When reading about the importance of portfolio allocation the casual retail investor learns that the professionals frequently employ an investing strategy called Sector Rotation.  The idea is simple in concept – sell out of industrial sectors that are performing poorly and buy into sectors that are outperforming.

This strategy attempts to capture the ups and downs of business cycles by moving in and out of sectors as they react to macroeconomic conditions.  Right now you do not need the opinion of an investment guru to realize that the mining sector in Australia is hot and the retailing sector is not hot.

In fact, those of you who follow the Top Ten Shorted Shares feature on theBull know that 7 of the ten on the list are retail shares.  For the past several months, JBH (JB Hi-Fi) has been at or near the top of the list.

Just a few days ago Deloitte Access Economics partner David Rumbens predicted the already beaten down retail sector will go from bad to worse.

Much of our recent history would appear to support his view.  From natural disasters to falling housing prices to rising unemployment, it has been a tough year so far for the Australian consumer.  

Consumer sentiment is dropping and the rising value of the Australian dollar is sending Australians who are comfortable with their financial condition to capitalise on this increased purchasing power offshore.  

When share market participants stgelop the perception that a particular sector is going to be adversely affected by the economic climate, the selling is more often than not indiscriminate.  Not all retailers are equal and some have business models well-suited to survive whatever downturn is in progress.  Yet almost all retailers suffer equally when it comes to declining share price.

Hard core value investors flock to beaten down sectors in search of companies whose share price has collapsed while its fundamentals remain sound.  JBH may be one of those companies.

Here is a share price movement chart comparing JBH with the ASX for the past six months:

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Obviously, JBH has not performed as well as the underperforming ASX.  However, when JBH released its financial performance for Fiscal Year 2010 a few weeks ago, the fundamental numbers showed a different picture.

Here is the way the company’s earnings were summarised by one source:

•    Today, JBH reported a 7.6% drop in FY11 net profit to $109.7 million.  A final dividend of 77 cents was declared.

•    The result was impacted by a $24.7 million write-down of its Clive Anthony stores, with underlying earnings actually rising 13.3% to $134.4 million.

•    Sales increased 8.3% despite challenging trading conditions, which JBH expects to persist into FY12.

•    Despite the uncertain outlook, JBH was anticipating 16 new stores to be opened in FY12 and sales to be 8% higher than the FY11.

Note that the first bullet item chooses to ignore the meaning of a one-off restructuring charge, or write down.  Generally speaking, we all expect the most important point to be listed first.  Emphasizing the decline in profit reinforces the belief that JBH is suffering like all retailers.  However, the purpose of reporting normalised earnings – which eliminate one-off charges – is to present a more normal picture of profits from actual operations.  For JBH, profitability showed a 13.3% increase along with an 8.3% increase in revenue.

If market participants focus on the non-normalised numbers, that might help explain why JBH is one of the most shorted stocks on the ASX.  Perception does not always follow reality.

However, there are other reasons for concern with JBH that are not evidenced in the reporting listed above.  

First, JBH added 18 stores in FY 2010, which explains the revenue increase.  The increase in existing stores was less than 1%.  In short, even if JBH is successful in adding another 16 stores in FY 2011, sooner or later they will run out of room to expand.  Experienced retail investors know to be wary of companies showing solid growth stemming only from opening new stores.

Second, share markets often price in the worst case scenario, and the carnage amidst the rubble of the Australian retail sector would seem to indicate a belief that no one in Australia is buying or planning to buy anything.  The reality is that in hard times, consumers still buy, although they may buy less; and more importantly, they change their shopping habits.  Typically, they turn to discount retailers in increasing numbers.  The business model that allowed JBH to become Australia’s sixth largest retailer is based on low margins and high volume.  It remains to be seen how they can discount further and remain profitable.

Do these factors justify the incredible interest in shorting JBH?  Is there anything else going on with this company than might point to it being an attractive opportunity at current price levels?

There has been much written of late about the impact of the growth of online sales on Australian retailers.  Compared to the Internet retail presence in the United States, online sales here are still in an infant stage.  In December 2010 Citi Investment Research estimated online retailers made up approximately 5% of total retail sales in Australia, and less than half of that came from offshore websites.

In the United States, the early rise of e-commerce included dire predictions for traditional “brick and mortar” retailers.  What actually happened was the evolution of a new strategy – the “brick and click” approach where traditional retailers added online shopping opportunities.

JBH already has a small online purchasing capability on their websites and it is set to explode.  Traditionally their well-visited website has served to drive traffic into their stores.  In the coming months they will be rolling out new software that will allow more online purchases as well as the capability to purchase online and pick up the product in a local store.  What’s more, they are introducing a mobile phone application for even more flexibility.

One can only speculate as to why the market as whole remains so negative on JBH.  Thompson Reuters shows less negativity amongst analysts, with 7 Strong Buy recommendations, 6 Buy recommendations, and 6 Hold ratings.

As you know, the market does not always get it right.  As a final point to consider, let us take a look at a share that has gone against the downtrend in retail – Australian specialty retailer Kathmandu (KMD).  In case you didn’t know, KMD designs and sells clothing and equipment for the outdoor enthusiast.  Here is a six month price chart for KMD, compared to JBH and the ASX:

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KMD has only been listed on the ASX since 2009 and its market cap is only 314 million.  Has the company earned its outperformance in share price appreciation in comparison to JBH and the overall market?

Let’s look at how the same source we cited above reported the recent earnings release for KMD:

•    Today, KMD reported a 24.5% increase in sales for the FY11, defying what has generally been a gloomy year for retailers.

•    Kathmandu faced tough trading conditions, but was able to grow sales due to better inventory management, favourable weather patterns and healthy results from its new stores.

•    KMD has been one of the hot stocks in what has otherwise been a bearish day for the Australian share market.

Does KMD deserve this obvious bullishness in the way the source released the numbers?  Common sense would make one wonder how something as radically discretionary as apparel and equipment for the adventurer remains positive in the face of declining consumer sentiment.

In that regard, KMD shares a common advantage with JBH – a customer demographic less likely to be concerned about their financial condition.  Both cater to a younger clientele, less likely to be concerned about mortgage payments and falling home prices.

While KMD also has an expanding online “click” platform to add to their “brick” locations, here is one final factor to consider if you are thinking of KMD as an investment opportunity.

While the rising Australian dollar has hurt some retailers, it has in all probability helped KMD a great deal.  With more Australians taking advantage of foreign travel opportunities, they may very well be going to KMD to get outfitted.

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