The Brutality of Smallcap Consumer Retail

Consistent with many small cap sectors, existential risk is ever present for retailers, and the best way to find the few opportunities that lead to outsized returns is to focus on the quality operators. Like Darwinian evolution, the hostile environment for new entrants can improve the longer-term returns for those that adapt and survive. Investment base rates are not favourable for small cap retail stocks. The base rates appear further skewed against retail turnarounds – despite the mirage of significant valuation appeal and potential upside if they work.

Over the past 10 years, the trends in Australian retail have been tough, with a brief period of respite in the immediate pandemic aftermath. Chronologically we have seen the emergence of ecommerce as a competing force (2010 onwards), growth in Australia of Amazon as a local competitor (2017 onwards), house price declines (2017-2020), COVID (2020 – 2022) and finally rapid interest rate increases (2022 – 2024). Throughout almost all this time, growth (both nominal and real) in retail sales (per Australian Bureau of Statistics) remained positive. This changed in early 2023 as real sales turned negative in February, and by September 2023 were negative on a 12-month rolling basis. They have only gotten worse since then.

Source: Australian Bureau of Statistics, Reserve Bank of Australia

Source: Australian Bureau of Statistics, Reserve Bank of Australia

Negative real retail sales growth is a big deal for retailers, as high fixed costs from rent and wages are likely to increase with inflation, putting significant pressure on margins. We have already seen a number of retailers lose profitability given weak sales and rising costs.

Source: Westpac – Melbourne Institute

Source: Australian Bureau of Statistics, Reserve Bank of Australia, Westpac – Melbourne Institute

To better understand the base rates of success and failure investing in small cap retailers, we examined a broad selection of listed small cap retailers in Australia and New Zealand over the past decade. As a group of companies, the base rates of stock performance have not been good. The average small cap retailer has underperformed the Small Ords index by 8-10% per annum.

There have been multiple complete failures (Surfstitch, Pumpkin Patch, Sunbridge, Smiths City) as well as outcomes that differ from complete failure in form only (Booktopia, Oroton Group, Wellington Merchants, MarleySpoon, Mosaic Brands, AMA Group, Country Road) given shareholders lost 90% or more of their investment.

This probably underestimates the failure rate of the overall retail category. Listed companies are likely to have a selection bias toward better quality retailers. Consumer categories in ASIC insolvency statistics (Retail Trade, Accommodation and Food Services) often compete with the Construction sector for the highest levels of insolvency every year – and they are currently rising sharply, almost doubling from (unusually low) F2022 levels and we still have two months of the year to go.

Source: ASIC

There is a small group of high-quality small cap retailers who have survived and evolved despite brutal industry conditions. They tend to have management teams that understand the difficulties of winning in this market and what survival requires. They include companies such as JB Hifi, Harvey Norman, Premier Investments, Lovisa, Super Retail Group, Nick Scali, Reece, Accent Group and ironically Myer (!) given they are still around.

Emerging players currently doing well such as Temple & Webster, Cettire and Universal Stores probably need the test of more time to see if they can survive longer term.

The greatest lessons markets teach investors come from mistakes. Over time, we aim to get better by learning from mistakes we have made (and hope never to repeat). Our investment process ensures this is more than just hope, as we code these painful lessons directly into our future decision making.

Unfortunately, there also seems to be an infinite number of new mistakes to learn from!

One of these may be the futility in turn-arounds in the small cap retail sector. Turn-arounds are hard enough, but retailers who have lost their position in the consumers’ minds (and wallets) can find it difficult, if not impossible to regain.

This can be observed in the comparable store sales growth – a.k.a same-store-sales (SSS) or like-for-like sales (LFL) of a retail business – either in absolute terms, or relative to the category. Ongoing negative relative comp store sales can more than wash away any hard-won turn-around gains made elsewhere in the business (product sourcing, gross margins, logistics, rent reviews, store rationalisation, productivity gains, new Point of Sale software, etc).

We have previously made a small number of investments premised on the ability of management to turn around an underperforming retail business – if not to former glory, then at least to something economically sustainable and reasonable. None of them went well and we no longer hold any retailers with this as the investment thesis.