The U.S. brick-and-mortar retail sector has dramatically underperformed the market over the past 12 months. Like every sector that has underperformed the market, retail has now attracted the attention of value investors who act with a contrarian viewpoint. Websites such as the Motley Fool have started to promote retail stocks like American Eagle Outfitters (AEO, Financial) due to their depressed valuations and desire to turn around the businesses.
Should these stocks really be viewed as contrarian value plays or should they be avoided altogether?
Undervalued?
Value traps can be hugely detrimental to your long-term investment performance. If a stock turns out to be a value trap, it can take years before you realize you have fallen down the hole and, by this time, what was initially a small investment may have become substantial.
Trying to avoid value traps is a key part of value investing, but you will  not be able to avoid all of them. There is no set approach to avoiding traps, you can only try to avoid those companies with all the hallmarks.
One of the key hallmarks of value traps is the overall nature of the industry they operate within. Is the industry suffering a broader cyclical decline or is the decline structural?
A cyclical decline is just part of the natural business process and presents an attractive entry point for investors. On the other hand, if the industry is suffering a structural decline, you could run into bigger problems. It is arguable that the U.S. brick-and-mortar retailer industry is suffering a structural decline. While overall retail sales are expanding, many retailers are reporting declining sales in traditional stores as costs creep up. Online retailers such as Amazon (AMZN, Financial), which have a much lower cost base and bigger distribution network, are dominating the market. The price advantage these competitors have over traditional brick-and-mortar peers means they can cut costs to levels where others cannot compete. It is clear this is not a cyclical problem, it is a structural issue that is affecting the entire U.S. retail industry.
Not helping
Retailers themselves are not helping the situation. Many retailers have now entered somewhat of a death spiral where they are trying to cut costs by closing stores, but are damaging their appeal with customers, physical presence and footprint by doing so.
Closures will lead to more closures, which will lead to more closures as the stores become less and less relevant. Do they have a choice? Not really. Few companies can carry on with declining sales forever without reducing the cost base. The difference with retailers is they need a large presence in order to keep their appeal with customers. The one thing shopping online will never be able to recreate is the experience of wandering a mall or browsing a store. Retailers are killing their only advantage by closing their physical presence.
Not cheap enough
Considering all of the above, even if you have a positive outlook on the sector, it is pretty hard to justify buying U.S. retail as a value investment.
As Benjamin Graham said, however, there are no bad assets, just bad prices, which is correct even in this case. U.S. retail may become a value play, but only when everyone else has given up on the sector. When store cuts have gone as far as they can and retailers' sales declines start to slow, the industry may become attractive again. But for the time being, it looks as if online retailers will continue to rule the market, especially with new minimum wage rules coming into effect. These rules will only make the sector more uncompetitive. The only advantage brick-and-mortar retailers have over online competitors is the physical shopping experience. They need to learn to utilize this unique selling point before sales declines cannot be reversed.
Overall, U.S. retail may become a contrarian value play, but the sector’s structural declines are still too severe for the time being.
Disclosure: The author owns no stock mentioned.
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