Reflecting on mistakes

update on Aritzia post rally to $45

I want to give some thoughts on Aritzia since I wrote it up last September on my previous website. If you are not familiar with the Aritzia story, I would recommend reading me and my partner’s full rundown of the business here.

Here's a brief summary of the report (numbers valid as of early October if not otherwise mentioned). Feel free to skip:

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“Aritzia is a high-quality fashion brand with a long growth runway. Due to a nearly 50% decline in share price YTD, amidst concerns about margin pressure and inflation, Aritzia now trades at a steep discount to peers, considering the fact that Aritzia hasn’t stepped outside half the States in the US. This is an interesting opportunity to own Gen-Z’s most admired clothing brand with a growth runway that could bring excellent returns in the long term.

Note: figure sourced from latest quarterly presentation

Aritzia occupies a unique niche in the fashion space, which they describe as "Everyday Luxury”, generally in between mid-market and sub-luxury. They offer high-quality apparel in North America. Their product range includes t-shirts, tops, bodysuits, sweaters, jumpsuits, skirts, activewear, pants, dresses, jackets, shoes, and accessories like hats, socks, face masks, belts, and bags. Aritzia's in-house brands generate 95% of their revenue. Prices typically range from $50 to $400 per item. Aritzia’s brand can be described as aspirational and classy, with quite a unique style. Their fabric is stretchy and comfortable, and pieces have very unnoticeable logos and are mostly in neutral colour schemes. The designs are typically classy and subtle. The brand is built on quality basics, timeless items that can last them years.

Jennifer Wong took the reins of CEO May of last year. Hill is now Executive Chairman. Like most leaders in the firm, she came from within the company, starting out as a style advisor from almost the very beginning in 1987, slowly working her way up to COO, which she held since 2007 until she was selected as CEO 15 years later. While she came from a sales background, she knows the company inside and out and has proven to be an excellent operator. She has been credited with pushing into e-commerce and leading the development of Aritzia’s distribution chain. People greatly admire Wong, for her story of climbing her way to the top and being one of the few female public company CEOs in North America. Nevertheless, it seems that it is still very much Hill’s company, and his culture and way of doing things have not been changed.

Former employees describe Hill as conservative when it comes to capital allocation, preferring profitability over growth. For instance, he will not expand to a region if he is not sure that stores there will succeed. As a result of cautious expansion and focus on profitability, Aritzia has consistently grown its sales productivity, more than peers.”

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Since writing up Aritzia, Aritzia's stock has gone up nearly 90%+ to $45/share, from its sub-25 lows. I was happy with the performance of the business as the market started to recognize the long-term growth runway in the US looking past short-term inflationary and operational uncertainty. 

However, as I look back, I realize I have made a couple of serious mistakes — and I want to share them with you today.

In this post, I will be going into these mistakes as I tracked Aritzia and how you can avoid them too.

Mistake #1: Not paying enough attention to competitors. 

While doing research on Aritzia, we interviewed around 50 customers in downtown Toronto locations to learn more about the brand value and customer behavior. 

We asked about how much Aritzia items they bought every year, what % of their basket was Aritzia, how they were introduced to Aritzia, why they like Aritzia, what they think of the quality, everything! 

(Side note: I was actually banned from the Bloor Street Aritzia shop for doing this. Then the manager, this woman walked up to me, told me she took our photos, and was going to call the cops next time I arrived. I laughed, then walked over to the Eaton Center branch and continued my interviews.)

Anyway, one of the key questions we asked was "do you shop at any brands similar to Aritzia's style and what do you think of their pieces?" The reason we asked this was because Aritzia has a unique market position: most of the SKUs were casual and professional basics with high quality. While there were similar brands, none had the same kind of mindshare for the "slay" look Aritzia had. 

When we asked the question, we would get a lot of "Oak and Fort" and "Club Monaco" but they were really smart portions of their basket and didn't click with them as much as Aritzia. But what we also found common was they would recommend Abercrombie. They said Abercrombie was similar to Aritzia and sometimes were cheaper for a similar level of quality. In fact, Abercrombie on average was 10% of their basket in comparison to Aritzia's 50%.

Abercrombie? I thought. You mean the old 2000s brand that died because of overexpansion and the business having every -ist and -phobe clamped to their name? That Abercrombie? After looking at Abercrombie, I was dead wrong. Abercrombie was turning around. Since the new CEO Fran Horowitz took the helm in 2017, Abercrombie has been shifting away from printed, fast fashion pieces to something more similar to Aritzia. After closing a bunch of stores, Abercrombie was able to cut down unprofitable branches and focus on its best locations, brining operating margins from 3% to 11% and raising sales per square foot from $500/sqft to $863/sqft. Abercrombie was replicating Aritzia and with more disciplined capital allocation, was slowly taking market share.

