When Ugly Stocks Make For Great Investments

Unless you’ve been living under a rock, you know that retail stocks have been getting pounded in 2017.

Just in the last couple of days, the stocks of Michael Kors and Express, Inc. have fallen off a cliff. Meanwhile, Amazon.com recently hit $1,000 for the first time and is riding a strong uptrend.

The Amazonization of shopping has acted as a major headwind for large traditional retailers. Remember Blockbuster? Your kids sure don’t!

Mall REITS have been under assault, and big retailers like Macy’s and Dick’s Sporting Goods have seen their shares drop like rocks.

Same-store sales metrics are under pressure, inventory builds have led to greater discounting and hammered margins, so the financial outlook for old-school retail just isn’t that bright.

It’s fugly out there!

But sometimes ugly stocks make beautiful investments.

After all, most of these stocks aren’t going to zero… Consumers are still going to buy Under Armour sneakers and Ralph Lauren polo shirts. They just aren’t going to do it at Dick’s Sporting Goods or Macy’s.

Meanwhile, there are three things investors can do to take advantage of the coming bargains in the retail sector.

1. Don’t catch a falling knife. Most retail stocks are in sharp downtrends. Stocks often overreact in either direction and move much farther than the fundamentals suggest. What goes down can continue to go down longer and faster than is justified. You don’t have to like it, but it is what it is.

Patience here will pay off. While waiting for value investors to accumulate shares (such as up days where the volume is much higher than average), you can start to build your list of potential positions. Let the market come to you.

2. Avoid the big-box retailers and mall REITs. It’s very possible that the mall could go the way of the dodo bird. It’s a lot easier to sit in your underwear and, in a few clicks, buy what you need and have it delivered to your house. No need to deal with parking during the holidays either! Many of the mall REITS offer attractive dividend yields, but that could be a pure value trap. Sometimes stocks have high yields for a reason – and it’s not because business is good.

The problem with big-box retailers is that many of them have to scale back substantially in order to get sales per square foot to where it was a decade ago. We’re talking thousands of store closings and at a record pace. That’s going to be a messy process – possibly for years to come. It also makes earnings analysis tricky, as charges and other write-offs obscure the true earnings power of a company. Earnings quality can take a hit, too.

3. Follow the cash flow. Companies with solid cash flows while their businesses are under pressure, are worth a look on the long side. Many retailers got caught holding too much inventory and were forced to push too much product into the sales channel, causing receivables to spike. This has a negative impact on cash flow.

Before its stock imploded, Under Armour was the lowest-ranked stock in my large company earnings quality model. Just because it was ranked last doesn’t make Under Armour a bad company. Someone has to be ranked last!

Historically, companies near the bottom of the pile have been substantial underperformers.

Inventory levels and receivables were flashing ”red.” Cash flow was under pressure. But, now that Under Armour’s stock has been pounded, its ranking has moved to the middle of the pack. Still not great, but better than last!

What to watch for is cash flow deterioration starting to slow and eventually turning up. This can often happen before good news hits the stock. Once inventories get marked down and profit margins take a hit, they become easier hurdles to jump over in coming quarters.

Ralph Lauren has been in the news for walking away from its flagship store in New York City and getting stuck with a lease that runs in the hundreds of millions of dollars. You know business is bad when you’d rather pay $70,000 a day in rent to not make a sale.

Ralph Lauren’s inventory levels are the lowest in years, and the company is also converting sales to cash at the fastest pace in that timeframe. Earnings quality has started to tick up. The stock chart still looks terrible, so that underscores point #1 above.

It’s very possible that many of these retail stocks will bottom before the broader market breaks, making them interesting long positions with reasonable valuations while the rest of the market finally starts to roll over.

It could be the start of the ultimate contrarian investment play.

Good investing,

John Del Vecchio
Editor, Hidden Profits

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Categories: Stocks

About Author

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.