June 2017 | Evan Hornbuckle, Global Industry Analyst, Consumer Retail
We believe our GIAs — specialist stock pickers for whom industry research is a career path — are one of Wellington’s key differentiators. Their role is to use fundamental analysis to identify investment opportunities for clients’ portfolios. We believe that stock selection based on in-depth knowledge of an industry has the potential to generate strong investment performance over the long term.
I began my investing career as a research associate covering utilities and media from 1999 – 2001. Then I spent two years working as a line cook at highly rated restaurants in Boston and New York to explore my interest in cooking and the restaurant business. So restaurants, which are part of the consumer sector, were a natural area of focus when I went back to investing after business school.
I first started covering retail stocks in 2005. Over the past 12 years, I’ve covered many sectors across the US consumer discretionary space. I find the sector fascinating, given its global scale, ever-changing trends and major structural evolutions, which provide ample opportunities for creative primary research.
The firm has many differentiating strengths that make it an ideal place to build an investing career. These include its strong client-focused culture, the long tenure of its investors and their deep relationships with the management teams of the companies they cover. It also provides the unique opportunity to manage portfolios across various mandates, including long-only and long-short strategies.
It is ideal for picking stocks. There is a wide and broadening spectrum of business quality, management teams, competitive positions, growth rates, margins and so on. Every year, the spread between the best- and worst-performing companies is over 100% for large caps and even higher for small and mid-caps, creating strong opportunities for active managers to generate outperformance.
I believe the potential to generate alpha arises when the market over- or under-estimates business quality/growth and risk, which often happens within my coverage universe. My process for seeking to harvest this alpha centres around evaluating the risk/reward for each stock — its upside versus its downside potential. I measure it by assessing business quality and growth, fundamental momentum, the catalyst roadmap (our expectations compared with the consensus) and valuation. Ideally, I look for great businesses with temporary challenges and discounted stock prices that I think can soon return to beating expectations.
The consumer sector is well suited to this process because it typically offers frequent periods of low stock dispersion — for example, when falling gasoline prices cause the whole sector to rally together because cheaper gas is supposed to be good for the consumer. These are generally followed by periods of greater dispersion stemming from the natural differentiation of fundamentals inherent in this diverse group of businesses. During these temporary periods of low dispersion, we seek to identify the potential fundamental winners and build positions at favourable risk/rewards.
The main way for a retailer to win is to solidify a clear, strong customer value proposition. This may be through quality, value, convenience or assortment (product range). Online retailers are redefining how consumers measure all of those factors, so the competitive bar is rising for most companies, as is the cost of doing business. As e-commerce continues to take the majority of incremental retail sales growth, we have constructed a framework that helps us to identify the companies with the greatest risk or opportunity.
Focusing on improving the offering for customers and sound capital allocation are crucial for the success of a business. Most retailers — even those in long-term decline — generate hefty cash flow, which gives them ample options for reinvesting. I like to see management teams directing that cash to create more compelling customer value propositions or to build better e-commerce engines. For companies with little or no organic growth, I view share buybacks — a common use of retail cash flow — as misguided and likely to produce low returns over time.
Consumers are increasingly valuing experiences over possessions. This is especially true among millennials. Many suppliers of traditional retail goods have failed to keep their brands relevant and are now forced to reduce prices as new lower-cost, lower-priced players take market share. This theme is spreading across much of the traditional apparel landscape. Another clear theme we expect to impact the sector for the foreseeable future is excessive industry square footage. The US retail industry has vastly more square footage per capita than any other developed economy, but a retrenchment is finally under way. More stores were closed in the first quarter of 2017 than the worst quarter of the global financial crisis. This could have major repercussions for retailers and mall real estate investment trusts unless they can find a way to repurpose these large spaces.
It’s different for the various sub-sectors. For example, retail is a capital-intensive industry. The largest companies have the most capital and so are able to invest the most in innovation. Smaller companies with innovative products or technology often become takeover targets.
In restaurants, it’s the polar opposite: smaller companies have found ways to deliver interesting food at the same prices as the big chains, despite not having their economies of scale. Compared with their retail counterparts, these small restaurant companies face far less risk of disruption from factors such as technological innovation among their competitors. We currently prefer the restaurant and global brands sub-sectors versus retail.
Most are global phenomena, because they’re rooted in universal customer value propositions. Everyone wants more convenience, assortment and value (that is, higher quality at lower prices).
But there are some variations from region to region. For example, China and South Korea have avoided accumulating excess store growth, because e-commerce has developed so rapidly before the physical infrastructure was built. By contrast, some other parts of South East Asia, Latin America and Western Europe share the US’s overcapacity problem. Clearly, the market is not fully efficient: department stores in South East Asia are trading at far higher multiples than their US counterparts, even though they will be under the same pressures from e-commerce players.
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