17 June 2016

The demise of former high street stalwart BHS is a timely reminder of the fragility of parts of the retail sector. It comes just days after Austin Reed also went into administration, and only shortly after a relatively tough Christmas trading period for many retailers. Is it RIP the high street?

This weakness has come in spite of a relatively robust picture for the UK consumer. The UK consumer has enjoyed a tremendous tailwind in recent years. Disposable incomes have risen as mortgage rates and utility bills have fallen; the lower oil price continues to support consumer spending, which has been on a steady, but inexorable rise for the past three years (1.). There is every reason to believe that this strength will continue as the new minimum wage is introduced and wage inflation holds steady at around 2.2% (2.).

But for retail businesses, this strength is not evenly spread. Certain parts of the market are highly competitive; others are in permanent decline, their lunch stolen by online retailing. This structural shift in the retail sector has created real pressure for some businesses. The high street stories have stores, rent, staff to support, while footfall drops. However, online is less profitable until a business is very large. As a result, margins for retailers have been under pressure despite a good backdrop for consumer spending.

Where does this leave us as fund managers? Do we avoid the sector altogether? No, sectors undergoing significant change can present significant opportunities and to avoid it might mean missing out on important growth and income options. However, we need to ensure we are on the right side of that change. This is an unforgiving environment and those businesses with weakness in their business models will be quickly exposed. In the case of BHS, excessive leverage and a burgeoning pension deficit were contributory to its problems.

We have around 10% of our portfolio dedicated to turnaround stories, but this is not the same as buying companies that are in real distress. Instead, in this category we put companies that may have become unfashionable – because their sector is out of favour, or they have had a series of one-off problems – and where we see evidence that management is undertaking enduring, effective self-help.

Equally, our focus on cash flow should eliminate those retailers with real problems. Our favoured type of stock, and those that form the bulk of our portfolio, are ‘cashflow compounders’ – companies that can grow and pay dividends even if interest rates rise.

For this, firms need pricing power. This is far harder to find in the retail sector, but it is possible. We look for companies that have a lot of free cashflow and a good track record of returning that cash to shareholders. It also requires a solid appreciation of value: There was a time when the supermarkets were valued extremely highly. The markets considered that their dependability in more difficult economic climates deserved a premium. We would naturally question this type of assumption, particularly as it became clear that new competitive pressures were emerging.

Perhaps most of all, investing in the retail sector requires adaptability. In navigating its complexities, we believe it is unhelpful to be wedded to a particular style or process. The consumer has had many tailwinds over the past few years and over time these are abating, PPI is ending, for example, deflation is softening and oil is stabilising. That said, the sector has performed very poorly over past six months (3.) and opportunities are beginning to present themselves across ‘domestic’ facing industries.

The high street is not dead, but it is changing. This is an environment that exposes weakness. BHS and Austin Reed are its most high profile casualties, but there will be others. The key is not to avoid it altogether, but to put the right tools in place to select the likely winners.

Reference to the names of each company mentioned in this communications is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies.

1. Office of National Statistics, March 2016
2. Office of National Statistics, February 2016
3. Morningstar, April 2016

This material is for distribution to Professional Clients (as defined by the FCA Rules) only and should not be relied upon by any other persons.
Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.
Past performance is not a guide to current or future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.
Fund specific risks: Investors in this Fund should understand that capital growth is not a priority and values may fluctuate and the level of income may vary from time to time and is not guaranteed. Where some or all of the fund's charges are taken from capital rather than income, this will increase yield but decrease the potential for capital growth. Smaller company investments are often associated with greater investment risk than those of larger company shares. Investment risk is concentrated in specific sectors, countries, currencies or companies. This means the Fund is more sensitive to any localised economic, market, political or regulatory events.
Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.
This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.
© 2016 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES, BUILD ON BLACKROCK, SO WHAT DO I DO WITH MY MONEY and the stylized i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.
CARS ref: UKRSM-0156

This weakness has come in spite of a relatively robust picture for the UK consumer.