And I don't know what my peabrain was thinking. Why didn't I just invest in Abercrombie instead of Ariztia?!? Here you had a turnaround business replicating Aritzia's success with a much bigger store footprint and reach. Abercrombie, like Aritzia and most of retail, was suffering from inflationary pressure, causing margins to drop and with it, many short-term investors. Abercrombie was in a similar cheapish valuation and with the change in brand perception could've arguable snapped up sales way more than Aritzia ever could. 

While Aritzia's stock almost doubled, in the same time Abercrombie's stock more than tripled! 

Abercrombie (ANF) Purple and Aritzia (ATZ) Red chart from September

Now, there are a variety of nuances that makes Aritzia a completely different business than Abercrombie, and you can learn more about in my original Ariztia writeup. Nevertheless, this was a massive mistake of omission! This is what plagues many investors. Ommission was in fact Buffet's most common form of mistake. After this, I realized you should never ever look over heightening competition. Not just because competition poses a real threat to your business, but because many times, it's better to invest in the competitor. 

Now I often ask management "who is your scariest competitor". Notice the word scariest — not strongest, not best, not competent, not threatening — scariest. Because fear is a strong emotion and when someone tells you they are afraid of something, especially in a business setting you better believe them. 

That said this story goes to show how competitive retail is. This is an absolutely brutal space — mainly because consumer preferences in retail change so quickly. There are many mistakes a CEO can make to ruin their brand value.

And this leads to my second big mistake with Aritzia. 

Mistake #2: Not paying enough attention to customers.

Part of our research involved going on forums and understanding what customers had to say about Ariztia outside of our in person interviews. 

What we found was that many customers overtime have been complaining more and more about a decline in Aritzia's quality.

Reports of…

• previously double-lined skirts now only single lined,

• tops previously made with silk now made with cotton

• pants previously made very stretchy now very stiff

• new items being just recycled old designs

• new items drifting away from their style

• and more

We ignored these anecdotal opinions. We were biased. Granted, forums like reddit usually bring only those who had bad experiences. But still, we put too much weight on the good reviews and didn't put enough on the bad reviews. 

As it turns out, Aritzia has had a steady quality decline over the past several years. It started Aritzia's expansion to the States was revving up, leading to cost cutting in order to maintain Margins and build new/expand current distribution centers. In fact, as their expansion and e-commerce ramp up hurled volume to the moon, Aritzia was forced to work with more suppliers, oftentimes those which procured lower quality materials or sometimes a completely different material altogether if it means meeting production quotas in times. This was the case with their silk producers, leading to many previously silk items being made with either lower quality silk or none at all.

This was made even worse when Aritzia started doing more fast-fashion outside of their basics and winter coats which make up most of their SKUs. This lead to cramped production schedules and higher and higher quotas, causing further crunches on their suppliers and further jacking up volume. This heightened level of inventory was oftentimes unsold as not all product lines sold well.

I understood there was this risk but I never felt the true weight of it as I was doing my research. Aritzia’s whole brand is built on quality. No quality, no brand value — and this is likely going to be the case for Abercrombie as well if they end up falling the same expansion trap. Unfortunately for brands like these, there isn’t much logo loyalty similar to Nike or Lululemon. Aritzia fans don’t buy Aritzia just because Aritzia is on the logo. They buy because Aritzia makes high quality aspirational basic clothing that fits their everyday needs.

This is the cycle of most retail businesses: they capture a niche that works really well. they expand quickly and rapidly grow sales. their expansion efforts slowly lead to a decline in the quality and scarcity value that made their brand work in the first place. they lose customers and with it their competitive advantage.

I do think highly of the management team. The dedication to keeping store expansion conservative and disciplined. The incentives they’ve placed to bring in only the best sales people. The mindshare they’ve been able to capture.

That said, I was not strict enough with my investment criteria. I overlooked important pieces of information. I ignored anecdotal evidence because of my own bias. These pitfalls are a stark reminder of how you should use always approach investing with a checklist mindset. Every variable and aspect of the competitive advantage must be checked out with equal weighting.

To put it simply: The stars must align — not a single one can be out of place, they must align.

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I realize I’m just not smart enough to be in a retail businesses like Aritzia. I cannot predict what will happen with customer preferences. I cannot predict how customers will react to changes in production and quality. I cannot predict how the business will perform both in top-line growth and operationally 10 years from now.

In other words, this is not the kind of business I want to buy and hold forever. 

This is kind of a mistake no. 3: not understanding my circle of competence. A warning for those who take this concept for granted — as Buffet said, “it’s not the size of the circle that matters, it’s about knowing it’s boundaries.”

Explore industries and different business models. And from there, narrow it down to models where you can be confident in predicting the key variables that will affect the business in the long-term.