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Shopping for Opportunities as Online Rocks Retail

Retail is hurting as more brick and mortar stores feel the pressure from online merchants and the rising costs of a physical presence. But three key areas present opportunities.

Denny Galindo Equity Strategist, Wealth Management

Although U.S. consumer spending is forecast to increase 2.5% this year—and consumer sentiment indicators are reaching levels not seen since the early 2000s—retail is troubled.

Consumer spending represents a whopping 70% of the U.S. economy, with retail about one third of that. However, shoppers’ growing preference for online purchases, the overbuilding of stores and rising interest rates have put retail under pressure.

Retail stocks are up 7% this year compared with a 6% gain for the S&P 500. But a deeper examination shows that nearly half of retail stocks are down for the year to date since some of the largest index constituents are e-commerce only and have double-digit returns that offset declines from traditional retailers.

So where does this leave the outlook for retail stocks?  And where are the opportunities?

Such closings impact malls: by lowering traffic at nearby stores;  pricing, which flows down to industry profits; and inventory, as fewer stores require less inventory. Interestingly, fear of a retailer’s bankruptcy can be self-fulfilling since vendors may require stiffer payment terms for struggling retailers, which could exacerbate any underlying cash-flow issues.

In addition to pricing and traffic pressures, uncertainty regarding a potential U.S. border tax—most retailers import much of their wares—seems likely to weigh on the sector until the details of tax reform are finalized.

However, even an industry in turmoil has opportunities. We at Morgan Stanley Wealth Management are now focusing on consumer-facing businesses with recurring customer sales and customer loyalty, secular growth and the least exposure to store closings.

Business models with high upfront costs often lead to recurring sales. Organizations with annual fees, such as warehouse clubs, encourage customers to concentrate purchases to maximize the value of the fee. The companies with the best selection tend to achieve a high and growing share and stable revenue from membership fees. Another form of customer captivity is organizations like media companies; they may win over a customer with a popular movie, then generate a repeat sale at an affiliated resort or through branded consumer content. In both cases, recurring sales often lead to less volatile stock prices and high returns.

Consumer companies with favorable secular growth. Online-only retailers are gaining share of total retail transactions yet they account for only 8% of the total which means they have room to increase penetration. Additionally, payment networks are still gaining share versus cash and actually benefit from online growth. These secular growth industries are well positioned to grow as traditional retailers struggle.

Second-order effects on store traffic and inventory. Companies depending on mall traffic will likely feel the impact of store closures nearby—even if their own businesses are solidly profitable. Consumer products companies selling wares from T-shirts to shoes to cosmetics may suffer as liquidating stores redistribute inventories to other stores, reducing new orders or marking down inventories for quick sales, thereby suppressing prices.

The bottom line: a focus on customer captivity, recurring revenue and secular growth while avoiding second order impacts should reduce risks and lead to better returns. 

Note: This article first appeared in the March 2017 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

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