Exaggeration through extrapolation

June 9, 2022

A person checking stock market data on a mobile device.

“Intuition is linear; our imaginations are weak. Even the brightest of us only extrapolate from what we know now; for the most part, we’re afraid to really stretch.” – Ray Kurzweil

When it comes to investing, similar to technology, vision and imagination play a big role in achieving outsized outcomes. Ray Kurzweil was referring to the human imagination – or the lack of it – when we extrapolate linearly into a future with infinite possibilities. While human beings sometimes have difficulty grasping exponential change, there are also instances where we blindly extrapolate and exaggerate a recent trend indefinitely into the future. It’s easy to forget sometimes that the more things change, the more they stay the same.

It wasn’t that long ago that we were confined to the four walls of our homes, completely reliant on the internet economy to feed, clothe and entertain us. Much was made of the internet adoption of the future being fast forwarded back into the present. We were quick to pronounce the end of the brick and mortar economy. Turns out we were a bit too premature with this conclusion.

To understand why, we need to take a look at why the digital takeover did not quite live up to its promise. First, the pandemic led to large scale disruptions to a supply chain that is finely tuned to the needs of just-in-time inventory. It is no longer cheap to get your product from its factory in China to a warehouse/store near you. The cost to ship a container from China sky rocketed from a few thousand dollars pre pandemic to close to $15,000 today.

Second, the soaring cost of digital ads means the barriers to entry for a digital only brand/venture to succeed is much higher now. Many brands in the early 2010s were built on the back of cheap digital advertising. The cost of acquiring customers now is much higher and digital ads don’t quite make the impact they used to with their poor targeting and lower click through rates.

For example, the cost to advertise on Facebook has tripled in the last two years. At the same time, Apple’s latest privacy update has forced apps to comply with the Ad Tracking Transparency (ATT) framework, which requires advertisers to seek permission to track user activity. This makes it harder to track ad performance, leading companies to spend more for sub optimal results.

What this means is that a lot of digital-only brands and startups looking for new tricks to achieve growth have settled for an old trick – brick and mortar stores. It helps that the pandemic has led to plenty of empty store fronts to choose from. Landlords are now open to shorter leases and better terms, allowing digital native brands to experiment with a brick and mortar presence.

A classic example of a digital native brand thriving in this new world is Warby Parker. While Warby Parker is not new to physical stores, their big bet on brick and mortar is an admission of the fact that the adoption of online purchase of glasses has not fully lived up to expectations. Currently, their brick and mortar stores are more profitable than their website and the company expects most of the growth in 2022 to be driven by retail stores.

This trend has borne out in the larger economy. In 2021, U.S. brick and mortar sales overtook e-commerce for the first time ever. It remains to be seen if this is a sustainable trend, but clearly, brick and mortar is far from dead. At Global Alpha, we are cognizant of the fact that trends tend to get exaggerated to the extremes. The goal is to be mindful of these extreme swings and to look for mispriced opportunities when they arise.

Clicks Group (CLICKS SJ)

One of the brick and mortar champions within the emerging market universe is the Clicks Group based in South Africa. Clicks operates the largest retail pharmacy chain in South Africa, along with a health and beauty retail business. It also operates a wholesale distribution business and runs the Body Shop and GNC franchises in South Africa.

In a difficult environment marked by Covid and social unrest, Clicks continues to invest in its brick and mortar operations by opening close to 40+ stores every year. In spite of pandemic-led restrictions, its 800 stores have driven both top and bottom line growth.

Clicks interestingly uses the online channel as a more defensive strategy, letting them add and experiment with new categories and private label products. Our conversation with management informed us that South Africans prefer to go to shopping centres where most of the Clicks stores are located rather than shop online. They also value the privacy of shopping in a pharmacy rather than having items delivered home. Clicks illustrates how traditional retail and e-commerce can complement each other to drive sustainable growth. Irrespective of headlines, we continue to keep our ears to the ground to find great businesses.

Global Alpha Capital Management Ltd.
June 9th, 2022