Winners And Losers In Small-Cap Retail

Bill Hench looks at the dynamics in the retail industry and outlines the factors that he thinks will help some companies to survive and thrive.

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What’s making small-cap retail attractive?

There are a whole list of factors that have driven these stocks to levels that traditional value people and deep value people would look at. The valuations have been driven down primarily by a lack of earnings, and that lack of earnings was spurred by many things.

Primarily, it was just a massive expansion during the free money period. Sales growth did not keep up with square footage growth. But the market was paying for significant square footage growth, so managements were incented to open new stores, open bigger stores, come up with new concepts. As free money has now ended, and competition from other sources, mainly online, has come in, you’ve seen a big, big displacement and you’ve seen also opportunities.

Everyone’s gone multi-channel or omni-channel now. But also it’s just making sure you’ve got the right goods at price points that you don’t have to tremendously discount, right? You don’t want to be stuck waiting till the end of the period to get rid of inventory. So you’re looking at people now doing much, much better controlling inventory, much better at limiting the types of products that they have, and really concentrating on what they do best.

How are you avoiding value traps?

If you ran a value screen on the retail sector, you’d have a pretty long list. Ours is a two-step process where we identify things—number one, as being cheap. But then we want to make sure that there is some reason that this thing is going to get better earnings or better margin, or return to, you know, investors’ good side.

And that usually involves a new plan. It could be a cost-cutting situation. In many instances, though, it’s just executing on a better plan, right? It’s taking those assets and making sure that most of them are dedicated to profitability—right?—versus what’s been happening as opposed to growth just for the sake of growth.

What potential advantages does new management bring?

New managements typically have a lot more latitude in what they can do. Also they’re not wedded to anything that may be dear to them, or near and dear to their hearts. Acquisitions, projects, you name it, okay? Everything usually is on the table. And the Board, when they are hired, are usually looking for some freshness, right? So you tend to get a lot more activity, a lot more action, and a lot more willingness, I think, for people to take a chance with them.

Are there potential advantages for active small-cap management?

I think there is such a negative tone that I think people are blinded by the fact that you can do well in a competitive industry. You know, most industries are incredibly competitive, and retail is no different. I think that if you really sort of look at the numbers and just treat it like you would any other consumer business, you’ll see that you’re going to have big winners and you’re going to have big losers.

Fortunately for us in small-cap, in micro-cap land, it’s a group that is very, very nimble because of their size. So, not a lot of legacy stores—maybe, you know, very, very simple business models. All these things lend themselves to being fixed or corrected a lot quicker than perhaps these giants that are out there with long histories and long leases and other things like that that could inhibit change.

We’ve also had a dramatic reduction, I think, in the amount of coverage from Wall Street. So their stories, when they do change them, and when they do have an opportunity to really turn around, really aren’t getting out there as quickly as they used to. Which just delays the reward. It doesn’t change it.

Article by Bill Hench, The Royce Funds


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