Store Closing sign in front of a store in the city

Are retail stocks worth the risk?

The recent bankruptcy filing by former retail giant Sears proves that the retail sector is continuing to experience a vast disruption. Struggling for years, Sears had closed 300 stores and cut more than 20,000 employees already this year.

Whether Sears can survive remains to be seen. But even if it joins the growing graveyard of brick-and-mortar retailers gone bust, we’re not sure the company’s potential failure means the whole sector should be written off.

Unfortunately, the stock market tends to paint all companies in a struggling industry with a broad brush, even though it’s likely that some retailers will continue to be successful. The problem is stock investors in general don’t know which ones. If a sector comes under pressure, investors tend to sell everything in the sector … the good with the bad.

It’s true that many physical retail businesses are struggling. Recent bankruptcy victims include: Toys R Us, Sports Authority, Radio Shack, and Payless Shoe Source. What’s really happening is the pressure from online sales is exposing the weakest of the physical retailers. First, many retailers have too much physical space, which is expensive to maintain. The U.S. has about six times the physical retail space per capita as most of Europe. Retailers with lots of space will have a hard time building a competitive digital presence. The fixed costs for physical space suck up all the cash flow, leaving little to invest in online infrastructure.

Many retailers have relied on the convenience of their physical locations for sales. Unfortunately, the advantage of the prime retail location is eroding with digital platforms. Yet, they still carry all the legacy costs of those physical locations. When an industry changes rapidly, those with high fixed costs and entrenched management usually are hurt the most.

Yet, while many investors fear that online retailing will gut business models for physical retailers, the reality is that currently 90 percent of retail sales in the U.S. are made in physical stores. It’s likely the best retailers will figure out an appropriate mix of online and in-store sales that fit for the products they are selling. For instance, if you sell sacks of cement, you won’t need much of an online presence. But if you sell clothing that can be easily shipped and returned, you’ll likely need a blended business model because consumers like the convenience.

For investors interested in trying to find the solid retailers, there are many branded retail companies that have solid profits, low debt, adequate cash flow, a growing digital platform, and even pay healthy dividends. Yet, many have still seen their stock prices fall by 50 percent, because in general, investors have little faith that these business models will succeed.

If you want to invest in solid retailers at a bargain price, then you’ll need to do your fundamental research. That will help you identify the firms that are currently in good shape, but ultimately, you’ll have to make a leap of faith about their business models.

You’ll have to decide how much different the future will be from the past in terms of distribution and buying patterns.  If it’s completely different, then the current profitability for some retailers won’t provide much protection. If it’s somewhat different, like online sales grow to 30 percent of the market, then those retail firms that are nimble and are adjusting may well be worth the leap of faith at these bargain basement prices.

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