Last week was particularly tough on retailers thanks to a report that showed online spending increased 1.4 percent while it declined -0.50 percent for brick and mortar stores. Department stores like Nordstrom’s and JC Penny both fell more than -10 percent on earnings and forward guidance news.
Even though we don’t own either of these two retailers, we own others and the bad news made its way into the stocks that we do own. For once, I’m happy that I’m not allowed to mention the specific stocks that we own, a regulation that I usually find annoying.
We bought the retailers a few years ago for two reasons. First, as a whole, they still generate a lot of gross profits with their assets, a strong measure of profitability. Second, they were cheap! Everyone is rightly afraid of the online competition and have sold of the stock.
This setup epitomizes good value investing: quality companies that trade at discount prices. Warren Buffett makes it sound so easy: ‘Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.’
But here’s the problem: retail stocks just keep getting cheaper and cheaper. As a whole, department stores fell almost 40 percent in 2015, which seems like an opportunity. They stabilized in 2016, but are off another 15 percent or so this year.
One of the problems with value investing is that there are periodically stocks that are referred to as ‘value traps.’ A value trap is just what it sounds like: a cheap stock that looks more and more attractive right up until the time that it goes out of business. Borders book store is a great example in my mind.
Value traps are part of value investing. Most of the time, companies are cheap because something is happening in the industry. Most of the time, management figures out how to respond to the threat and makes changes. The companies go back to normal valuations instead of being cheap and that process allows for outperformance.
Even though these traps always exist, on average and over time, the winners from value investing more than pay for the losers.
There are growth traps too. Professor Jeremy Siegel of Wharton tells the story of an oil company and a technology company in 1955 (I’m annoyed again that I can’t name names because both are on our Approved List).
The oil company was an old-line solid performer, but nothing to get excited about. The technology company dominated the industry and was a real innovator, better positioned to profit from the forthcoming digital revolution than anyone else.
What happened? Both stocks did fabulously well, but the oil company fared a lot better than the technology company because investors paid far too much for the tech company because everyone knew that it would grow rapidly (and it did).
I’ve been afraid of that growth trap with Amazon for more than a decade. People ask me if I’ve ever heard that Amazon was taking business from the retailers. Duh. The question is whether or not they are taking enough business to justify a PE-ratio of more than 100. For the last decade, to my surprise, it has – Amazon has done fabulously well and I’ve been wrong.
These traps are part of why we don’t just invest in individual stocks and include exposure to the overall market and factor funds. The overall market funds give us exposure to companies like Amazon, which is the third largest stock in the S&P 500.
The factor funds are trickier. A value fund might own the retailers because they are cheap. A momentum fund would have Amazon, but not the retailers. Funds that pursue both value and momentum will vary a lot depending on the rules of the fund.
We’re looking at our retail stocks to see whether we should continue to keep them, but we may not have a decision for a few months. Growth and value traps are part of investing and are inevitable, unfortunately.