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Seismic change and investing in barbells

Change can be an investor’s worst nightmare. Fast-changing industries are often accompanied by equally dynamic competitive landscapes making the prospects for each player almost impossible to predict. Even more challenging, 70% of the gain in the S&P500 and 85% in the MSCI World index between 2012 and 2016 was due to P/E expansion. Investing requires navigating industries where an asymmetric barbell forms with a handful of massive winners at one end and virtually everyone else losing at the other.

Australian retail downgrades: permanent or temporary?

Investors in the Australian retail sector are perhaps the first to experience the effects of this 'barbelling' of outcomes locally and many are yet to fall into value traps. Some analysts believe that which is in fact permanent and structural is merely cyclical or temporary.

The arrival of Amazon has put the fox in the henhouse. In a recent note to its clients, Citigroup wrote:

“Amazon has confirmed their plans to enter the Australian market. Analysis of US, UK and German retailer performance around Amazon Prime market entry and our survey of price differentials results in downgrades to our long term earnings forecasts for JB H-Fi by more than 40% and Harvey Norman by more than 30%, following the expected launch of Amazon Prime in FY19e. We downgrade JB Hi-Fi to Sell and cut our target price by 35%. We maintain our Sell rating on Harvey Norman and cut our target price by 33%.” (My emphasis).

Another broker has performed a similar amputation to valuations for some of Australia’s retailers:

“We expect that Harvey Norman is approaching peak-cycle sales and earnings growth as the tailwinds from a prolonged housing cycle begin to moderate. The company also faces substantial competitive headwinds as Amazon prepares to launch in the Australian market …”


“Whilst near-term earnings are likely to surprise on the upside, we think that structural and competitive changes in the Australian electronics industry, particularly from Amazon, will put pressure on long-term earnings. Whilst we expect JB Hi-Fi could extract greater synergies from its purchase of The Good Guys, it is likely that EBIT margins will remain under pressure.”

In the United States where fully 52% of households have an Amazon Prime account – that’s more than the number of households that own a gun or have a landline – the retail landscape may have irretrievably altered.

Foot traffic to shopping malls there has fallen by more than 50% in the last six years, reversing the experience between 1970 and 2015, when the number of malls grew at double the rate of the population.

Not only retailing but major brands

Amazon is not only putting a knife into the traditional model of retailing, it is starting a war with brands themselves.

It is now argued that brands earn an undeserved premium in return for offering consumers a short cut to the due diligence that would be required to identify varying levels of quality. The supporters argue that Amazon, through the use of technology and millions of consumer reviews, will serve customers better by removing the brand premium that is just compensation for advertising, in store promotions and shelf space deals with retailers, none of which adds value to the consumer.

Investors who have seen global brands as some of the most powerful economic franchises are on notice.

It may also surprise that the fixed-price tags found on goods in stores today is historically a relatively recent phenomenon, created to remove the need for owners of the once-new department stores to train staff in the art of haggling. Amazon has dynamic pricing. Prices change by the minute and depend on your geographic location as well as your previous search behaviour. Check where Amazon product prices are tracked by the minute producing patterns like intraday stock charts. It is doing away with fixed price tags and permanently and simultaneously changing the price discovery power of consumers.

Through Amazon’s virtual personal assistant Alexa, Amazon offers cheaper prices, incentivising consumers onto the echo smart speaker and removing the important visual aids brands use to differentiate themselves. Unsurprisingly, Amazon offers up those products that it makes the best margin on and takes some brands completely off its shelves. It’s a strategy that suppliers to Coles and Woolies know only too well.

Retail collapses commonplace

For landlords of retail property and landlords of retail brands, the outlook has changed seismically. Witness for example the litany of recent retail collapses overseas this year, with dozens of major companies, thousands of stores and massive numbers of employees affected. Large retailers in the US have filed for Chapter 11 bankruptcy and Sears is expected to do so after July 17, to avoid the US bankruptcy code’s two-year look-back period.

Fashion retailer Bebe Stores closed all 180 of its stores and may file for bankruptcy to get out of the store leases, selling only online, while 44-store luxury fashion chain Neiman Marcus/Bergdorf Goodman, owned by Ares Management and the Canada Pension Plan Investment Board, announced it will not pay interest on a $600 million 8.75% bond issue in cash, but ‘in kind’.

The excess supply of retail space must kill growth in capital and rental yields for a long time and the shift from brands to homogeneity will decimate the margins for manufacturing, and down the track, innovation through research and development.

In Australia, struggling retailers including David Lawrence, Marcs, Payless Shoes, Pumpkin Patch and Herringbone were recently joined by Top Shop. The barbell emerges as retailers cop it on the chin, not only from Amazon’s arrival but from the projected 23% decline in attached dwelling starts, including the 38% decline in attached dwelling starts in NSW alone.

Construction and retail industries are the two largest employers in Australia and that makes navigating the next cycle even more challenging.

