is it time to stock up on struggling retailers?

[Note: this post originally appeared on the CFA Institute’s Enterprising Investor blog.]

Many retailers enjoyed a cheerful holiday season. November sales figures handily beat analysts’ expectations, rising nearly 5% year-over-year (YOY), and lower gas prices and an improving economy drove strong results in December as well. Investors looking to capitalize on these glad tidings might be tempted to consider some of the bargain stocks in the sector, especially those that have faltered in recent years, such as JC Penney (JCP) and Sears (SHLD), or even deeply troubled firms, such as RadioShack (RSH) and Wet Seal (WTSL).

Not to play the Grinch, but history suggests this would be a terrible idea.

Last month, I interviewed the senior management of the home decor chain Tuesday Morning (TUES), including its accomplished CEO Michael Rouleau. Rouleau was one of the original employees of Target. He also cofounded Office Warehouse and served as CEO of Michaels. During our meeting, he told me that in all his years in the business, he could count the number of successful turnarounds he had witnessed in the retail world on one hand.

That statement jibed with my own experience as a fund manager. I unfortunately missed out on Tuesday Morning’s turnaround (in early 2009, its stock dipped below a dollar), but in three decades of studying and investing in thousands of companies, I have bought into exactly two successful retail rescues, both of which I profile in my book Dead Companies Walking: Cost Plus World Market and Zales.

Over-expansion and poor merchandising choices took both firms perilously close to bankruptcy before strategic redirection by new managements saved them. I bought the stock of each as their turnarounds were underway and made a nice return when they were acquired by larger competitors (Cost Plus by Bed, Bath and Beyond; Zales by Signet Jewelers). But corporate Lazaruses like these are exceedingly rare. If anything, they are exceptions that prove an unforgiving rule of retailing: once shoppers turn away from a brand, they usually stay away for good.

In my career, I have visited dozens of struggling retailers whose turnaround bids ended in bankruptcy, including Worlds of Wonder, Ultimate Electronics, Blockbuster Video Entertainment, Bombay, Factory 2-U, Wilsons Leather, and Discovery Zone. I expect RadioShack and Wet Seal to join these ranks soon. I have been to both headquarters in recent years and have heard hopeful — and familiar — predictions for redirection and better times ahead. But even if both post better-than-expected holiday seasons this year, I am doubtful that they’ll survive for many more Christmases, at least in their current form.

Although RadioShack and Wet Seal offer different products to different types of customers, they can both trace their troubles to the same two factors that doom most retailers: unpopular merchandise decisions and — more importantly — intense competition. If a retailer isn’t giving its target customers exactly what they want — at the best possible price — someone else surely is. Competition is so fierce and margins are so tight that even small strategic missteps can doom the most established businesses. JC Penney and Sears once dominated the retail landscape. But Sears failed to keep up with the times and JC Penney’s former CEO disastrously alienated its middle- and working-class customer base by eliminating coupons and stocking higher-end goods. Both companies have implemented strategic shifts and each could still recover. (As I wrote in my last post, I even bought some stock in JC Penney earlier this year.) But even after an upbeat holiday season, investing in either company is a highly speculative move. They have both seen negative or flat same-store sales in recent quarters, and they’re both loaded down with huge amounts of debt, which gives them very little time to turn things around.

Calling the bottom of a declining stock, as the old saying goes, is like trying to catch a falling knife. Calling the bottom of struggling retailer stocks is particularly risky, because even the worst performers can rally on such short-term results as seasonal promotions, only to plunge again after the good times wear off. This holiday season’s strong sales could keep some of them aloft just long enough to make for a very unhappy new year for their investors.

One thought on “is it time to stock up on struggling retailers?

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