The Illusion of Bargain Retail Stocks - and How to Trade Them Now

Everyone loves a sale, unless that sale is an investment you bought at half-off and then continued to plummet to zero.

That's already happened to a handful of once-promising retail stocks.

And they're just the tip of an iceberg.

Not only are more name-brand retailers melting down and preparing to declare bankruptcy, the Real Estate Investment Trusts (REITs) that own and operate the malls they're in are headed for the half-off sales bin.

But if you feel like a kid in a candy shop surrounded by these "bargains," you've been duped.

Some retailers will declare bankruptcy and be buried once and for all. Some will declare bankruptcy and rise from the ashes. And some will rise from the ashes just to declare bankruptcy again.

Here's the deal on retail stocks and REITs... and how to trade the dying, the living dead, and the comeback kids...

The Difference between Chapter 7 and Chapter 11

The first thing to understand is there are different bankruptcy filings companies generally employ.

Filing Chapter 7 is throwing in the towel.

It means the company ceases operations; however, in unusual circumstances a Chapter 7 trustee can continue some operations. But, more often than not, the trustee oversees the liquidation of the company's assets, and proceeds are used to pay off creditors.

In a Chapter 11 filing, the principal debtor (known as debtor in possession) or a trustee, is empowered to reorganize the company.

Under the protection of the bankruptcy court, the debtor in possession or trustee can refinance loans. This gives new lenders first priority on the business's earnings, the ability to reject and cancel contracts, and shelter the company from some types of litigation against the business through the imposition of an automatic stay. With an automatic stay, creditors are stayed from any collection attempts or activities against the debtor in possession.

Retailers filing Chapter 7 are going out of business, usually for good. If you see what you think is that familiar company again, it's usually because a buyer of their name and other assets of the dead company may start-up another company they want associated with a legacy brand.

Most retailers declare bankruptcy because they can't pay the interest or principal on the money they owe.

Reorganizing under Chapter 11 is an opportunity to change-up management, close stores, lay off employees, rework loans, slim down, and try to reflate the brand and sales.

But debt is more often the symptom, and not the cause of the retailer's troubles.

One huge problem retailers have in America is there are so many of them taking up so much retail space.

Not Worth the Ground They Sit On

In terms of square foot per capita, the United States has an estimated 48 square feet of retail space for each person in the country. That's twice as much as the UK, the next largest retail per capita country in the world.

The knock on retailers who own or lease real estate is that they're competing against ecommerce companies who aren't burdened with bricks-and-mortar overhead, store sales, or management personnel.

Then there's the decline of America's middle class, the sector of the population who made malls and strip centers across the country popular. Besides the cost of gas to get to shopping areas (opposed to the free shipping offers across Internet e-tailers), most millennials don't own cars and are increasingly moving to urban cities away from the suburbs, where malls were once a place to "hang out."

As if competitors like Amazon aren't enough to deal with, traditional retailers are also wrestling with "fast fashion" across the Internet, as well as bricks-and-mortar fast fashion chains like H&M.

Retail specialty shops aren't so special anymore. Department stores sell most of the brands shoppers can find online, often for less and sometimes without having to pay tax or shipping.

These trends are killing traditional shopping malls, whose anchor stores are usually big department stores.

Giant anchor stores usually pay about one third what mall shops pay in rent, as they drive the foot traffic specialty shops expect through malls and shopping centers, yet they are still losing a lot of money and closing their stores right and left.

Several household-name anchor department stores are closing big stores across the country. Macy's Inc. (NYSE:M) said it's closing more than 100 stores and J.C. Penney Co. Inc. (NYSE:JCP) is expected to as well. Sears Holdings Corp.'s (NASDAQ:SHLD) Sears and Kmart stores are folding up tents across America and have been for years now. Dillard's Inc. (NYSE:DDS) is probably on the verge of closing altogether.

The Real Estate Investment Trusts (REITs) that own and operate most of the malls and big shopping centers around the country are already feeling the pinch as they lose anchors and as brand-name specialty retailers go out of business or have to shut down unprofitable stores.

Mall REITs have slumped dramatically since August and show no signs of levelling off, in spite of their attractive dividend yields.

But, they may not be able to maintain those payouts if anchors keep closing and leased space goes the way of the dinosaurs.

Losses on retail-related loans in 2016 totaled $1.7 billion, up from a loss of $1.3 billion in 2015, according to Moody's.

While REITs with mostly Class A properties have fared poorly, their cousins with Class B &C properties in their portfolios have been hit harder and are headed towards a very slippery slope.

Spreads on BBB and below rated retail-related bonds are widening over Treasuries, and savvy investors are increasingly shorting CMBS (commercial mortgage-backed securities) by betting on CMBX, a credit default swap index that tracks commercial mortgage-backed securities.

Some big stores and mall owners are going to manage and may well thrive again, at least as they rebound from asset sales, closing stores, cutting overhead, and selling/monetizing valuable real estate like Macy's or Target may have to do. Some malls will try inserting new anchors like grocery stores or movie complexes. Some retailers and REITs will suffer, and inevitably have to reorganize under Chapter 11. And some will die and be buried in Chapter 7 graves.

We're already playing some of these retailers in my Short-Side Fortunes and Capital Wave Forecast trading services.

And we're going to play a lot more of them.

None of the old-school retailers are long-term holds... At least, we're not playing them that way.

The way to play most retail now is to short the ones with the most debt, the ones who have only a handful of quarters left before they can't meet their monthly interest and principal payments, and are facing slowing sales at the exact same time.

We've got a list of those and are watching the ticking clock on their debt service timing.

As far as investments going on sale, it's going to look like Black Friday meets Cyber Monday in Hell starting next quarter and continuing well into 2018.

So, don't be too quick to reach into that bargain bin, even if what's in there sports a nice fat dividend.

Lots of those goodies have razor blades in them.



The post The Illusion of Bargain Retail Stocks - and How to Trade Them Now appeared first on Wall Street Insights & Indictments.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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