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What I Learned at the Mall about Investing

February 13, 2014

Investors can learn a lot of lessons from past decisions and indecisions. It is easier to learn from the decisions, as they leave a paper trail, than from the indecisions, which are lurking in our subconscious. We need to (sometimes painfully) extract indecisions and then analyze and study them.

There’s one mistake of indecision I’ve made at least half a dozen times over the past decade. I’d stumble on a very cheap, significantly beaten-up clothing retailer. I would do an enormous amount of research — visit stores, talk to customers and competitors, and model the hell out of the company. After all that work, I’d come to the conclusion that the stock was hugely undervalued — but I wouldn’t pull the trigger and buy its shares.

I did this with Claire’s and then Timberland in the mid-2000s, with Children’s Place and Carter’s in the late 2000s, with Skechers a few years ago, and with Deckers (maker of Uggs) last year. The Children’s Place indecision was the most painful, because I am constantly reminded about it by my dear wife. She loves their stores and tried to persuade me on more than one occasion to buy the stock. I didn’t listen. Now every time we go by a Children’s Place store, she asks me where the stock is. Ridden with pain and guilt, I get a price quote on my phone, my head sinks to my chest, and I tell her how smart and beautiful she is and that the stock has tripled. It is not just Children’s Place, though — the stocks of all the aforementioned companies have done incredibly well since my failure to buy them.

Learning from past decisions or indecisions is a delicate endeavor and can be dangerous, as you could take away the wrong lesson. You want to make sure you don’t have selective amnesia. You don’t want to be cherry-picking your sample.

Of course, there are many variables (including randomness) that could have impacted stock prices and the fundamental performance of these retailers. Though different, all of them have had a lot in common: Their businesses are extremely sensitive to fashion — which is almost by definition unpredictable and always in flux. They have been around for a long time and have built a consumer following. Though the products they sell are subject to fashion risk, they are not at risk of being transitory — they are not Beanie Babies or Heelys shoes.

When these retailers got in trouble, their businesses were not fundamentally broken; the companies just found themselves on the wrong side of fashion trends. Yet all of them had cash-heavy balance sheets and no or little debt, which bought them time to turn around their businesses and made the probability of permanent loss of capital very low. They all have had decent management teams whose mistakes were at worst tactical, not strategic.

Also, their most recent financials at the time I looked were a mess. Their inventories were superbloated, same-store sales were in a tailspin, profit margins were plummeting, and profits were scant or negative. Valuations reflected the scariness of their financials — the stocks were trading at single-digit multiples of earnings achieved just a few short years earlier. The fashion shift was a reality and was more than reflected in the stock prices.

Merchandising mistakes are fixable, but the process of repairing them is painful in the short term, and its financial optics are simply ugly. First, management has to recognize that they have missed the trend — that may take a quarter or two. Then they have to start discounting the inventory that is out of step with demand. Inducing consumers to buy winter coats or sweaters when it is 70 degrees outside (instead of the expected 20 degrees) is difficult, but lowered prices are a great cure for any weather. So retailers mark down unwanted merchandise, and inventory starts declining — which is good, as cash starts going up — but margins and sales keep getting hammered (since the average transaction now has a lower ticket value).

It takes time for bad inventory to work through a company’s sales. As retailers are clearing out unwanted inventory, they may still be receiving new out-of-fashion inventory from the orders they placed six or nine months earlier. While this is happening, the financial numbers they put out are hideous.

While I was waiting indecisively, the stocks in some cases went even lower, and I patted myself on the back. But from a longer-term perch, a 20 to 30 percent short-term decline pales in comparison with the 300 to 400 percent return I gave up. As I was patiently sitting on the sidelines waiting for fundamentals to improve, stock prices moved up before earnings or same-store sales improved.

The lesson is that I should have embraced the ugliness of their financials, because that ugliness is what creates opportunity, and it’s a natural part of the healing process when merchandising mistakes are made.

Today, American Eagle and Aéropostale, retailers of teen clothing, look a whole lot like my indecision stocks of the past decade: They have strong balance sheets and good management, they’ve been around for a long time, and teens know where to find them in the mall. They have missed a trend that was caught by fast-fashion retailers such as Forever 21 and H&M, which deemphasized logos and sold cheap, low-quality clothes but rotated them very often. American Eagle and Aéropostale are adjusting, and it will take time, but fast fashion is just another fad — it will pass. In the meantime, both stocks are incredibly cheap and in the long run should trade at much higher prices.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


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Comments

shaved_head_and_balls
Shaved_head_and_balls - 7 months ago

One could have made a similar argument for Body Central, Eddie Bauer, Pacific Sun, Coldwater Creek, and so on. Retail clothing turnarounds are as rare as computing industry turnarounds.

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