Retail a Solid Equity Performer

NEW YORK — Looking to double the value of an investment in just five years?

This may sound like a late-night infomercial come-on, but by at least one critical measure, return on equity, investing in retail apparel stocks may do just that, according to an ROE analysis by WWD.

Before eyes glaze over at the mention of performance metrics, there’s a reason analysts spend so much time crunching numbers: It helps show them the money, and one of the key benchmarks of potential future returns is return on equity.

ROE is a ratio, expressed as a percentage, of net earnings divided by shareholder equity for a trailing 12-month period. That makes it a supremely useful and seductive analytical tool, because it indicates how effective a company is at squeezing profits out of a shareholder’s investment.

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Investors love it because implicit in that number is the promise of future returns. For example, if a company maintains an ROE of 15 percent, it means a shareholder can expect the value of his investment to more than double in five years. An ROE of 20 percent means the investment will more than double in just four years. An ROE of 40 percent? A little more than two years.

In WWD’s survey of retail apparel stocks, more than two-fifths generated ROE’s of greater than 15 percent and more than half did better than 12 percent.

Some read ROE as a depersonalized measure of corporate profitability. Others interpret it in more personal terms, as a metric of management effectiveness. Either way, of the seemingly endless number of ways to measure a company’s performance, ROE is perhaps the most important, and among the most widely used.

It’s important to note that ROE is one of many factors that investors consider. The WWD analysis covers ROE for the trailing 12 months only. For a fuller picture, ROE is often also calculated for the trailing five years, as well.

And that said, the standard trope is nevertheless true that past performance is not an indication of future returns. Moreover, there are different ways of calculating ROE. In this case, WWD has used beginning equity as it allows for a better apples-to-apples comparison: If a company lowered its equity by, say, repurchasing shares, that would boost its ROE. By employing beginning equity, those types of events are isolated from the results.

Turning to the survey, by channel, mass merchants were by far the most effective at employing their shareholder capital. Most impressive were the major off-pricers TJX Cos. Inc. and Ross Stores Inc., with truly dizzying returns on equity. Double-digit earnings and sales growth account for part of that, as does better gross margins and relatively light bottom-line eroding leverage.

Keep in mind, higher margins mean higher profits, while long-term debt leads to interest expense eating away at those profits. Target Corp., for example, had an enviable ROE of 19.5 percent, but because of its credit card business, it is also relatively highly leveraged. Add to that the plunging contribution to earnings from its Mervyn’s and Marshall Field’s divisions, and Target’s resilient ROE is astounding. It takes little imagination to see how the company’s ROE will shoot up once it completes the divestiture of those two operations.

Stronger gross margins drawing greater income out of higher sales also helps explain some of the stunning results coming out of the specialty channel. Many of the companies in this most nimble of sectors — Aeropostale Inc., Chico’s FAS Inc., and Gap Inc., to name a few — have figured out how to enjoy more full-price selling by increasing their inventory turns. That boosted margins. Also, as a class, the specialty channel is very lightly leveraged, and in many cases, has no long-term debt at all. That’s one of the benefits of leasing rather than owning retail space.

Department stores, for their part, collectively had the lowest average and median ROE — no surprise there — but a good number of individual companies had excellent ROE’s, regardless. Sears, Roebuck & Co.’s ROE looks too good to be true at more than 50 percent, and it is. The company’s profits got a onetime $4.14 billion injection from the sale of its credit and financial services business. Historically, Sears’ ROE is closer to a compelling, but more earthbound, 20 percent.

Other impressive players included Nordstrom Inc. and Neiman Marcus Group Inc., which have benefited from greater demand for luxury goods and first-rate service. May Department Stores Co., for all its past struggles, did an admirable job of using its shareholder capital effectively. And despite posting its first profit decline in more than a decade, Kohl’s Corp. still managed to return more than 16 percent on its shareholder equity.

From here, investors would do well to keep in mind two macroeconomic factors that could wreak havoc on ROE’s in the near future. The first is deflationary pressure, which shows no sign of abating. Once all the cost cuts have been wrung out of a business and efficiencies have been revealed, retailers once again will become more dependent on top-line growth to drive bottom-line gains.

Finally, investors should probably consider the likelihood that historically low interest rates will eventually rise. In turn, companies that are highly leveraged with short-term debt will end up seeing their profits pinched.