Shop till you drop

Every great ‘80s coming-of-age movie includes a montage where our main character emerges from a dressing room in a new outfit, only to receive a thumbs down from their comedy counterpart, until – wait, that’s it. That’s the one.

Well, investors have found their perfect outfit, and boy do they wear the retail sector well.

In 2019, global retail sales topped $25 trillion for the first time, and of that, $319 billion was luxury goods. So clearly, understanding retail is key to unlocking some of the most lucrative returns the stock market has to offer. Just look at Amazon: the world’s most valuable retail stock has delivered 2000% returns over the past 20 years. Chinese counterpart Alibaba, meanwhile, has doubled in value in just five.

This Pack is going to focus on one area of retail in particular, known as the “consumer discretionary” sector. Unlike “staples” that everyone needs_ – think groceries, toothpaste, cleaning supplies – consumer discretionary products are goodies we just _want. Clothes, gadgets, furniture, handbags – they’re the things that make life a little more fun.

You can generally split consumer discretionaries into two categories: there are the companies that make the products – Nike, Louis Vuitton, Apple, etc – and the companies that sell the products – Amazon, Walmart, Best Buy. We say “generally” because that distinction can get a little blurry. All three of those brands have their own stores, while all three retailers make own-brand products. We’ll look at why that is in later sessions, as well as rifle through the huge changes that ecommerce has brought to the both of them.

In the meantime, a Hermès handbag has just caught our eye, and it’s got us wondering: how can they sell even their cheapest bags at over $3,000?

The takeaway: Consumer discretionary products are the things we want but don’t need, and the sector’s made up of both brands and retailers.

What’s in a name?

The world’s been brand-crazy since at least 2700 BC, when ancient Egyptians branded their cattle with a hot iron to mark it as their own – hence the name. These days, though, a brand’s essentially just a concept, which makes it remarkably hard to define: it’s a mish-mash of a company name, logo, reputation, aesthetic, personality, and the kitchen sink for good measure. But whatever it is exactly, businesses know just how powerful they’re done right. That is to say, a good brand can make people spend.

There are all sorts of reasons for that. The best brands might make you feel like you have good taste. Anyone can make, say, sparkling wine, but only those who buy champagne are buying the real deal. Others might make you feel like you’re buying heritage: luxury fashion brand Hermès, has been around for almost 200 years, and uses that to justify its outlandishly expensive bags. And some brands give you an identity: people who buy Nike products, for instance, often just want to feel like a pro athlete.

In short, brands add value to products because of the feelings they evoke. According to investment bank Goldman Sachs, “good brands have unique characteristics… that drive differentiation and ultimately pricing power”. The bank considers a strong brand one that can capture a niche, scale geographically, and fend off competition. Clearly, there’s room for more than one brand in each industry – Nike, for example, faces stiff competition from Adidas and Puma – but they all try to set themselves apart in one way or another.

A good brand doesn’t necessarily lead to success, mind you. Take Hugo Boss, the fashionista that’s seen its share price plummet in the past five years. The former powerhouse struggled to monetize its brand due to a continued focus on clothing, at a time when luxury shoppers are more interested in accessories like handbags. It also opted to take the middle lane between expensive brands and cheaper ones, and it’s being overtaken on both sides. That’ll be why Goldman Sachs puts so much focus on defensibility when it’s analyzing a brand’s value: it wants to see the brand has “pricing power” – that is, if it can charge significantly more than its competitors and still bring in sales.

That’s particularly true if you’re talking about luxury brands, which turn traditional ideas of economics on their head. Demand for a product normally drops as its price increases, which makes sense: shoppers are generally unwilling to pay more for functionally similar products. But with luxury goods, price increases tend to lead to an increase in demand. The more expensive they are, after all, the more status they convey. You can see that mentality playing out in real time among members of the emerging Chinese middle class, who are keen to cast a spotlight on their wealth. That might be why China’s a major driver of the 3% annual growth in the luxury goods market.

Of course, the problem with ultra-high pricing is that lots of people can’t afford the products, no matter how much they want them. That’s why savvy luxury brands also leverage their reputations to sell more affordable products, namely cosmetics and accessories. You mightn’t be able to stretch to $3,000 for one of Hermès’ handbags, for example, but you might be willing to spend $80 on a bottle of its perfume.

Still, that kind of influence might be about to face unprecedented competition for the first time. While decades-old brands like Hermès have always dominated the luxury market, the internet has now done away with the barriers to entry for new brands. Anyone can put a sleek-looking website together and start selling high-end products, and then use their digital name-recognition to go physical. Potentially a smart strategy: an Away store that sits next to a Soho House members club should make its suitcases look infinitely fancier.

Then again, a real-life store isn’t all changing room montages, you know. That’s up next.

The takeaway: Brands are valuable because they make people buy things they otherwise wouldn’t – and for luxury brands, higher prices can lead to higher demand.

