Retailers Aren't Worth the Risk

It didn't take long before others began replicating the Starbucks model. Starbucks' arbitrage spread is narrowing every day, and there isn't a whole lot the company can do about it. Building a brand does help slow the decline of the arbitrage spread, but ingenious entrepreneurs are already creating niches within the Italian-caf? category and helping close the gap.

Diminishing Advantages

If you invested in Wal-Mart, Home Depot or The Limited 20 years ago, your returns would be amazing. But there were virtually no data points two decades ago that would have given you any comfort that these arbitrage spreads were likely to still be there 20 years out. Innumerable highflying retailers from the 1980s aren't with us today.

As an exercise, think of any retailer that appeals to you as an investment today, identify the arbitrage spread it's exploiting, and ask yourself why you believe that gap will remain intact for 20 years, 10 years, or even five years.

Consider the case of Victoria's Secret, part of The Limited. This chain has grown the market for women's undergarments pretty dramatically over the years and has scaled nicely. The chain has a well-established brand, high product margins and a history of strong innovation. As other hungry innovative entrepreneurs see the dollar signs, I can visualize them beginning to carve away at chunks of Victoria's Secret's market, while others will clone and speed-source all the company's latest innovations and offer them at lower prices. It's not rocket science.

The counterargument is that the Victoria's Secret brand creates a moat that easily insulates it for another 20 years. Also, it does seem that Wexner's team is less likely to miss the next bra trend than they are to get skirt lengths wrong. They less dependent they are on getting fashion trends right, the better off they'll be.

The bottom line on Victoria's Secret is this: The 20-year outcome is murky and unpredictable, with enough of a probability of market-lagging returns that you're better off having nothing to do with it.

If you're still attracted to any multibillion dollar retailer, take a look at an article I wrote entitled The Danger in Buying the Biggest. Size is a huge factor in future returns, and buying the biggest retailers is fraught with risk.

I'm reminded of a quote by Warren Buffett: "A horse that can count to 10 is a remarkable horse, not a remarkable mathematician."

It's likely that the retailers you love are the most remarkable horses. Your best strategy is looking for the most remarkable business.

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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.