Magic Formula Business Sector #6: Consumer Services
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This is a lot of industries to investigate! In the interest of time, we can group a number of these into a single "Retail" sub-sector. When we break it down like this, the table above looks like:
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I won't go into Hotels since this industry had just a single day in the Magic Formula screen. Let's take a closer look at each of these businesses.
This grouping consists of the Clothing Stores, Electronics Stores, Specialty Retail, Groceries, Online Retail, and Furniture Retail industries. Examples of Magic Formula stocks in this industry include Bed Bath and Beyond (BBBY), Best Buy (BBY), American Eagle (AEO), and FTD Group (FTD). For many investors, these stocks are attractive as they fall into the "buy what you know" advice so often tossed about. But it is important to realize that retail firms have very few built-in competitive moats. You or I can just as easily cross the street to Wal-Mart (WMT) to buy that new video game instead of buying it at Best Buy, for example. Think of all the once mighty retailers that have declined or are a shell of their former selves, such as Montgomery Ward, Woolworth's, and K-Mart (SHLD). Clearly we must tread carefully when investing in a retail firm.
The one method of building a narrow competitive moat in this business is through execution or being a low cost provider. At MagicDiligence, I look for retail firms that are clearly head and shoulders above their competition, because in difficult markets these companies take market share and position themselves to rebound strongly when conditions improve. In fact, I feel that a particular strength of the Magic Formula screen is turning up exceptional retail firms during down markets. Only a well run retailer can earn high return on capital due to the high expenditures necessary to build and maintain stores, and these companies only sell cheap during a downturn in consumer confidence.
The restaurant business is probably one of the least attractive industries for investment. As with retailers, customers can easily choose a different restaurant to patronize, or just not eat out if times are tight. The business requires a lot of capital investment to build new locations, and once a new location is established it is very difficult to increase sales at that location for any period of time. Like retail, the ultra-competitive restaurant business has consumed once well known chains such as Bob's Big Boy and Sizzler.
The two Magic Formula stocks from this group are Popeye's parent AFC Enterprises (AFCE) and tiny Nathan's Famous (NATH). AFC Enterprises is an unattractive company due to a heavy debt burden, while Nathan's Famous is a micro-cap stock that runs a few local chains in the northeast such as Kenny Rogers Roasters and Miami Subs, as well as the namesake hot dog shop. In general, I would recommend avoiding the restaurant segment - it's not a great business and sustainable returns on capital are quite elusive.
Personal services consists of companies that offer service based products to consumers. The 2 Personal Services stocks that appeared in the Magic Formula are Jackson-Hewitt Tax Service (JTX), and Ambassador's Group (EPAX), a provider of educational travel services.
This segment has the potential for offering some attractive investments. Most service based companies do not require a lot of capital investment to grow or maintain earnings. For example, Jackson-Hewitt is a franchise based business. It spends none of it's own capital to open new locations, it simply sells franchise rights to franchisees who then bear the burden of acquiring a lease and opening a new location, while the parent company collects royalties and marketing fees. Ambassador's Group simply organizes and plans travel - it requires only small offices and some computer equipment to run it's business. This minimal capital can then be leveraged to handle increasingly larger business brought in by advertising, growing revenues and profits with minimal costs for new assets. Both companies have very profitable and scalable business models.
However, Personal Services is less attractive than Business Services. Few personal service business have truly high switching costs, while companies are more reluctant to switch service providers, lest business be interrupted. Like most consumer oriented stocks, look for strong brands and unique services in this segment.
Consumer Services - Summary
Despite the conventional wisdom to "buy what you know", Consumer stocks are often difficult investments. Clearly, retail and restaurants have very low switching costs, high competition, significant capital requirements, and few ways to build a competitive moat. Personal services firms have better business models, but few consumer services are truly "sticky" businesses that people feel they cannot get rid of in a pinch. The best Magic Formula opportunities in Consumer Services stem from best in class retailers with weak competition that have been sold down due to recession or consumer confidence fears. Luckily, the Magic Formula screen is very efficient at digging these companies up and leaving out their competition.
Magic Formula Business Sector Countdown
#6 - Consumer Services
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