Retail and reversion to the mean

In investing, some people often make the argument that the profitability of a company will move away from the extremes towards the average of its (public) peers.  I see it often on valueinvestorsclub.com.  For example, this writeup on Aeropostale argues that Aeropostale’s profitability should trend back towards its past.  I think that this is a dangerous and flawed argument.

The correlation between the CEO and profitability

This correlation has been very strong historically.  Legendary CEOs such as Mickey Drexler and Allen Questrom brought success to the various retailers that they have run.  When really good CEOs leave, the companies they run often fall from their glory.  JCP faded into mediocrity when Questrom was replaced by Ullman.  Retailers like Pacific Sun often fade into mediocrity (or start losing money) once their founder leaves.  Aeropostale’s profitability has been declining ever since Julian Geiger left.

The real reversion to the mean occurring here is in the quality of the CEO.  Superstar CEOs are outliers and they are extremely difficult to replace.  If the quality of replacement CEOs follows some type of normal distribution, then one would expect that the replacement CEO usually won’t be as good as the original superstar CEO.  This seems to be mostly true in the real world.  (While some CEOs seem to be good at finding and attracting an above-average successor, other CEOs seem to lack this skill.  There could be a very weak force at work where superstar CEOs tend to be replaced with above-average CEOs.)  At the end of the day, the departure of a superstar CEO is typically very bad for a retailer.

(*The correlation between the CEO and profitability isn’t perfect.  Ron Johnson headed Apple’s retail operations, which is one of the greatest retailers of all time with ~$7000/sqft in sales.  He subsequently ran JCP into the ground and was fired.  Geiger left Aeropostale and is now the CEO of Crumbs, a cupcake/food service business.  Crumbs’ performance has been dismal under Geiger.)

Good retailers may be overrepresented in the public markets

The investment banking community likely weeds out poorly-operated retailers due to the following reasons:

  1. Investment bankers want to IPO hot stocks with lots of growth potential.  Only well-operated retailers have lots of growth potential.
  2. Because there are significant recurring overhead costs to a public listing, it doesn’t make sense to IPO very small retailers.  Because the better CEOs tend to end up with more stores than the bad CEOs, this causes the better CEOs to be overrepresented in IPOs.

I don’t think that it is reasonable to assume that the publicly-listed retailers are representative of the overall retail market.  The calibre of the average CEO of a public retailer is likely higher than the calibre of all retail CEOs (public and private).  When the founder of a public retailer leaves, I might expect the replacement CEO to do worse than his/her public peers on average.  (Though due to the variance in skill, the CEO might do a lot better or worse than his/her public peers.)

Buffett and Munger learned the hard way that retailing is a very tough industry where many people lose money.

Time  is the friend of the wonderful business, the enemy of the  mediocre.

You might think this principle is obvious, but I had to  learn it the hard way – in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore  department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were  first-class, and the deal included some extras – unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o- three years later I was lucky to sell the business for about what I had paid.
– Warren Buffett (1989 shareholder’s letter)

Leaving the competition behind

There are a few, rare superstar CEOs that will get even better at what they do.  Sam Walton wasn’t a very good retailer when he started out.  He made really bad deals that are described in his autobiography.  But he was hard-working, thought for himself, learned from his mistakes, and slowly became a lot better at retailing.  Some retailers will slowly increase their margins (and sales per square foot, ROIC, etc.).  They will continue to increase them to levels well above their peers.  This is the opposite of reversion to the mean.

Of course, this behaviour does not continue forever and slows down at some point.  Eventually, a retailer’s metrics will come down as its newest stores begin to cannibalize sales.  Retailers cannot grow forever and will hit a maturity phase.

Fundamentals of the retail business

My current model for predicting the success of a retailer is as follows:

  1. The quality of the CEO is the most important factor.
  2. The CEO’s future performance will be very similar to their past performance.  This correlation is stronger if the CEO has a track record at his/her existing company. What worked at another company may not work for the current company.
  3. Growth in the business will slow down once it saturates the domestic market.
  4. International expansions usually fail.  (This is unique to retailing.  Many other industries do not exhibit this pattern.)  Combined with #3, this means that the growth days for a retailer are usually over once they saturate their domestic market.
  5. Online retailing is a trend that will hurt particular segments of the retail industry.
  6. The rules for online retailers is different than bricks and mortar retailers.  Scale is an advantage.  Online retailers have an easier time expanding internationally.

Things that I ignore:

  1. Size does not seem to be a competitive advantage at all.  I don’t believe that Walmart’s scale is an advantage overall.  While it enjoys economies of scale, large organizations tend to have bureaucracies and more political fiefdoms.  Greater size brings inefficiencies with it.  Smaller companies such as Tractor Supply are succeeding in former Walmart locations.  Walmart does not seem to have a magic superiority over other retailers.
  2. Writeups on VIC often argue that a new strategy will improve profitability.  I don’t think it works that way.  Retail is continually evolving and is fiercely competitive.  Every retailer is trying something new and is finding efficiencies in their operations.  It’s like a treadmill: you have to run to stay in the same place.
  3. Writeups on VIC often argue that profitability will increase when they cut out some money-losing part of the business.  While this may be true in turnarounds where the incoming CEO slashes costs (e.g. many of John Malone’s companies), I don’t think that this happens often in retail.  A management team that created a money losing segment in the first place will find new ways of losing money.  The retailers that learn from their mistakes tend to show slow and steady improvements in their operations.
  4. Arguments that claim that slashing store count (or employees) will improve profits are usually wrong.  See #3.

*Disclosure:  No position in any of these retailers.  Aeropostale and Gamestop are stocks that I think about shorting.

EDIT: I made minor revisions to this article on 8/21/2014.

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2 thoughts on “Retail and reversion to the mean

  1. Pingback: Coach: Victor Luis could be the next Ron Johnson | Glenn Chan's Random Notes on Investing

  2. Pingback: Aeropostale (ARO): Teen titan or turnaround trap? | Glenn Chan's Random Notes on Investing

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