Buyer beware: value traps abound on the high street
Iwas moderating a panel discussion last week at which my colleague Jeremy Podger, manager of our Global Special Situations Fund, was asked to name two value traps. He thought for a while and replied, “anything that depends on the internal combustion engine – oh and most of the high street”.
This is a good time to be thinking about value traps – shares that look more of a bargain than they really are. The rapid pace of technological and cultural change means there are many businesses that appear to have fallen on temporarily hard times but that in reality will never recover. They are cheap for a reason. Their world has changed irrevocably.
The time horizons of Podger’s two value traps are different. Petrol engines (although perhaps not diesel) will be with us for a few years yet, I suspect. But hardly a day passes when we are not served further evidence that the retail sector is in crisis.
The few crumbs of good news, like Tesco’s return to health, are the exceptions that prove the rule. The pit out of which Tesco is crawling illustrates the deep-seated problems retailers face. Once the dominant force in UK food retail, it had big ambitions to replicate its success around the world. It busied itself with moves into adjacent areas from restaurants to banking. Taking its eye off the ball in this way, Tesco made such a Horlicks of things at home that just getting profits back to a third of their former glory is seen as a triumph. Been down so long, it looks like up to me.
Rarely has a sector faced such a perfect storm of negatives. Here are half a dozen:
Top of the list is, of course, the Amazon effect. Toys R Us confirmed last week that it will close its remaining stores in the UK, at the cost of 2,000 more jobs. The demise of the big-box toy retailer is not just about the shift online but it has been a significant factor. Mothercare, too, is a victim of the relative ease and convenience of internet shopping. Just the growth in Amazon’s sales last year was bigger than the total market value of the 10 main retailers in America’s shopping malls. President Trump is right to worry about Amazon, even if he’s doing it for the wrong reason.
Next is what appears to be a durable cultural shift away from buying things, to doing them. Perhaps because the old dreams of home ownership have died for anyone under the age of 35, the desire to accumulate stuff within those homes has also perished. Young people want experiences not possessions. Allied to this is the demise of shopping as a leisure activity.
This rapid cultural change has been particularly hard to handle for the retail sector because it is structurally slow moving. It is, for example, tied into long property leases that are expensive to unwind. For years, it invested heavily in an out-of-town shopping-mall infrastructure that looks increasingly irrelevant to modern lifestyles. As Carpetright’s chief executive Wilf Walsh said last week “we created an over-rented and unsustainable property portfolio”. That was fine “as long as people were happy to visit a tin shed and spend on credit”.
The financial crisis put an end to that. The higher financial uncertainty after 2008 means that the cultural shift in what we spend our money on has been mirrored by a change in how much stuff we buy and how much we are prepared to pay for it. There were many things Tesco got wrong between the departure of Terry Leahy in 2011 and its recent return to form, but failing to grasp the appeal of the German discounters Aldi and Lidl in an era of austerity was certainly one.
Other retailers have failed to live up to their customers’ raised expectations. WH Smith has been a rare success story in the sector despite, not because of, its core high street business. Selling over-priced water and magazines to a captive audience on the move through airports and railway stations has disguised the poverty of its traditional shops. Last week’s results showed that its dowdy high street outlets are an ongoing drag. The cost of keeping a brand fresh and relevant is enormous.
The restaurant sector is another that is paying the price for boring its customers, with too many similar formats. The cost of standing out from the pack is just one facing a retail sector that is being squeezed on multiple fronts. A business that employs so many low earners is obviously vulnerable to increases in the minimum wage. The anachronistic business rates regime is another heavy burden for the sector.
So, while it is tempting to see the retail sector’s shares, standing at multi-year lows, as a kind of midseason sale, investors need to be very careful that they are not walking into a classic value trap. Against a list of the traditional red flags, bricks and mortar retail ticks most of the boxes.
First, it is struggling at a time in the economic cycle when it should be doing well. If retail is troubled at a time of low unemployment and lower interest rates, what hope when conditions worsen? Second, its market share is falling, the sign of a structural, not a cyclical, problem. Third, there is no obvious catalyst for change. Value investors need a recovery narrative – there is none. Finally, where are the activist investors? There is a reason the vultures are not circling yet.
The best investors are contrarians who know when to go with the flow. It is good to buy low, but not if cheap becomes cheaper still. We fall into value traps when we don’t listen to what the market is telling us.
‘If retail is troubled at a time of low unemployment and lower interest rates, what hope when conditions worsen?’