What characteristics make a retail stock an attractive value investment?

Juan Torres Rodriguez, Research Analyst from the Equity Value team at global asset manager Schroders

In addition to a suitably cheap valuation, another important factor for value investors is the strength of a business’s balance sheet and particularly the amount of borrowing it may – or may not – reveal.

When whole industries sell off – as has certainly happened in the case of retail in recent years – it tends to offer a fertile environment for value investors. This is according to Juan Torres Rodriguez, Research Analyst from the Equity Value team at global asset manager Schroders. “Markets tend to hate uncertainty – the worries the growth of e-commerce is engendering about more traditional retail business models being a case in point – and that causes them to sell off stocks indiscriminately, regardless of their underlying quality,” says Torres Rodriguez.

Being contrarian in nature and willing to go against the crowd, Torres Rodriguez believes that value investors should be well placed to pick up good businesses at bargain prices. “That said, they also need to put their analytical skills to good use to ensure the risk-return ratio of any stock bought is attractive and there is a suitable ‘margin of safety’ should things happen to get worse before they get better,” explains Torres Rodriguez.

”We anticipate spending a lot of our time over the coming months – possibly even years – scrutinising retail stocks but what will we be looking for in addition to the obvious criterion of an appropriately cheap valuation? Another important factor will be the strength of a business’s balance sheet, which is measured – among other things – by the amount of leverage (borrowing) it has,” says Torres Rodriguez.

He goes on to say that a retailer with a strong balance sheet – for example a net cash position or a low level of debt – should have more time and room to adjust itself to the new e-commerce environment, allowing it to make the changes necessary to survive the tough times so it can prosper in the good. “The problem for those investors unwilling to do the hard work, however, is that a business’s debt does not necessarily show up on the balance sheet itself.”

Torres Rodriguez explains, “Debt can also exist ‘off balance sheet’ in the form of leases, for example, so that, while a retailer may appear to have no bank loans or debentures, that does not automatically mean it has no debt. He says that further digging will show, amongst other things, how many of its stores operate under rental contracts – and the maturity of these contracts and the cost to bail out of such obligations must be part of the analysis when assessing the risks of these businesses.”

Should a retailer find itself in a position where it needs to close stores quickly – for example, after a sustained decline in traffic – Torres Rodriguez believes that how fast and at what cost it can do so becomes a key component in its chances of survival. He says that this helps to explain why companies that look to deliver very high returns on their invested capital, and may appear highly cash-generative can end up restructuring within a couple of years.

Torres Rodriguez concludes, “A related development – and one that is not widely known – is the accounting rules concerning the treatment of leases are about to change, with the result that many retail businesses will be forced to capitalise such leases on their balance sheets. At this point the true extent of their borrowing – and thus their chances of making it through these troubled times for the retail sector – will become much more apparent.”