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Consumer gloom and Amazon’s threat to Australian retailing headline a long list of reasons to avoid retail stocks. But sector-wide fears inevitably create opportunity for contrarians who spot quality companies unfairly caught in the selling carnage. 
Do not read that as a call to buy retail stocks aggressively. Many have fallen more than 40 per cent in the past 12 months, yet still look more like value traps than good value. Too often, investors have been burned by supposed “bargain hunting” in retail.
Investing in retail is always about bottom-up stock picking rather than top-down sector trends. Commentators focus on retail sales growth and consumer sentiment, two key factors that are huge tailwinds or headwinds for the sector, depending on their direction. Quality retailers can still make good money in tough markets as they take market share.
Others do well in niches. I have identified cosmetics provider BWX and MotorCycle Holdings – two retailers going gangbusters – for The Bull this year. Online retailer Kogan.com, covered favourably in this column in August 2017, is another that has starred.
Many more retail stocks have struggled. The sector faces a “perfect storm” of cyclical challenges from consumers battling high household debt, record-low wages growth and rising utilities bills. And structural challenges from an influx of foreign competitors and growth in online retailing, not to mention Amazon, a competitor the likes of which Australia has never seen.
My time in media companies highlighted the immense challenge when companies face cyclical and structural threats simultaneously. It’s hard to respond quickly enough to combat structural threats when the core business is suffering from a cyclical slowdown.
In spite of this gloom, I keep seeing progress from a handful of retailers. The negativity far overshadows these glimmers of good news, but it also creates opportunity when the market does not pay enough attention to company news and focuses on sector trends.
Consider Nick Scali, a long-term small-cap favourite of mine. The furniture retailer fell from a 52-week high of $7.60 to as low as $5.36, before recovering to $7.14. The market reacted harshly to the company’s guidance for flat earnings growth in FY18 at its latest result.
The market wanted faster growth to justify Nick Scali’s rising valuation. I’m sure some retailers would kill for “flat earnings growth” in such a challenged retail market. My hunch is Nick Scali took an overly conservative view given retail headwinds, but it’s too soon to know.
I favour Nick Scali for six reasons. First, the furniture category is less affected by online competition. Unlike other retailers, Nick Scali will not become roadkill for Amazon as the e-commerce giant’s Australian operations grow. Upmarket furniture is less of an online purchase, partly because of its size and consumers wanting to choose and test products in-store. 
Second, Nick Scali has an excellent inventory/cash-flow model. Those who’ve bought its lounges know you pay for them upfront and wait a few months for them to be built to order and delivered. Compare that to a department store or electronic retailer stocked full of depreciating inventory and at risk of products remaining unsold or heavily discounted.
Third, Nick Scali is selling more “case goods” – dining and coffee tables, for example, which complement its lounge settings. Many investors think of it only as a lounge retailer, even though a third of its revenue comes from case goods and is rising. This evolving product mix reduces the company’s risk and creates cross-selling opportunities. There has not been enough focus by commentators on Nick Scali’s expanding product success.
Fourth, Nick Scali owns properties that house some of its key stores rather than relying on leases. That makes it less affected by potentially higher rents in shopping centres than some retailers. I wrote for The Bull recently that the big shopping-centre owners were an interesting way to play the retail sector given they were maintaining lease rates and had low vacancy rates. That’s good for listed retail trusts; not so good for retailers forced to pay higher rents.
Fifth, Nick Scali’s customer demographic is established home owners rather than first-home buyers – the market under most pressure as high household debts lead to rising mortgage stress and less discretionary income to buy things. Nick Scali’s upmarket furniture appeals to those who already own a home and have probably benefited from rising property prices.
The sixth reason is valuation. Nick Scali is undervalued, trading on a forecast P/E multiple of just over 14 times and yielding over 5 per cent (based on consensus analyst forecasts). That’s not excessive for a well-run company with a good return on equity and potential to lift growth by rolling out more stores and selling a wider product range. 
Nick Scali’s rally from about $6 in early October to $7.13 has brought it closer to fair value. A handful of analysts who cover the stock have a median target of $7.08, suggesting Nick Scali is a hold rather than buy. Gains will be slower from here, but Nick Scali has more potential for positive surprises than most small-cap retailers given its market position, business model and management.
Chart 1: Nick ScaliSource: The Bull

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• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. He does not own Fairfax shares and has no financial interest in Domain. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at Nov 8, 2017.