Core Concepts: Specialty Retailers

Mr. Market is alive and well and arguably hyperactive in the specialty retail sector. While many sectors rarely have a stock in the bargain bin, such as those in the beverage category, that's not the case here. Stocks in the specialty retail space regularly swing from severely undervalued to wildly overvalued and back again.

This is evidenced, in part, by the wide price range for stocks in this group. The magnitude of change in these stocks far exceeds the change in the underlying business values. The five-year high for these fashion-sensitive specialty retailers is on average more than 600% higher than the five-year low: Abercrombie & Fitch (ANF - commentary - Cramer's Take), Pacific Sunwear (PSUN - commentary - Cramer's Take), Charming Shoppes (CHRS - commentary - Cramer's Take) and American Eagle Outfitters (AEO - commentary - Cramer's Take).

One factor that contributes to wide swings in investor sentiment is the group's razor-thin profit margins. Relatively small incremental improvements can lead to whopping increases in profits (and vice versa).

Over the last five years, for example, PetSmart (PETM - commentary - Cramer's Take) has increased net profitability from 1.4% of sales to 4.4% of sales. Incrementally, that amounts to a 3-cent improvement for every dollar of revenue. But because margins were so thin to begin with, a 3% incremental improvement has an enormous impact. The stock is up tenfold over the last five years, from $3 per share to a recent quote of about $30, primarily because of this incremental improvement in profit margins.

Another reason Mr. Market is active in this sector is because material shifts in market share are the norm, not the exception. Consumers are notoriously fickle in their allegiance to small-box retailers. While there is a high probability that big-box retailers such as Wal-Mart (WMT - commentary - Cramer's Take) and Target (TGT - commentary - Cramer's Take) will maintain and grow their market share over the next 10 years, the opposite is true for most small-box retailers.

Betting that a specialty retailer will thrive and flourish over, say, a 10-year period, is a high-risk gambit. Even specialty retailers that sell products into end markets with stable aggregate demand, such as retailers of shoes, go through intermittent cycles of success and struggle. Examples include Foot Locker (FL - commentary - Cramer's Take) and Payless ShoeSource (PSS - commentary - Cramer's Take).

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At time of publication, Alsin and/or ACM was long Blockbuster, Pier 1 and Wal-Mart, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.