Window shopping

Remember department stores? They came to dominate the American shopping landscape after World War II. Macy’s, Barneys, Kohl’s: they all offered a one-stop-shop where you could buy everything and anything you needed – and more than a few things you didn’t. Then, throughout the ‘50s and ‘60s, discount stores like Walmart and Price Club started to flourish. Next came the rise of specialty retailers like Gap and Toys “R” Us. And now we’ve ended up back where we started with the biggest department store of all: Amazon.

The retail business is fairly simple: it can be tricky for brands to get their products in front of customers, so they sell their products to retailers. The retailers – which have their own stores and distribution networks – then sell the products onto consumers at a markup and pocket the difference. That markup can be pretty substantial: according to Goldman Sachs, the average retail price for discretionary goods is three times the cost of goods sold.

Both brands and stores are making trade-offs here. Brands don’t have to find customers or handle distribution, but they do have to sacrifice a chunk of their revenue. Stores don’t have to make their own products, but they only get to keep part of the revenue those products make. So while it’s a lot of work to do both, a handful of companies give it a go.

Some brands, for example, are “direct to consumer” (or “D2C” to the cool kids) – brands like LVMH, the world’s biggest luxury conglomerate, which has gone from 2,300 stores worldwide in 2008 to over 4,500. But physical stores are a risk. For one, rent can be high: Hong Kong’s Causeway Bay costs an average of $2,745 per square foot per year, while New York’s Upper Fifth Avenue costs $2,250. Retailers often need to commit to long leases, too – and they might regret being stuck with ten stores in London seven years from now.

Retailers, meanwhile, have a long history of selling their own “private label” products – i.e. those the retailer buys directly from a manufacturer but markets as its own. Some retail brands, like Macy’s, rely on them for a big chunk of their revenue. But just as physical stores present problems for brands themselves, building a brand from scratch isn’t easy. If a retailer wanted to launch, say, its own luxury private label brand, it would need to spend millions on marketing just like a “real” luxury brand would.

Some retailers are “end-to-end”, which means they control the entire retail experience – as opposed to selling their private label products elsewhere, or selling a variety of branded products. Inditex – owner of Zara, Massimo Dutti, and Bershka – is a good example. Owning every aspect of the value chain offers huge cost-savings: it allows, say, Zara to manufacture a new design, roll it out to thousands of stores in a matter of weeks, and sell it at whatever price it likes. That’s partly why Inditex has a gross margin of 58%, compared to Nike’s 45% and Macy’s 39%.

This total control is valuable for one other key reason too. Did someone say ecommerce? Right you are.

The takeaway: Brands have traditionally sold their product at a discount to retailers, who then handle distribution. But they’re increasingly going direct to consumers, while retailers build their own brands.

Shopping.com

Retailers love a website because it’s a shopfront you don’t have to pay rent on. That might be why Goldman Sachs estimates ecommerce margins are 10% higher than those of physical retail. And those huge margins can mean one of two things: bumper profits – we’re looking at you, Hermès – or rock-bottom prices – we’re looking at you, Amazon.

Ecommerce is changing brands and retailers in a few big ways. For one, it’s responsible for a massive drop in store footfall, so they’re getting far less exposure and sales. And for another, those companies that do have physical visitors are now expected to sync the experience up with their online presence. It’s known as “omnichannel” retailing, and it enables shoppers to buy something online, pick it up from a store, and return it elsewhere.

That might sound straightforward, but it actually involves complicated logistics to make sure inventory is the same across stores and the website, and that the products can be shipped to consumers wherever they are. It’s also one reason ecommerce platforms like Shopify have grown so big: they provide the tech that retailers need to operate an omnichannel business.

Ecommerce has also made branding even more important. In a world of limitless choice and dubious product reviews, a well-positioned brand counts for a lot. For one, it has a better chance of capturing online sales directly: if you want a Louis Vuitton bag, you know you’d need to go directly to their website, rather than, say, Amazon. An unknown brand, on the other hand, is more likely to need to give Amazon a hunk of its profits in return for increased visibility. A broad online distribution strategy damages pricing power too, given that retailers are bound to compete with each other on price. Hugo Boss – which is widely available online – is experiencing that first-hand, and so did Burberry before it embarked on its recent turnaround.

For retailers themselves, the shift to digital has had two major effects. One is on product selection: those with exclusive products have the edge on everyone’s biggest competition, Amazon, which has its sights set on becoming “the everything store”. Richemont’s YOOX Net-a-Porter is in high demand for exactly that reason, and that’s probably why Alibaba has partnered with Net-a-Porter to launch the business in China.

