When retailing goes bad In One Up on Wall Street famed investor Peter Lynch urges us to invest in the companies we know and, for most of us, retailers will fit the bill. The sector has a homespun appeal. To see what we're investing in and check on its progress, all we need do is drive to the local shopping centre, which is a lot easier for most of us than weighing up the quality of a bank's loan book or testing out the latest cancer drug. Best of all, unlike the CBAs or the CSLs of this world, the inner workings of a retailer are literally spread out on the pavement before us. We can see the product lines and store layout, and talk to the sales person to see how things are going. This last point is especially useful. Scuttlebutt, as analysts call it, is far easier to obtain in retailing than any other industry because sales assistants simply can't stop talking. The ubiquity of the retail chain also boosts our innate confidence in retailers. How can a business with a store in every major town be a bad investment? Assuming investors purchase their shares at sensible prices, for the big grocery chains like Woolworths and Coles, that's almost certainly true. Homo sapiens have been eating for a long time. It's a reasonable bet we'll continue to do so. But buying shiny pencil cases and plasma TVs? Well, that's a little harder to predict. That's why discretionary retailers like JB Hi-Fi, Harvey Norman and the big department stores are an altogether different proposition. In this sector, Lynch's advice takes a dangerous turn. Because when discretionary retailers go bad, they tend not to get better. I know this from bitter experience. Some of Intelligent Investor share advisor's greatest mistakes over the past 12 years have come from previously successful retailers on the verge of a turnaround that never came, including Brazin, owner of the Sanity music chain, Miller's Retail and, the latest example, Billabong. In getting in early in the rollout phase, as we did when recommending JB Hi-Fi at $3.43 in 2005, we made good money. But in each case, and for slightly different reasons, the models started to fail. The digitisation of the music industry killed Sanity's profitability; Miller's Retail was mismanaged in the face of growing competition; and Billabong screwed up its brand, expanded its retail footprint and took on too much debt at exactly the wrong time. At the heart of these failures rest a few key facts. The first is that discretionary retailing is an intensely difficult business operating on high fixed costs and thin margins. The widespread presence of their outlets and easy familiarity of their sales staff belie this fact. There is simply no room for error in discretionary retailing when casual staff can earn well above $25 per hour, and more than $50 per hour on public holidays. The sector is also driven by fads and fashions that are intensely difficult to pick. Take a look at Smiggle next time you're in the local Westfield as an example. Owned by Solomon Lew's Premier Investments, the self-described "world's hottest stationary brand" (if that isn't a clue then I don't know what is) sells pencil case stuffers and paper to kids and parents that like everything to be just so. Smiggle has hundreds of stores across Australia, 23 in New Zealand and 16 in Singapore. More Asian cities beckon. It may well take off across the region but I wouldn't want to bet on the chain's long-term durability. As a concept, Smiggle has "fad" written all over it. "Hot" brands tend to cool. Even so, you can make money from this kind of expansion by getting in at the early stage of the rollout, when there's enough evidence that the concept has been proven but enough expansion potential left on the table. The saps come in later, when new store openings are less profitable and management problems, brought on by maturity and the cannibalisation of stores, start to emerge. This is a problem more acute in Australia with its relatively small population. The rollout potential here is much less than it is in the US, Europe or Asia. Still these problems are typical of discretionary retailers the world over and existed well before Amazon and ASOS. But the arrival of online retailing makes already unsteady positions more volatile. Why would you wander around David Jones looking for someone to take your money when you can buy everything it sells, and more, at cheaper prices at home? For investors at least, the discretionary retailing sector has always been a place of big winners and even bigger losers. But too often the big winners turn into even bigger losers. In June 2007, Billabong was trading at more than $17 a share. Six years later it's changing hands for less than 20 cents. Even the famed Harvey Norman has fallen 65 per cent since its pre-GFC high of $7.15. As fund manager Wayne Jones of Ganes Capital says of discretionary retailers, "once they turn down, they tend not to turnaround." The internet makes that an even more likely outcome. So it's time to update Peter Lynch's advice. It is a good idea to invest in what you know, but none of us, including the people that actually run discretionary retailers, can really say what these businesses might look like in five years' time, or whether they'll be around at all. Unless you can get in before the big roll-out and pick the warning signs, as and when they emerge, this is a sector best avoided altogether. This article contains general investment advice only (under AFSL 282288). John Addis is a director at Intelligent Investor. BusinessDay readers can enjoy a free trial offer to Intelligent Investor Share Advisor, including access to 17 current "Buy" recommendations. For more Intelligent Investor articles click here.