The categories have been killed
Staples founder Tom Stemberg argues that the key to investing in retail is finding companies that serve a lifestyle niche, not looking for the next Wal-Mart.
By Jon Birger, Fortune senior writer

(Fortune Magazine) -- The retail sector boasts more than its share of stocks that have been mammoth hits: Wal-Mart, Best Buy, Walgreen, not to mention Christopher & Banks and Chico's - a duo that both rank among the five top-performing stocks of the past ten years.

But investors on the lookout for retailing's next category-killing stock may be wasting their time. Or so says Staples founder Tom Stemberg, who established the office superstore company in 1973 and stepped down as CEO in 2002. Stemberg subsequently founded two other retailers: Kabloom, a flower chain with 100 outlets, and Zoots, which has 50 dry-cleaning stores.

Now a principal in Highland Capital Partners, a venture capital firm based in Lexington, Mass., Stemberg recently spoke to Fortune about his outlook for retailers and his view that opportunities are more likely to be found in companies with a narrower focus.

What's your best advice for anyone thinking about putting money into retail stocks these days?

My first advice is to be highly selective. I believe that in general things are going to be challenging for the consumer. In the aggregate, retail sales growth will be modest. The idea that the combination of higher energy prices and higher interest costs is not going to affect our consumer-spending power I think is naive.

Does that mean sticking with category leaders?

What is truly perverse now is that whereas normally the great companies have sold at significant multiple premiums to the laggards, exactly the opposite is true right now among publicly traded retailers. For example, you'll find that Circuit City (Charts) - which is so far behind in second place that they can barely see Best Buy with binoculars - is trading at a higher multiple than Best Buy (Charts).

But Circuit City's earnings have been growing faster.

Only because when your base is near zero, it's not hard to have higher percentage growth. Their profit on sales is only about a third of Best Buy's, and their sales growth is slower. Here's another example: Office Depot (Charts) and Office Max are selling at materially higher multiples than Staples. (Charts)

Right down the list, the assumption by investors seems to be that the lesser company earning, say, 3% on sales vs. 8% for the leader will surely get to 6%, and therefore it deserves a higher multiple. I've got news for those investors: It doesn't work that way. Historically, the strong get stronger and the weak get weaker.

Let me play devil's advocate. Probably the two most high-profile No. 2's in all of retailing - Lowe's (Charts) and Target (Charts) - are doing considerably better than their respective No. 1's. Don't they have more room to grow?

I didn't mention those two, did I? In those cases, frankly, I think you'd have to call both Home Depot and Lowe's leaders, just as you'd have to call Target and Wal-Mart (Charts) both leaders. They're all great, great companies.

I read that you have doubts about Wal-Mart living up to the market's lofty expectations for international growth.

Wal-Mart is, without question, the best retailer in the world. Ever. Having said that, their process for running things - having the system's infrastructure highly centralized in Bentonville and many vendor relationships centralized around Bentonville - makes it very hard for them to succeed in difficult operating environments like Germany, like Japan, like South America. [Since the interview, Wal-Mart has announced it is selling its German stores.]

If much of their growth is to come from those markets and those markets aren't doing nearly as well as the States did at a similar point in time, it ain't good.

I think the problem is cultural. They're very American-oriented. They're a highly centralized organization that's now operating in highly decentralized competitive environments.

When you look at the retail landscape these days, do you see any future Staples or Best Buys out there?

I come out of the category-killer category. My first two killings were Staples and PetsMart. [Stemberg was an early PetsMart investor and serves on the company's board.] And with that backdrop, I now recognize 20-odd years later that the future opportunities are probably not in category killers because all the categories have already been killed. You can't think of many retail categories where there isn't a dominant, complete-selection, good-prices operator.

The real opportunity, I believe, is in serving demographic or lifestyle niches, preferably those that are growing rapidly.

Along those lines, I know Highland Capital has made venture capital investments in yoga-wear chain Lululemon Athletica. Do you worry about investing in apparel stores, whose fortunes seem so tied to the whims of fashion? After all, it wasn't that long ago when Hot Topic was Wall Street's stock du jour.

In Lululemon's case, its appeal is as much function as fashion. Lots of people have jackets where you put your iPod, for example. But how many have a jacket with not only a pocket but a channel for the wire so the wire doesn't dangle or touch your skin?

Are there any public companies that fit your niche-retailing strategy?

One that I like is Zumiez (Charts), which focuses on surf wear [and skateboards]. It's as much about the surf lifestyle as surfing itself.

Don't touch that dial.

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