The other is on the importance of physical stores. There’s now less reason to go to one to actually buy something, which means they’re taking on a new, more experiential role. They’re offering services, like Apple’s Genius Bar repair service, or entertainment, like the art installations at France’s Galeries Lafayette. This is true at the lower-end of the market too: Target is currently experimenting with mini Disney Stores inside its own. After all, companies don’t want to lose their physical stores: they can help reinforce how its consumers feel, as well as simply allow them to try things in person. That’s part of the reason digital-first brands like Warby Parker are still opening stores in major markets.

All this matters to potential investors because the move to online shopping has only really just begun in the US. Just 15% of US retail is made up of online shopping, compared to 25% in China. And that number’s bound to grow, minting winners along the way and leaving behind those that can’t adapt. Onto the next session to make sure you back those winners.

The takeaway: Ecommerce has made brands more important, increased margins for those that can are getting those brands right, and putting pressure on physical stores to change tactics.

Does my sum look big in this?

So we’ve talked about how retailers and brands work: the question now is how to actually pick the ones that’ll turn heads.

When you’re assessing a retailer, it’s common practice to compare figures like revenue and profit to the same period the year – not the quarter – before. Comparing sales between quarters like you would with lots of industries’ stocks isn’t particularly helpful, in light of retail’s seasonal business model (around a third of sales are made in the fourth quarter alone, thanks to the holiday period). Investors also tend to look at inventory levels: when they’re rising faster than revenue, the company is probably struggling to sell what it’s making.

If the retailer has physical stores, you’ll want to look at same-store sales, which exclude recently opened or shuttered stores. The metric lets you compare like for like: a retailer’s revenue might’ve increased because it’s opened ten new stores, after all, but there still might be reason to worry when same-store sales are down. Look at sales per square foot too: it‘s a good way to compare how different companies use their physical space. If one retailer has much higher sales per square foot than another, but equivalent rent costs, it might be a better investment. Still, you need to keep in mind the context of the overall business. As Goldman Sachs points out, “in an omnichannel market, brick-and-mortar locations participate in digital sales in a way they may not get credit for”.

If you’re feeling fancy, you might even want to build a financial model to make predictions about the future of a retail business. (Don’t worry if the following gets a bit technical: you can find a full walkthrough of what we’re talking about in our How to Value Stocks Pack.)

So for a given company, you could find how much cash the average store brings in, as well as how many stores it has. That gives you an idea of overall “sustainable cash flow”, which you can then model out into the future by applying your own assumptions about store growth. You can then use a “discounted cash flow model” to figure out what that cash is worth today, and how much you should be paying for its stock. The problem is that many firms are now shutting stores, which can make it hard to predict just how much of the sustainable cash flow really is “sustainable”.

If you’re not feeling so fancy, you could just compare retail stocks using price-to-earnings multiples, which give a sense of how cheap or expensive a stock is relative to its peers. Admittedly, though, they’re not always a perfect metric for retail because they ignore the different ways companies use debt and leases. So investors instead tend to divide a company’s “enterprise value” – which is essentially its market capitalization, plus its debt, minus its cash – by its earnings before interest, tax, demortization, amortization, and rent (a.k.a. EBITDAR). That gives you a multiple known as “EV/EBITDAR” you can use to compare stocks to one another. A company with a lower multiple is “cheaper” than one with a higher multiple, which means investors might be less bullish on its growth prospects.

Keep in mind that other things affect multiples beyond prospects for growth, mind you. Hermès, for example, trades at much higher multiples than other firms in part because of its brand value. It’s very hard to put a number on that – though various firms try their best anyway.

And if all that’s too much math, you could always just go and do some good old-fashioned qualitative analysis. In other words, visit the stores themselves. Published sales data is a lagging indicator: it tells you how busy last quarter was. But if you can see the hype for a new Nike collection with your own two eyes, you might be able to get in before this quarter’s higher sales numbers are published…

Whatever your strategy, it’s worth remembering that consumer discretionary firms are “cyclical” companies, which means their fortunes rest on those of the wider economy. In fact, discretionary products are often the first to suffer in an economic downturn, as consumers cut out unnecessary luxuries. So any investment in this sector is at risk of being affected by wage growth, interest rates, and inflation. And sure, that could work in your favor if you time it right – but it could also work against you if wage growth slows while rates and inflation rise.

And you wouldn’t want your returns to suffer: how else will you be able to stump up for that Gucci handbag you’ve had your eye on?

In this Pack, you’ve learned:

🔷 Consumer discretionary products are those that we want but don’t need, and the sector’s made up of brands and retailers.

🔷 Brands can make people buy things they otherwise wouldn’t, which adds value to their products.

🔷 Brands sell their products at a discount to retailers, who handle distribution. But to boost their margins, brands are increasingly going direct to consumers, and retailers are increasingly building brands.

🔷 Ecommerce can massively boost profits, but it’s expensive to implement and is changing the role of physical stores.

🔷 When it comes to evaluating retail stocks, look at same-store sales, sales per square foot, and EV/EBITDAR.