Look to the Top When Buying Retailers

 | Aug 22, 2013 | 1:30 PM EDT
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No industry has lower entry barriers than that of general retailers. They have no trade secrets, no patents, no special manufacturing process or anything that prevents competition from sprouting up.

Anyone that wants to open up a retail business can spend a few weeks visiting the competition and know all that is needed. It's no wonder why nearly all retailers operate on thin margins and heavy markdowns. 

This week, activist investor Bill Ackman was forced to resign from the Board of J.C. Penney (JCP), a company in which he owns 17.7% and is the largest shareholder. More painful is that Ackman now concedes that he may have made a mistake investing in JCP and may exit the position.

Ackman is one of the most successful activist investors, at least during the past decade. His activist fund launched in 2004 is up over 450% since inception. Yet, JCP is not the first time Ackman has made a mistake investing in retail. It's not even the second time. Previous efforts to unlock value at Target (TGT) and Borders have also been unsuccessful.

For the vast majority of investors, there is an important lesson here. Retailing is a tough business with little to no competitive advantages. It is not the most promising area for capital appreciation. There are exceptions, however, for the truly unique concepts.

Charlie Munger, Warren Buffett's partner at Berkshire Hathaway, once asked business students to name the one product whereby an increase in price will actually lead to an increase in demand. The answer was luxury goods. Luxury goods, by definition, are the brands that everyone wants but are only available to the few who can afford them. Luxury goods also are instantly recognizable, so they create a sense of pride or confidence among the owner.

Luxury goods are marketed as the must have products for those consumers who demand the absolute best. For the most part, that segment of retailing is the most fruitful. Margins are high, the brand following offers the only competitive advantage and consumers of luxury products are less sensitive to economic conditions. Those sets of conditions are about the best you can ask for in retailing.

That's why a retailer like Nordstrom (JWN) can deliver operating margins of 14% to 15% while names like Dillard's (DDS) and Macy's (M) operate with 10% to 12% operating margins. It's why a Louis Vuitton purse, Tag Heuer watch, or Ferragamo shoes never ever go on sale.

The higher up the luxury chain, the more attractive the numbers become. Michael Kors (KORS) generates 30% operating margins while Ralph Lauren (RL) is earning 20% in operating margins. These high quality brand names don't have to compete in the mass market; they cater to consumers who want to be associated with the brand and are willing to pay for it. Up the luxury chain, there is less competition while the mass retailer competes with hundreds of brands for the limited budget of the shopper.  

Purveyors of luxury goods like to assert that consumers get what they pay for. It looks like the same rule applies with respect to their share prices.

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