Black Friday Thoughts: Identifying inevitable retail winners
A few months back, I had a post where I poked some (light) fun of investors whose portfolio consisted of 10 retail stocks all priced like they were about to be the next Walmart or Home Depot.
I was thinking about that post when reading my friend John Huber’s post on Charlie Munger’s podcast appearance. John makes a lot of points, but I like the one he leads off with the most. He says (and actually he’s saying what Munger is saying, so I suppose this is a case of he says he says!) that retail is generally a difficult business, but it can be really special when you get it right. He goes on,
What's interesting about retail is the industry's aggregate returns on capital are poor, yet some of the greatest stocks of all time are retailers (Walmart, Home Depot, Lowes, Amazon, Target, AutoZone, O'Reilly Auto Parts, Tractor Supply, Family Dollar have all been 100-baggers and the majority of these have even risen 1,000x or more). Many will attribute these success stories to survivorship bias, but is there a predictable element to a business once it reaches a certain level of success? I think the probabilities are dynamic and the odds might improve at certain junctures. Amazon or Walmart might have been unpredictable in the early years for most outsiders, but unlike the coin flipper who claims to have insights into calling heads and tails, it's clear that they now possess a moat that nearly every other business would trade places with if given the chance. So this begs the question: at what point does a retailer go from the “too hard pile” to a candidate for investment? And it's interesting to me that Charlie seems willing to invest in those latter stage retailers whereas Buffett is not.
Something about that paragraph / framework stuck with me. Investing in retailers is an insanely difficult task (I have several scars from 2022 to prove it!)….. but if there’s some inflection point where a retailer magically “switches” to winner and you can buy after that point, being able to identify that point successfully would be a massive profit generator.
The longer I’ve been investing, the more I find that one of the best places for alpha is when you’ve got a solid thesis, and something happens that hugely confirms the thesis and the market under responds to it. If I went back to one of my favorite historical investments (forcing Elon to buy Twitter), there were multiple opportunities where there was a huge inflection point where it became clear Twitter’s case was getting even stronger, and the market under-traded it. Heck, in early October, Elon put in a court filing that he was going to close the Twitter deal by the end of October, and a week later the stock was only trading at ~$50/share (versus a deal price of $54.20). Talk about under-trading! Elon was saying he would close and the market was so skeptical that it left almost a 10% spread!
That’s a very visible example (to be fair, for those who remember the Twitter deal, there was some worry over the use of a solvency clause that could justify the spread, and the huge spread speaks to how little people trusted Elon)…. but it was not the only example of the market under reacting during the trial. Multiple times during the trial, a bombshell would fall and the stock would only go up ~1%…. which would imply the bombshell had barely changed the odds of the deal going through, when it was clear that the bombshell made it much more likely the deal was closing.
Anyway, what I’m trying to get at is this: sometimes the market can under trade inflection points, and I’m wondering if there’s some magic inflection point where a retail business hits where it becomes much more likely it’s going to scale into a great business, and does the market under trade that point?
The most likely point would probably be once a retailer proves they can expand outside of their local / regional niche by opening a few stores successfully in very new markets. There are a few groceries and convenience stores that dominate their local or regional niche but can’t grow outside of it. Because they can’t grow, these are great businesses that spit off tons of cash, but there’s no real growth there / no opportunity to invest incremental capital at attractive returns, so ultimately these businesses end up just being cash cows. Think of something like H-E-B in Texas or Wawa in the North East. These are great businesses that can spit off a lot of cash, but, as an investor, for the real compounding magic to happen you need a retailer to have the opportunity to profitably invest in new stores and geographic expansion (i.e. you need to buy Walmart when they dominate the southeast with the expectation that they’ll grow to dominate the nation!).
So the thesis here would be a “great” retailer that’s set to go on an incredible compounding run would have an inflection point once a business can prove themselves outside of their regional niche, so the time to buy is once they’ve opened a few stores in a new region / outside there core. Why would this be a good time to buy? If they successfully open a few stores outside of their region, it proves that the business model can sustain outside of the region, that the brand can move outside of the region, and that the management team has the chops to open stores outside of their existing logistics / distribution.
How would you model this? Once a business expanded outside of their initial region successfully, you could model them successfully expanding nationwide. Take the future potential store base, apply the average profits of the current store base to that number, and discount back to today to get the current value of all that growth (that’s a bit simplified but directionally correct!).
This approach / theory is a similar to Peter Lynch recommended (I believe he recommended it in in One Up on Wall Street; I mentioned this model in the original write up) with growth restaurants; if one worked through California, it’s reasonable to think it could work nationwide, and buy them on that assumed growth.
So here’s my question to you, dear reader: are there any businesses you can think of that fit this model currently? Munger mentioned FND as a possible example; I have another one that could fit the bill I’ll discuss in a later post (likely on Cyber Monday just to stick with the retail theme).
Or are there any other inflection points that you can think of that would suggest a retail business is going to be a winner? I used expanding outside their region, but there could be plenty of other inflection points. I’ve generally been discussing retailers here, but retailers and restaurants share a lot of similarities, and I could imagine for restaurants a rule of thumb that once a restaurant hits X number of locations, or Y number of franchisees, that history suggests they’re going to grow quite large. Or, turning back to retailers, maybe the real trick isn’t a business that expands beyond its region, but can maintain some level of ROIC once they breach a certain store level (i.e. every retailer that maintains an incremental ROIC of >25% once they’ve hit 250 stores or $1B in sales grows into a winner). I don’t know, I’m just spitballing on all of these, but I’m interested if any one can point to specific rules of thumb that suggest these “inevitable” winners John discussed.
**Editor’s postscript: my follow up post discussing some of the winners readers had mentioned is now live here**