2012 Market Outlook; challenges in retail sector

Not all investors have enjoyed the year’s strong start. For short sellers, it has been a painful month, with some sectors like retail seeing a sharp price squeeze.

Few tears will be shed for their plight. But, perhaps we should worry. The market needs efficient stock pricing and liquidity. Short sellers often have a key role in price formation, with a strategic view that looks beyond conventional short term analysis.

To ensure a healthy market, all investors should demand an even-handed approach by regulators. In the near term, short sellers might be the victims, but eventually all participants could lose from excessive price volatility.

When short sellers scramble to cover positions, price bubbles are created, which will inevitably burst as the panic eases. But typically it is the short sellers who have the right fundamental analysis and are focusing on poor long term prospects. The volatility often seems to be created by company managements telling a good story about short term trends, and sell-side research that looks too optimistic.

The UK retail sector shows the volatility. Despite a tough trading environment, shares in the sector have started the year very strongly. Dixons gained 50% in the month, with others close behind. There was strong performance from Home Retail Group, Kesa and Carpetright. It seems that the most challenged businesses have had the biggest re-rating. Some of this can be easily explained; results were not as bad as feared, and there were few failures. The retail chains that moved into administration were typically private, and analysts have been quick to suggest that surviving businesses will now face less competition. The sector is never short of encouraging words despite the pattern of recent years. Retail executives are again talking of “optimism” and “confidence”.

Undoubtedly, the combination of meeting or beating low expectations along with renewed analyst enthusiasm, is a toxic one for short sellers. But the price jumps in some cases seem to reflect more than that. Stock lenders were reported to be recalling stock, triggering a scramble to cover short positions amidst crowded trades and thin volumes. This seems to have been the catalyst for som of the most extreme moves. Carpetright shares have gained 60% in two months, even as it reported its worst first-half trading performance in its history as a listed company.

Yet, we can have little confidence that the new share prices are the right ones. Last year, for example, Dixons enjoyed a similar rally, but its overall share price trend has been down. Its shares have lost 90% in five years. Some of the most shorted retailers have shown a similar pattern; long term underperformance punctuated by sharp rallies. Over the past five years, shares of HMV have fallen from 200p to 6p, but have enjoyed seven rallies of 30% or more in that time. It seems we were gradually discovering the true value of HMV, but the short squeezes on the way have been departures from that.

Who loses if a share price is 30% too high? Certainly, private investors who may not have access to strategic research, and are swayed by executives’ outlook statements. And, passive investors automatically invest at market prices, relying on others’ analysis. Index funds are an increasing component of pension funds and other investors seeking low cost investment – a free ride on a belief in market efficiency. And, there is always a greater risk that troubled companies will raise more finance. Indeed, the recent credit tightening has triggered further share issues from a number of smaller companies as bank lending is cut. For investors putting up new money for problem companies, entry at the right price is key. Loss of market efficiency has serious consequences.

It seems that the worse the long term picture is for a sector, the more that executives and analysts focus on the short term. For the retail sector, the strategic outlook is challenged. This is not just in products that are facing technological challenge, such as CDs, DVDs and books. The internet is changing the basis of competition itself. A successful business making good use of the internet may now need no more than 60 stores to cover the country. This points to a lot of excess space on the high street. Many traditional retailers will need to shrink, and this could prove expensive even for those with good balance sheets. E-commerce relies much more on promotions. In contrast, traditional retailers need to make high profit margins to fund physical expansion –most chains hope growth will be driven by roll-outs. And, it is not just the high street that will be hit. Second-tier malls face more adjacent competition by discounters, and this could force rents down.

There is little sign of respite in the retail sector. Use of smart phones is accelerating, driving online pricing competition. For newer entrants, social media offer a relatively cheap way to build a client base. Many traditional retailers have tried to adapt their business model, with online offerings and services from the store. Few have made it work. Yet, a weak business model, combined with a sound balance sheet, can limp along for years. Along the way, investors will have many opportunities to scent recovery, but experience tells us turnarounds are rare.

Executives suffering a falling share price often blame the City. Short selling by hedge funds can be seen as the problem, rather than the messenger. Through the credit crisis, there were repeated calls to restrict stock lending. This merely briefly shored up prices, and so enabled re-financing at the wrong price. Regulators should learn from this and take more responsibility for minimising barriers to price formation. They need to take a broad view of potential market abuse, recognising the contributions of different types of investor.

A healthy stockmarket involves a range of views and analysis. Short sellers have strong incentives on accuracy, and arguably contribute a contrarian view when analysts are at their most consensual. Market imbalance, when short positions are squeezed out, can adversely impact everyone.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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