It is no secret that the retail sector is an absolute disaster this year. By all rights, it should be. Consumer spending has been relatively weak and most of the dollars spent have gone to everyday items. People are buying the have-to-have items and skimping on the want to have discretionary spending. They are also being very cost conscious, with those stores that specialize in discount or bulk items showing sales increases, while the specialty retailers have suffered dramatic sales declines so far in 2008.

It is hard to get excited about shopping for a new suit, arts and crafts, or toy for the kids when you are trying to decide between paying the mortgage or buying food with this week's paycheck. The stocks of many of these have been absolutely pummeled, dropping more than 50% in some cases. This may present an opportunity for long-term investors who are aggressive in nature.

A look at what's going in retail shows us that it really is bad right now. Consumers have been hit by a tidal wave of problems this year. Fuel and food prices are up substantially. Increasingly larger percentages of shopper's paychecks are going to the gas station and supermarket. For many, their mortgage has reset to higher payments, even as their house declined in value. Unemployment is rising and few new job opportunities are being created in the tight credit environment.

To make matters worse, savings in the United sates is pretty much zero, so there are no reserves upon which to draw. The standby for the last decade of refinancing the house to free up cash is no longer an option. These are not the conditions that make you want to jump into a car and head to the mall on a shopping spree. Interest-rate cuts have not helped, nor have tax-stimulus checks. Consumers are scared, and scared people do not shop. According to some industry groups, mall traffic is down 14% in 2008, and it is even worse for apparel stores.

How to Find Cheap Stocks

To better understand why I think this should be an opportunity in what is, at best, a difficult time for retailers, you should understand that I consider myself one of a handful of true Ben Graham style investors still practicing the method. I look for stocks that are cheap, primarily based on asset and enterprise value (EV).

Stocks do not trade cheaply because business prospects are wonderful. I leave those stocks for my friends who trade momentum and growth stocks. Most of what I like is unloved and has at least some operating difficulties. I ask myself four questions when I look at a stock.

  1. Is it cheap?
  2. Why is it cheap?
  3. Can it survive?
  4. Has anybody noticed besides me?

Let's drill down and find a few companies that meet the first criterion, and then subject them to the rest.

Is It Cheap?

The question of is it cheap is fairly easy to answer. Running two simple stock screens can give me a list of names that are cheap to assets and enterprise value. For assets, I use tangible book value, and for enterprise value, I use the enterprise value (equity+debt-cash) divided by the company's earnings before Interest, taxes, depreciation and amortization (EBITDA). I am looking for stocks that trade at or below book value or less than five times EV/EBITDA.

Statistically, there are three stocks that jump off the page. Charlotte Ruse (CHIC), a women's apparel retailer trades at 1.5 times tangible book and has an enterprise ratio of less than three. A.C. Moore (ACMR) runs a chain of arts-and-crafts stores and is also cheap. The shares trade above my enterprise ratio targets, but at just 80% of book value. Auto parts chain Pep Boys (PBY) trades at just 70% of its book value.

Why Is It Cheap?

Why they are cheap has much to do with the economic environment. Charlotte Ruse has had significant management shakeups, and currently operates with interim management in several key executive positions. They expanded too rapidly just as retail slowed, and this has hurt the bottom line.

Pep Boys operates in a crowded, competitive segment of the retail industry. They are in the process of transforming their stores, putting a greater emphasis on service and less on higher dollar discretionary purchases. They have missed Wall Street earnings estimates by a wide margin in three of the last four quarters, and the stock has been hit hard as a result.

A.C. Moore is simply in what is a bad business right now. Arts and crafts rely totally on discretionary spending. People worried about food on the table do not head out to buy arts-and-crafts materials. The company's earnings have declined sharply and it is reflected in the stock price.

Can It Survive?

The next question is can the company survive? In a highly cyclical industry like specialty retail, this is a critical question. They are the first to suffer in a downturn, but they also are among the first to recover when the economy turns around. I use both subjective and quantitative approaches to judging this. The quant measure is simply an Altman Z-score. This is a simple credit scoring system that measures a company's ability to survive. A score above three is considered to show a company is likely to survive and the higher the better.

More subjective is a review of asset quality and operational plans. Charlotte Ruse easily passes muster. They have a Z-score well over 4 and are debt free. As of the last quarter, they have over $60 million of cash on the books, and the company generates free cash flow, even in the current economy. They have been buying back stock this year and have slowed expansion plans to allow the company to catch up with the economy.

A.C. Moore also passes with flying colors, with a Z-score of almost 4 and very little debt. In addition, they have over $45 million of cash on hand.

Pep Boys is the diciest of the three. They have a Z-score below three, reflecting some uncertainty about they balance sheet. The company does carry a substantial amount of debt on its balance sheets.

This is where the subjective comes into play. Pep Boys owns most of its real estate and is aggressively engaging in sale leaseback transactions to liquefy their balance sheet. So far, they have raised over $300 million in this fashion. That is roughly equivalent to the amount of long-term debt and changes the picture somewhat. All in all, management calculates the real estate portfolio is worth twice the current stock price.

Has Anybody Noticed Besides Me?

The last question is critical to having a potential winner. Stocks will stay cheap until someone notices and starts buying them. I look for three types of buying. The first is corporate officers and executive. Pep Boys and A.C. Moore pass this test. Charlotte Ruse has no buying, but no insiders have sold stock either.

The second is respected value-oriented hedge funds and mutual funds. All three stocks have seen buying by some of most successful mutual funds. Well-known fund, managers such as Royce and Associates, Gabelli Funds and Renaissance Capital, have been buying the three stocks.

The final category is activist investors. These are investors, primarily hedge funds, that buy stock in a company and push for changes to unlock shareholder value. While all three have seen some level of activist buying, Pep Boys in particular has a shareholder list that resembles an activist investor's hall of fame. Motivated by the real estate values, several firms are pushing management to increase the value and share price of the company.

Retail right now is a terrible business. It won't always be so. Long-term aggressive investors can profit by owning companies that are cheap, but will survive. Using buying by insiders, successful investors and activists as a confirming factor can only increase your odds of long-term success.

  • The contraction in the U.S. economy has made a retail a minefield, with nearly any non-essential-goods companies suffering mightily.
  • Despite being severely beaten down, there are several companies that appear to be fairly cheap and well-positioned when a turn in the sector comes.
  • Buying stocks in sectors that have seen this sort of carnage isn't for the weak, but if your risk tolerance is high enough, it can be quite lucrative.