Stock Market Tips for Retail Investors

By Markets Fool.com

Investing in the retail industry can be quite challenging. Competition in the business is remarkably aggressive, so investors need to make sure they're positioned in the right companies to succeed. On the other hand, the retail industry can offer extraordinary opportunities for gains when picking the best performers in the business. Let's go over a couple of important aspects to consider when investing in retail.

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Looking for competitive strengths
Competitive advantages are of the utmost importance when investing for the long term, be it in retail or in any other sector. Competitive advantages are the factors that protect the company's sales and earnings from the competition, allowing it to succeed and grow over time. In the retail business, there are two crucial sources of competitive strengths to consider: scale and brand differentiation.

Scale is particularly relevant in discount retail. Companies operating with a bigger scale have more negotiating power with suppliers, allowing them to obtain lower prices for their products and more convenient payment conditions. Besides, selling more products means the company can spread its fixed costs over a bigger amount of units, which decreases fixed costs per unit. Cost advantages are a key success factor for discount retailers, since consumers expect competitively low prices from these companies.

Strong discount retailers
With annual revenues in the neighborhood of $490 billion, Wal-Mart is the biggest retailer on the planet. This position has some disadvantages when it comes to growth, since it's not easy to continue growing rapidly when you're a market leader in a mature industry. However, massive scale and geographical presence around the world provide stability and predictability for investors in Wal-Mart stock. Currently offering a 2.5% dividend yield, according to S&P Capital IQ, the company has a rock-solid trajectory of dividend growth. Wal-Mart has raised dividends over the past 42 consecutive years -- a great reflection of its ability to produce growing cash flows through good and bad economic times.

Source: Wal-Mart.

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Another discount retailer that benefits from massive scale is TJX , themarket leader in off-price home and apparel fashions and theparent company of T.J. Maxx, Marshalls, Winners, and HomeGoods.The company sources for products from over 17,000 vendors in more than 100 countries, and it sells its products at a pricing discount of between 20% and 60% versus typical retail prices. Management has translated TJX's scale advantages into impressive financial performance for investors in TJX; comparable-store sales have increased annually for the past 18 years, and earnings per share have grown in the double digits over the past six years.

On the other end of the pricing spectrum, high-quality players such as Nordstrom are building brand differentiation on the back of superior customer service and top merchandising strengths, which is great for both consumers and investors. Based on data from the American Customer Satisfaction Survey, Nordstrom has been ranked as the industry leader among department stores for customer satisfaction every year since 1995. Nordstrom has been America's favorite fashion retailer in the Market Force Information survey over the past three consecutive quarters.

Nordstrom is well-known for its special focus on customer service and product differentiation, and this powerful strategy has helped the company consolidate customer loyalty over time. According to the latest financial report from the company, Nordstrom has 4.4 million active Nordstrom Rewards accounts, and sales from members represented 38% of total revenues during the last quarter.

Retail redefined
Beyond brick-and-mortar stores, the Internet and related technologies are dramatically changing the way we make purchase decisions. E-commerce represents an increasingly growing share of the retail industry, and the e-commerce trend will likely continue gaining strength over time. For this reason, successful retailers are those with a big and growing online presence.

US E-Commerce Sales as Percent of Retail Sales Chart

US E-Commerce Sales as Percent of Retail Sales data by YCharts

Amazon.com is the undisputed king of online retail. The company has a relentless competitive drive, and it's willing to sell its products at razor-thin profit margins to gain market share versus the competition.

Back in 1995, Amazon was just an online bookstore, producing only $511,000 in total sales. Now the company has become the most disruptive force in the retail business over the past two decades, having generated almost $89 billion in total revenues during 2014. In addition, currency-neutral sales grew 22% in the past quarter, which is nothing short of breathtaking for a company of Amazon's size.

Source: Amazon.com.

In the process, Amazon has inflicted a lot of damage to bricks-and mortar retailers that didn't adapt rapidly enough to the e-commerce revolution, so investors should consider this factor when making investment decisions in the retail business.

Williams-Sonoma is doing an amazing job in this area. The company produced nearly 50% of sales from the online channel during the quarter ended on Feb. 1. This performance speaks wonders about management's vision and ability to adapt to changing industry conditions. What's more, the online segment typically generates higher profit margins versus traditional sales because of cost efficiencies.

What you need to know
When investing in retail, the importance of competitive strengths cannot be exaggerated, so investors may want to look for businesses with scale advantages and brand differentiation. And beyond those two key elements, don't forget to consider if these businesses can continue their success in light of the actively-expanding online retail arena.

The article Stock Market Tips for Retail Investors originally appeared on Fool.com.

Andrs Cardenal owns shares of Amazon.com and Apple. The Motley Fool recommends Amazon.com, Apple, Nordstrom, and Williams-Sonoma. The Motley Fool owns shares of Amazon.com and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.