Retailers Aren't Worth the Risk

Earlier this week I noticed a banner ad on the Internet proclaiming "Ten Stocks to Get it All Back. Click Here."

The proliferation of financial media in the last two decades has created a substantial demand for pundits to rant about their choice stock picks. I find it amazing how all of them have six to 12 great investment ideas at all times. What intrigues me is that these hot picks almost always include a smattering of retailers.

Virtually every retail entrepreneur got started with a single store. These entrepreneurs saw an offering gap in the market and rushed to fill it. Sam Walton saw that Kmart never opened a store in a town with under 50,000 people, and he felt that a population of 10,000 was adequate to support a Kmart clone. His solution was Wal-Mart (WMT - commentary - Cramer's Take).

In the 1960s, Leslie Wexner felt that the correct model for women's clothing was to offer a limited selection (hence The Limited (LTD - commentary - Cramer's Take)) of high-fashion clothing that was cloned from the Paris runways, but produced fast in Asia (hence Express) at ultracheap prices. His innovation was to have no designers on staff, replicate the latest fashions cheaply and fly the merchandise in from Asia. Because of the speed-sourcing innovation, Express and The Limited were able to change the merchandise mix in lock-step with the vagaries of women's fashion trends, and the chains scaled rapidly.

Howard Schultz noticed the lack of Italian-style small coffee houses in the U.S., and he projected that Americans would pay up for high quality coffee served in a caf? environment. He was right, and Starbucks (SBUX - commentary - Cramer's Take) mushroomed quickly.

Filling the Gap

Walton, Wexner and Schultz were arbitrage players. They saw a gap among the myriad of retail offerings and rushed to fill it. Bernie Marcus and Arthur Blank saw the same gap and created Home Depot (HD - commentary - Cramer's Take), while Thomas Stemberg saw a gap in the office products retail space and created Staples (SPLS - commentary - Cramer's Take). Arbitrage spreads are a low-risk way to make some good money as long as a wide spread remains.

But all arbitrage spreads eventually close. In the case of Wexner, he enjoyed an amazing 30-year run before the model was dead. Everyone had figured it out, and today everyone is cloning and speed-sourcing. Now The Limited is frantically trying to find the next gap. There isn't much hope for that.

Retail innovation is a crapshoot with an extremely low probability of widespread success. Only a minority of entrepreneurs are able to identify the right gaps and then execute to take advantage of it. For every successful retailer, there are hundreds, if not thousands, of failed retail ventures and strategy initiatives.

Another big problem with retail is the transparency of the business. Sam Walton spent thousands of hours inside his competitors' stores. It's virtually impossible to have any trade secrets in retailing. Your competitors can walk into your stores and, in about 15 minutes, understand your entire business-model advantage and how to replicate it. There are very few industries that are as openly transparent, and that's problematic for the long-term investor.

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Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.