Should investors buy into retail shares?

Jul 30 2008 by Andrew Miller, Barclays Wealth

THE European general retail sector has fallen by about 25% so far this year. But does this sharp decline in price make retail shares a good buy? We think that there are a variety of reasons to remain wary.

The first reason is a depressed outlook for consumer demand. With continued worries about inflation, the European Central Bank and the Bank of England are unlikely to cut interest rates any time soon, removing any chance of a related boost to spending. A muted outlook for wages growth will not help either.

Meanwhile, in the UK, grocers are continuing to take an increasing share of non-food discretionary spending – spending that is anyway shrinking because of rising fuel and food costs. Mortgage equity withdrawal, previously such a strong source of discretionary spending, has finally fallen back, hit by a slowing housing market. In Europe, the prognosis is increasingly very similar, with high interest rates and inflation and a consumer weakened by higher food and fuel costs.

The second reason relates to Chinese sourcing of goods. In recent years, clothing retailers have rapidly moved sourcing operations out to China, resulting to some extent in lower prices for consumers. (And, more obviously, boosting retailers’ margins for clothing). But with current inflationary trends in China, there is a chance that recent gains will be reversed, leaving the retailer with the decision of whether to pass higher costs straight back to the consumer, or suffer a hit to gross margins.

A third concern is excess space capacity. At the beginning of this year, new space was forecast to add 3.5% to UK retail sales growth. But, given that retail sales are now thought to be declining and expected to get worse, what does this imply for like-for-like sales values? Negative like-for-like sales growth implies rapid margin erosion.

At the same time, the market for the traditional high street retailer is being squeezed by the growth in online retailing and the grocers’ growing share of non-food spending.

So where does this leave retailers? “Hard goods” (ie non-food, non- clothing) retailers do look to have a fractionally improving price environment, or at least a less terrible one, and slightly less excess capacity.

Clothing, on the other hand, has so far suffered more, something which looks largely down to the absence of any strong “must have” trends and intense competition from the likes of Primark.

But the conclusion is that it is not yet time to be picking up what look like cheap stocks in the sector as there remains considerable forecast risk. There are, of course, some exceptions – we remain keen on Adidas, Burberry, Carphone Warehouse and Hennes & Mauritz. But, overall, caution is advised.

But with current inflationary trends in China, there is a chance that recent gains will be reversed