Want to Invest in a Retail Stock? Ask This Question First.

Retail is a tough business in any economic climate. A small number of retailers — think Costco (NASDAQ: COST) and Amazon (NASDAQ: AMZN) — manage to build up durable competitive advantages over the course of decades. Most retailers aren’t so lucky.

Right now, many retail stocks look surprisingly cheap based on trailing earnings. Consumer electronics retailer Best Buy (NYSE: BBY) goes for around 13 times earnings, department store Macy’s (NYSE: M) trades for less than 5 times earnings, and grocery chain Kroger (NYSE: KR) changes hands for roughly 14 times earnings. Those are not particularly optimistic valuation multiples.

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Valuation has its limits

With persistently high inflation and rising interest rates pressuring consumer spending, retailers in general are likely in for a rough and unpredictable 2023. Even the strongest retailers are starting to face headwinds. Walmart (NYSE: WMT), for example, suffered a gross margin decline in the third quarter of 2022 and guided for a drop in adjusted earnings for the full fiscal year.

Many retailers will see their margins contract this year as consumers pull back on spending. While Macy’s stock may look extremely inexpensive, for example, it’s probably not as cheap as it looks. Analysts are expecting a modest decline in earnings for the company in the upcoming fiscal year, but that could turn out to be far too optimistic.

It’s a similar story with Best Buy. Despite tumbling demand for PCs and smartphones, analysts still expect a small increase in Best Buy’s earnings per share in the upcoming fiscal year. Color me skeptical.

Deciding whether or not to invest in a retailer based on past earnings is problematic for two reasons. First, because the past is the past, and second, because the past few years have been pretty weird. An unprecedented shutdown of the economy due to the COVID-19 pandemic in early 2020 was followed by a period of booming demand and free-flowing stimulus. None of that was normal, so basing investment decisions on a retailer’s results during that time doesn’t make a ton of sense.

Basing investment decisions on analyst estimates for future earnings is problematic because analysts are often wrong, and sometimes very wrong. Analyst estimates can be useful, but they certainly shouldn’t form the foundation of anyone’s investing process.

The most important question

When I consider investing in a retailer, I naturally take into account valuation, earnings, and growth. But the most important question I ask is this: If the retailer disappeared from the face of the Earth tomorrow, would consumers really care?

Amazon: Yes, consumers would definitely care. There are plenty of e-commerce alternatives, but none of them have anywhere close to the product selection of Amazon. People order from Amazon because it’s easy, and no other retailer has replicated that.
Costco: Yes. While whether shopping at Costco actually saves you money depends on how prone you are to impulse purchases and overspending, consumers certainly believe that the company saves them money. Costco’s membership renewal rates are above 90%.
Best Buy: I’d say yes, but not nearly as strongly compared Amazon or Costco. Best Buy has transformed itself over the past decade partly by putting a renewed focus on customer service. That’s the company’s big differentiator, and it’s the reason why the retailer holds a somewhat unique place in the U.S. retail market.
Macy’s: No. There’s nothing special about Macy’s. There are surely some loyal customers out there, but that’s true of every retailer. Macy’s finds itself operating in a portion of the department store industry that has little reason to exist. It’s not focused on low prices and value like Kohl’s or even Target, and it doesn’t have the cachet of a higher-end department store like Nordstrom.
Kroger: The grocery business has become concentrated among a small number of megachains, so for that reason, consumers would probably care. But in the grocery industry, I like specialized chains like Sprouts that people shop at for reasons other than it being the closest store to their homes.

None of this is to say that the best retailers on this list will definitely be great investments, or that the worst retailers on this list will definitely be duds. But if you want the odds to be in your favor, stick with retailers that have some sort of edge, and that customers genuinely like.