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Three Ways to Score With Retail, Restaurant Stocks

Scott Rothbort

1. Don't Be Fooled by Same-Store Sales -- Gross Margins Matter Too

Same-store sales are so widely promoted that the emphasis on this metric has sprung up a cottage industry of hyper-focused data providers and analysts. Thomson Financial has one such product, but I do not use any of these third-party retail research products. I contend that same-store sales can be a misleading metric and that gross margins need to be factored in as well.

Why? Here's an example:

• Company A operates a store with a single location (open for at least 13 months). Last year, in October, that store sold $1,000 of merchandise, whereas in October of this year, the store sold $1,200 worth of goods. This would imply a positive 20% same-store sales comparison.
• Company B operates a store with a single location (open for at least 13 months). Last year, in October, that store sold $1,000 of merchandise, whereas in October of this year, the store sold $900 worth of goods. This would imply a negative 10% same-store comparison.

So far, Company A looks like a winner, and Company B looks likes it might be experiencing problems. Now let's incorporate the concept of gross margins .

• Company A's gross profits last year were $200, for a gross margin of 20%. This year, Company A's gross profits were $150, resulting in a gross margin of 12.5%.
• Company B's gross profits last year were $200, for a gross margin of 20%. This year, Company B's gross profits were $300, resulting in a gross margin of 33.3%.

So what happened? Company A made a clear effort to boost sales but did so by discounting or selling lower-margin products. On the other hand, Company B focused on selling more profitable products without concentrating on the "top line" number. If you relied solely on same-store sales, then Company A would be appear to be the better investment. However, once you factor in gross profit margins, then Company B proves to be the more successful business.

Same-store sales are a start, but as you can see, the metric doesn't really address corporate profitability.

2. Seek Growth

In conjunction with same-store sales and gross margins, another side of a retail or restaurant company that needs to be considered is growth.

Growth is a major ingredient in retail and restaurant stock investing. Typically, a retail or restaurant "concept" begins as one store. If it's successful, then the concept will expand to multiple stores in a local vicinity. As growth continues, store openings will spread to others states and eventually become a regional chain. From there, the company will expand to other regions and will strive to establish a nationwide brand. This is the local-to-national growth scenario.

However, when seeking growth, we can't stop there. With the prevalence of globalization, we also have to be on the lookout for companies that are moving from nationwide to worldwide.

Some of the companies in the process of going local to national that I closely monitor are Dick's Sporting Goods(DKS - Cramer's Take - Stockpickr) and Ruth's Chris Steakhouse(RUTH - Cramer's Take - Stockpickr). In the national-to-international category, McDonald's(MCD - Cramer's Take - Stockpickr), Yum! Brands(YUM - Cramer's Take - Stockpickr) and Costco(COST - Cramer's Take - Stockpickr) are expanding rapidly outside the U.S.

As investors, we want to capture companies as they are growing. Typically, that growth will result in increasing same-store sales, gross margins, total sales and earnings.

3. Do Your Own Field Research

Peter Lynch, the famous mutual fund manager known for his GARP (growth at a reasonable price) approach to investing, would get many of his stock ideas by checking the shopping bags that his wife would bring home. For the last two years, I have taken field trips with my students from Seton Hall University to the Palisades Center Mall in West Nyack, N.Y. At the mall, we conducted surveys and performed several observations of individual stores. Here are a few effective ways to conduct field research at a mall near you:

• Check to see how long the checkout lines are at different stores. For example, if you went to an Apple(AAPL - Cramer's Take - Stockpickr) store during the last few months, then you could appreciate the strength of the company's sales.
• Ask a few clerks at various stores how business is. You might be surprised how open and chatty they can be.
• Is foot traffic being converted into sales? Count the number of people going into a particular store and the number of people coming out of it with that store's shopping bag.
• Look at the inventory. What items are fully stocked? What items are flying off the shelves? Is the store discounting many products or just a few? Is non-seasonal or aged inventory still on the floor or has it been cleared out?
• Are parents shopping with their children? I find that successful concept stores will have parents shopping with and paying for their kids with their credit cards. Ultimately, parents have both the final say and the means to make large purchases.
• Are the store employees busy or are they milling around and wasting time? An idle staff might be the sign of an idle business.

Finally, don't confuse "good" products with "good" companies. A product might generate a lot of hype and foot traffic, but all that interest still needs to be converted into sales.