays well and attracts top talent. But those stereotypes don't apply to these top performers. Five of them are in categories that tend to do well in good times and bad: Two are discounters, two are groceries, and one is a drug chain. And the winners were far from stodgy. In fact, retailers have been among the main beneficiaries of the explosion in information technology over the past two decades. Thanks to IT, this labor-intensive sector has become leaner and far more productive.

Researchers at McKinsey & Co. recently dissected the remarkable acceleration in U.S. productivity growth - a full percentage point - from 1995 to 1999. Nearly one-third of that increase came from a single sector, retailing. Together, semiconductor and computer manufacturers accounted for a smaller share of the growth than retailers.

Wrote Bradford C. Johnson in the McKinsey Quarterly: "Retail may be the last place you would expect to find a productivity miracle. . . . This low-wage sector seems about as far from the new economy as you could get. Yet retail-productivity growth, as measured by real value added per hour, jumped from 2 percent (1987-95) to 6.3 percent (1995-99)."

Johnson points out that more than half the acceleration came from Wal-Mart alone, an amazing company that last year rang up more sales - $218 billion - than any other business in the world. Wal-Mart is larger than three other worldwide retail giants - Kroger; Royal Ahold (AHO), the Netherlands-based owner of Giant Food, Stop & Shop and several other groceries; and Carrefour, the French "hypermarket" chain -- combined.

Even more remarkable, Wal-Mart boosted its sales per employee to $181,000 a year in 1999 from $148,000 in 1995. Many of its innovations were copied by competitors, which had to keep up or die. Sears, Roebuck (S) actually increased employee productivity at a faster rate than Wal-Mart during the late 1990s, keeping bankruptcy at bay. Still, Sears is struggling, and the stock this year has dropped 60 percent.

Wal-Mart was one of the first retailers to adopt bar codes and wireless scanning guns, which allowed the company's computers to keep inventories tight and capital and labor costs down. But, as Johnson notes, "at least half of Wal-Mart's edge stems from managerial innovations that improve the efficiency of stores and have nothing to do with IT." One idea was to cross-train employees in different jobs, so they can fill in wherever they're needed, a practice that Southwest, unburdened by strict union rules, has also used effectively.

Despite last year's recession and terrorist attacks and this year's sluggish economy and impending war, consumers have continued spending and retail remains a hot sector - but only for well-run, innovative companies. As Money points out, "For every Wal-Mart, Walgreen, Circuit City and Kroger, there are dozens of K Marts, Eckerds, Silos and A&Ps that fall into oblivion." But excellent retailers abound. Of the 100 stocks that the Value Line Investment Survey rates "1" (tops) for "timeliness," one-fifth are retailers.

Besides being a hotbed of innovation, the retail sector is attractive because it's a place where small investors can spot winners in the early stages. You're unlikely to find the next great microchip maker, but close observation at the local mall can lead you to the next great retailer. Peter Lynch, the most successful mutual fund manager in history (he ran Fidelity Magellan), was a practitioner of the art of discovering terrific companies, such as Taco Bell and Dunkin Donuts, just by looking around. You can do it, too.

For example, keen shoppers in the past few years may have noticed the surge of activity in knitting and sewing. Jo-Ann Stores (JAS), which sells fabrics and crafts in about 1,000 stores in 49 states, has been profiting handsomely. Sales have tripled in the past 10 years, and the stock has been one of the best performers of 2002, rising to $26.50 on Friday from $4.40 at the start of the year. Value Line projects that earnings will grow at an incredible 29 percent annually through 2007.

Also benefiting from the trend in stay-and-home aesthetics is Michaels Stores (MIK), which this year will sell nearly $3 billion worth of hobby and art supplies, picture-framing materials, and the like. Like Jo-Ann, Michaels is rated "1" by Value Line. The stock is up 83 percent over the past 12 months, and earnings are projected to jump by nearly one-third this year.

Jo-Ann and Michaels trade at price-to-earnings (P/E) ratios in the mid- to upper 20s. A smaller chain, Hancock Fabrics (HKF), based in Tupelo, Miss., has grown more slowly, but it's cheaper and appears more stable. Hancock carries a P/E ratio of 17, has no debt and pays a nice dividend (currently yielding 2.1 percent). Value Line expects earnings growth to average 19 percent annually for the next five years.