Ask whether lofty valuations are justified

The key is to come back to valuations and ask if current market prices are offering future returns that are unappetising? Remembering the higher the price you pay, the lower your return, one must wonder at the lofty valuations at which most assets are traded at today, especially those that produce no income.

Witness for example the Basqiat painting that sold for US$110.5 million, a record for an American artist and a record for a painting created after 1980. Closer to home, Shannons auctioned the NSW number plate ‘29’ with expectations of $450,000-$550,000. It sold for $745,000.

In equities, companies in the firing line need to be avoided for the time being, as well as the unicorns that earn no profit. Dangers in here at both ends of the barbell. While some commentators call “Loss the New black” and cite the market capitalisations of Uber, Snapchat, Wework and Amazon as evidence of a new world order, investors must remember the tech bust that followed talk of a previous ‘new paradigm’.

For Australian investors, changes will be cyclical for some but structural and permanent for many more. The expected decline in the construction and retailing sectors will also produce opportunities. A likely fall in the Australian dollar will boost profits for companies that export such as CSL and Cochlear as well as those providing services to foreign customers locally such as IDP Education.

But most importantly investors need to be cautious and consider the incorporation of the asymmetric barbell metaphor into their framework.


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

June 05, 2017

I hope most Australians support Australian online business. Kogan, JB, Myer etc should all be used for some purchases to keep them alive.

Amazon is here to destroy others and this only leads to less competition.

A consumers short term gain will only lead to long term pain.

June 03, 2017

Do we not always try to over analyse everything and look for statements and articles etc that agree with what we want to see.

Why is it always doom and gloom?Reality just grinds on and pays no attention to opinions,or what occurs in some far off country.

Westfield has been a brilliant share,doesn't mean it will do that in the future.Thankfully I've owned them for around 20 yrs now.Probably for the past decade nothing much has occurred ,or it occurred very slowly so I have not noticed the change.Still made a good profit from them,a bit more divi would be handy but can't win them all.

No doubt the advice from an expert would be get out of them,sell and give the money to the expert,he/she knows what he/she is doing,for a small fee of course.

So I sell say $300k worth ,pay the CGT,say it leaves me with $240k.I give that to the expert in the hope that they will turn back into $300k over time,for a fee of course.seems crazy to me.They have no more ability to predict the future than I have,my ability is a big fat zero.

If the opinions and predictions turn out to be right then it means I was the meantime I'll just carry on regardless.

I think the much missed (by me) Frank Zappa was a trained economist.I think he had papers published.I wonder how much of it was tongue firmly in cheek.I think he would be having a field day if he was alive with great music and the lyrical humour.

C'est la vie.

Graham Hand
June 02, 2017

Interesting alternative opinion put out in a Media Release from funds management firm, Martin Currie.

Amazon to boost Australian retail sector: Martin Currie

Martin Currie Australia, an active equity affiliate of Legg Mason, today noted that contrary to some analyst reports, the entry of online retailer Amazon in Australia could boost the domestic retail sector instead of a ‘doomsday scenario’ for the sector.

Reece Birtles, chief investment officer, Martin Currie Australia says that “It’s clear that some hedge funds have been shorting discretionary retailers such as JB Hi-Fi (JBH) and Harvey Norman (HVN) since the market became aware of Amazon’s Australia strategy to open distribution centers later this year.”

“They have based their analysis looking at the demise of bricks and mortar retailers in the US, a very mature market, due to the ‘Amazon effect’.

“However, before we jump to any such conclusions in Australia, it’s worth looking at a comparable company to JBH, which is Best Buy USA,” he says.

Best Buy reported earnings which excluding abnormal items were up 40% pcp for the first quarter 2017. The share price rose 22%.

Birtles says “We believe that given JBH and HVN are very dominant and profitable retailers with leverage to population growth and housing, similar to Best Buy USA, they will be well placed when Amazon begins to operate in Australia.

“Wesfarmers (WES) and Woolworths (WOW) are also well prepared for the entry of Amazon with on-line home delivery already a significant part of their customer focus and innovation.”

The other key point is that WOW, Coles (owned by WES) and JBH are located in large shopping centers around Australia.

“And there are considerable differences between the US and Australian retail sector that need to be taken into account when considering the likely impact of Amazon’s entry into the local market.

Birtles points out that Australian retail centers are better placed then their US counterparts.

“In the US, supermarkets are not co-located with discretionary shops, so they are separate trips which affects foot traffic. Retail space per capita is multiple times greater in the US than in Australia.

“Australian online retail continues to grow towards market share levels seen in the US, so we may see a shift of market share within those online sales to Amazon.

“Overall, we think the physical mall winners will be those that can fulfil the role of the town square and offer an experience to the consumer. Australian shopping malls already have a variety of restaurants, movie theatres, free car parking and entertainment,” he says.

“We also think that real estate investment trusts with logistics assets will benefit from Amazon’s entry and moves by other retailers to beef up their online presence,” says Birtles.


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