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11/06/2005
Retail Magic: Expendable Products, Reproducible Concepts, by Victor Niederhoffer

A major qualitative regulatory that I discovered in the course of my extensive experience in operating businesses is that the best and most profitable businesses sell expendable products like razor blades, ink cartridges, welding rods, drill bits and inks. It would be interesting to develop an investment screen that classifies companies according to the extent of repeat business that they gain relative to their initial sales.

A second regularity recently hit home as my significant others made inordinate profits many times my own with their holdings of Whole Foods. In their initial phases of expansion, retail businesses have the ability to replicate their success by copying the initial success, much like an epidemic is propagated or evolution proceeds. The information cost of replication is relatively low relative to other costs for building a business. In the case of a good retailing concept like Starbucks or Krispy Kreme or McDonalds, or a hundred others that my friend the master retail investor Larry Leeds holds, the stock benefits not only from expansion into regional areas and niches but also patrons of the stores who become investors, as is the case in my family.

Larry is always partial to New Age concepts like Chico's and the Guitar Center that are ready to go rapidly from ten stores to a thousand. In addition to his success with his hedge fund and his research firm, he carries one other distinction with me. He's the youngest-hearted person above 60 I've ever met, and it's likely he's playing tennis at least twice each weekend day.

Dan Grossman comments:

May I suggest an addition to Victor's analysis of successful retail chains: the advantage of low cost of capital. Initially hot, successful retailers go public at and continue to sell at high multiples. Opening additional retail stores is very capital intensive. I suspect that availability of capital at very low cost (i.e., from high multiple stock) gives a significant continuing advantage over competitors who must borrow or otherwise raise capital at normal prices.

Charles Kin comments:

Am I the only one quibbling with the definition of the cost of equity capital? The standard definition employed in the Capital Asset Pricing Model is a function only of beta, expected return, and the risk-free rate. Ought there to be a term to take into account the current share price that is not contingent on a change in expected return?

For instance, a company that announces a large secondary offering might see its shares decline by a particular percentage, but if that firm's beta does not change, and the expected return remains constant (for simplicity sake) then the CAPM-derived cost of equity isn't altered, despite the fact that the new shares will be issued at a lower price. This was the case for a large secondary offering of AT&T shares in August 2002, in which the stock fell by 30% or so between the announcement of the secondary and its closing, yet the hypothetical cost of capital remained little changed.

Ibbotson Associates is apparently coming to grips with the need to refine the cost of capital methodologies. The firm has published some calculations that take into account small-company outperformance tendencies and a time series multiple regression model that incorporates a firm's monthly excess share price returns over T-Bills.

Dave comments:

I recall when I first entered the semiconductor sales business in a territory where the competition was stronger than my own firm (though looking back I didn't know it), I would lose orders at the buyers' desk. For about six months I struggled with it; the buyers were in the grips of a strong personality, relationships that preceded my arrival. I solved the problem by moving the game; I went to engineering, where I spent my annual entertainment budget on the engineers who designed the products into their own products, and essentially left the buyers alone. Within a year, as all these new designs hit production, I was taking over the trade, because I knew well enough to use companies. The competition could only second-source. In the process, I made a lot of friends in engineering departments. Those friendships lasted and produced continuing success. The competition eventually folded. From strength to weakness, the path is always the same. Open the door less traveled, because in all organizations, jealousy and decision-making are channels divided. Seek the path of least resistance, no matter the odds. Power corrupts, and those who wield it frivolously are always vulnerable, despite their seeming security by way of current popularity.

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