While big-box category killers such as Wal-Mart, Home Depot (HD) and Bed, Bath & Beyond (BBBY) were huge winners in the 1990s, smaller, niche chains like Michaels may be the wave of the future. Here are others that look interesting:

Hibbett Sporting Goods (HIBB): This chain of 340 stores, recently highlighted in Charles Allmon's notoriously cautious newsletter, Growth Stock Outlook, caters to smaller markets with populations under 250,000 in the Southeast. Earnings rose 15 percent last year, and the company's profit margins and returns on investment are impressive. A bonus: The stock has tumbled by one-fourth from its spring high.

Hot Topic (HOTT): This mall-based retailer is a serious, well-run company that sells apparel and accessories, influenced by the latest music, to teenagers of the MTV generation. It has high inventory turnover, $60 million in cash and just $200,000 in debt, and earnings that have risen, since it went public in 1996, in a Beautiful Line, increasing every year from 11 cents to an estimated 95 cents in 2002. Hot Topic's latest idea is a chain of stores called Torrid, catering to larger-size teenage girls. Red Chip Review, a research service that focuses on small-cap stocks, gives Hot Topic an "A" rating in its latest issue, recommending purchase. The stock trades at a P/E of 25, but its earnings are projected to grow at 24 percent annually. Another small-cap that caters to teens, Pacific Sunwear (PSUN), also gets an "A" rating from Red Chip.

Guitar Center (GTRC): Here's a chain in a notoriously fragmented sector - musical instruments. It's the largest retailer of guitars, amplifiers, keyboards, drums and professional audio equipment in the country, with 100 superstores. While shakier financially than companies like Hancock and Hot Topic, it has shown powerful growth and earnings and sales -- 18 percent annually through 2007, estimates the analyst at Value Line, who calls Guitar Center shares "a timely investment."

Besides looking for up-and-coming chains, smart stock shoppers can check out the merchandise at established retailers. For example, I quickly dumped my shares in Gap (GPS), a few years ago when (at least in my opinion) its new seasonal lines became dowdy and uninspired (khaki again!).

Meanwhile, I have been kicking myself for missing the revival of Coach (COH), since its purchase in 2000 from Sara Lee by a group of investors. It was a classic turnaround: A company with a reputation for quality (in handbags, luggage, scarves and so on) spruced up and extended its line. You didn't have to be a pro to see what was happening. Competition is getting tougher (from Kate Spade and elsewhere), but profits have doubled in two years, and there is plenty of opportunity for expansion, especially abroad. Coach gets 20 percent of its revenue from Japan. The stock has quadrupled in price since its initial public offering, but its valuation still seems modest compared with its growth potential.

On the subject of growth: Sanford C. Bernstein, the New York research and money-management firm, recently pointed out that investors, moving into more conservative value stocks, have created a "rare opportunity" in growth stocks. The firm's four largest sectors for investment now are finance, health care, technology and retail, and among its 10 top holdings are Kohl's (KSS), a large-cap specialty department-store chain whose same-store sales for the most recent six months rose 10 percent, and Walgreen, the No. 1 drug chain in sales despite having fewer stores than its rivals, CVS (CVS) and Rite Aid (RAD).

Other fast-growing retailers of note: Target (TGT), the brilliantly managed Minneapolis-based discount chain; Amazon.com (AMZN), the largest online retailer; and Petsmart (PETM), the category-killer chain in pet supplies, with 563 stores and sales that have risen to $2.5 billion from $187 million in 10 years.

Many savvy investors like to "trade" retail stocks, buying them as the economy is turning up and selling them at the first sign of sluggishness. That's the kind of guessing game small investors should avoid. Instead, with retailers, as with manufacturers, financials or any other kind of stock, you should find great companies you can buy and hold - until something (as with Gap) goes wrong.

A good example is Williams-Sonoma (WSM), a company I analyzed enthusiastically in this column on Sept. 25, 1994. Since then, the firm, which sells yuppie-oriented kitchenware in its Williams-Sonoma stores and also owns Pottery Barn and Hold Everything, has grown to 415 stores from 209, with mail orders still accounting for about two-fifths of its sales. Earnings have risen to 65 cents a share from 13 cents, and the stock has more than tripled.

Williams-Sonoma makes an interesting case study in the power of earnings growth. When I wrote about it, the stock had a P/E of 33, which seemed dauntingly high. But growth, at an annual average of more than 25 percent, easily trumped valuation. Today, by the way, the stock has a P/E of 29.

While Williams-Sonoma's sales have quadrupled since 1994, it's still battling to control costs. Writes Value Line analyst Deborah Y. Fung: "The company is currently working on several initiatives, including making improvements in delivery efforts, improving space and labor productivity, lowering product-return rates, and upgrading IT systems." In other words, better management and better technology can make successful retailers even more successful.

 

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