Easy Credit and the Demise of the Specialty Retailer

Year after year, the American consumer lives and breathes the quote originally attributed to Mark Twain: "The rumors of my death have been greatly exaggerated." Your local landfill is now making compost of predictions warning about the imminent demise of the American consumer. These predictions will likely prove correct one day, but the timing is very difficult to nail down.

These predictions of consumer retrenchment have not appreciated or fully respected a key tenet of human nature: When given the option to consume without producing (via credit cards), most people will choose "yes," and most people are reactive adjusters, rather than proactive planners. Instead of keeping in mind the odds of a job loss or a slump in the housing market, most consumers wait until they run into the proverbial budgetary brick wall before they adjust spending habits.

Though it's generally a bad idea to speculate on the possibility that consumers will reverse their habits overnight, drastically cutting back on spending, the odds shift in your favor if you selectively bet against the consumer. Referring to short sale candidates, J. Carlo Cannell of Cannell Capital asked the audience at this year's Value Investing Congress West, "Why should I go hunting in the rainforest for a puma when I can shoot a sick pigeon at the side of the road?"

There are many "sick pigeons" at the side of the road, waiting to be put out of their misery. They routinely consume far more capital than they will ever return to shareholders, and should be liquidated in order to allow capital to be diverted to more productive uses.

Using the past three years of hindsight, this means selling short Pier 1 rather than J.C. Penney, Krispy Kreme rather than Panera Bread, or Gateway rather than Apple. Whether it's due to obsolescence, fads, end market saturation, dumb acquisitions, or misguided corporate strategy, the reasons for 50-99% of crashes in a stock are numerous. So when the market gives you an opportunity to sell short a stock with several of the aforementioned characteristics (and is quite expensive relative to its earnings power), it's an opportunity you should take advantage of.

Specialty retailing is a market segment littered with "sick pigeon" short sale candidates. While a recession may signify little more than an inventory adjustment and a 30% stock correction for the Wal-Marts of the world, it represents a death knell for some specialty retailers counting on a critical mass of consumers continuing to overspend on very discretionary items.

While it's not reasonable to assume that consumers will change their habits overnight, it's reasonable to assume that most are a) fickle and b) too addicted to the "doorbuster" type of sales that are becoming mandatory in order to draw foot traffic. It's the marginal consumer that keeps dozens of specialty retailers afloat. Miss one fashion trend, or allow the competition to poach your customers, and it could mean lights out in a hurry.

Retailers usually declare bankruptcy when traffic and cash flow slows to the point where they can no longer repay suppliers for inventory on loan, make payments on their revolving debt, and make the contractual lease payments that they owe to their REIT landlords.

How did specialty retailing reach this point of saturation? The top reason is the incredibly easy credit conditions of the past generation. Consumers have been given every opportunity to overspend, and private entrepreneurs have been more than willing to oblige.

Craft and fabric retailing has leapfrogged from cottage industry to logistically complex nationwide empires - all with the intent of fulfilling demand for an eye-opening array of slow-turning merchandise. Lenders with more focus on fees than on risk have fallen over themselves to finance store openings and inventory builds, much of which will be liquidated at an economic, if not accounting, loss.

Now, the tide should reverse, or at least stagnate, favoring the retailers with the strongest balance sheets, best management teams, and most loyal customer bases.

Fiat monetary systems without the checks and balances of the gold standard allow credit creation to run out of control. It has greatly diminished lenders' need to accurately price risk and ration credit. Therefore, a great number of loans made to  specialty retailers over the past few years were made with poor assumptions about sustainability of the underlying business.

In the latest issue of The Richebacher Letter, Dr. Kurt Richebacher writes:

"It is one of the key postulates of Austrian theory that the most harmful effects of credit inflation are not in the price indexes, but in the misdirection of resources that it causes. For American economists, lacking any understanding of this part of the inflationary process, all these structural distortions are irrelevant.

To be sure, over time, they impinge on economic growth in various ways. The lowest interest rates in half a century and the biggest fiscal stimulus in U.S. history during 2002-2004 have given the economy a one-off boost, but the resulting recovery plainly lacks any self-sustaining and self-reinforcing traction."

The housing boom that ended last year was fueled by inflation. An "asset-based" economy is simply not sustainable over the long run. Since the housing boom promoted a "one-off spending boost," the profits of retailers that benefited the most from this boost should be viewed as artificially inflated.

Regards,

Dan Amoss, CFA
for The Daily Reckoning Australia

Editor's Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

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