As U.S. retailers gear up for what is traditionally their merriest time of the year -- the lucrative Christmas shopping season -- investors can feel fairly sanguine that the strong gains in retail stocks will hold up. And although the sector’s great clearance sale may be over, shoppers with a discerning eye can nonetheless find good values.
“There are some very good growth companies in the retail sector whose stocks could still outperform based on their earnings growth,” says Colin McGranahan, a specialty retail analyst at Sanford C. Bernstein & Co. in New York.
In the fall of 2002, as worry over the weak economy turned to anticipation of recovery, economically sensitive stocks began to climb. Cyclicals continued to rebound in 2003, with retail stocks in particular outperforming most market sectors. Through September 30 the Standard & Poor’s retail index had gained 28.8 percent, nearly wiping out its 24 percent loss in 2002. Many retail shares have racked up eye-popping gains. Best Buy Co. soared 90 percent through September; Fred’s, 84 percent; and Pacific Sunwear of California, 75 percent.
The $44.3 million-in-assets, Rockville, Marylandbased Rydex Retailing Fund and the $77 million Fidelity Select Retailing Portfolio -- the only mutual funds that invest almost exclusively in retail stocks -- gained 23.2 percent and 20.6 percent, respectively, through September, compared with a 14.7 percent increase for the S&P 500 index. Last year the two funds tumbled 23.8 percent and 18.9 percent, respectively. The $141 million, Greenwood Village, Coloradobased Icon Consumer Discretionary Fund, which has a 75 percent allocation to retail stocks, gained 29.8 percent through September after losing 19.1 percent in 2002.
But investors are again taking a cautious view of retail shares. “A lot of the good news is already in the stocks,” says Bernstein retailing analyst Emma Kozloff. With so many of the shares selling at 52-week highs, investors may begin to channel their gains into other sectors, she cautions. Although such an exodus could create a buying opportunity, Kozloff notes that retail stocks could be vulnerable if the U.S. recovery picks up and interest rates rise. “At this point investors need to be very selective,” she says. “It’s going to be a stock picker’s market.”
Her colleague McGranahan believes that Lowe’s Cos. (up 38.6 percent through September) and Staples (30.2 percent) could enjoy further gains. Best Buy may also offer good near-term appreciation potential, despite its big run-up. “We are very optimistic about consumer-electronics retailers,” McGranahan says.
Robert Straus, manager of the Icon fund, contends that many solid-quality midcap retail stocks remain undervalued by as much as 30 percent. He particularly likes Michaels Stores (up 30.5 through September), Electronics Boutique Holdings Corp. (up 80 percent) and Christopher & Banks Corp. (up 72 percent).
Most professional investors remain optimistic about the long-term growth prospects of discount retailers. They point to a secular shift in consumers’ buying habits away from department stores and traditional grocers toward discount stores and warehouse clubs like Costco Wholesale Corp. (up 7 percent this year). “Ninety-nine percent of shoppers are working to improve the value proposition,” says Daniel Poole, assistant director of research at National City Wealth Management in Cleveland.
When it comes to discount retailing, the name at the top of investors’ lists is, of course, Wal-Mart Stores. Lehman Brothers retail analyst Robert Drubl, who recommends overweighting the stock, gives this appraisal: “The hardest part of retail is getting people in the door, and Wal-Mart has 100 million people in its stores every week. Wal-Mart continues to capture market share in both the grocery and general merchandise segments of its business.” He adds that the company continues to grow internationally, 18 months ago buying a stake in Seiyu Limited, a Japanese supermarket chain, and introducing discounting to that country.
Wal-Mart’s stock is up 10.9 percent through September, yet it sells at 25 times earnings -- well below its average trailing five-year multiple of 33. “Wal-Mart is a very well managed company, and we expect continued solid growth,” Drubl says.
He also likes the marketing savvy of Target Corp., a discount retailer that recently gained extra cachet with customers by bringing in chichi designer Isaac Mizrahi to develop a line of low-priced sportswear for the chain. “The company has successfully used its marketing expertise to differentiate itself from Wal-Mart,” Drubl says. “Target has played a big role in creating upscale discounting.”
According to Mark Miller, an equity analyst at Chicago-based William Blair & Co., other discount retailers with superior long-term growth potential include Family Dollar Stores (up 28.6 percent through September), Dollar General Corp. (up 68.4 percent), Dollar Tree Stores (up 36.5 percent), 99 Cents Only Stores (up 20.4 percent) and Fred’s. “These companies have a very strong topline growth, and they are well-positioned to take market share away from department stores and conventional grocers,” Miller says.
By contrast, investors expect department stores and conventional grocers to underperform, and those stocks reflect their pessimism. Albertson’s declined 4.8 percent through September, after a 27 percent loss in 2002. And Safeway has gained just 4 percent this year, versus a 44 percent decline in 2002.
The Icon fund, managed by Greenwood Village, Coloradobased Meridian Investment Management, began a gradual shift into retail stocks in mid-March. At that juncture they were exhibiting good relative price strength and selling at an average discount of 54 percent to their intrinsic worth, according to Meridian’s valuation model. “The 54 percent discount has since narrowed to about 29 percent,” says Straus.
He bought Irving, Texasbased Michaels Stores, a retailer of arts and crafts supplies with 900 outlets in 48 states and Canada, in March. Through September the stock had gained 41 percent. “Michaels is a fundamentally strong company in an industry that stands to benefit from improving economic conditions,” Straus says. Despite the stock’s run-up, he hasn’t begun taking profits: “We think Michaels Stores is undervalued by about 30 percent.”
The company was selling in late September at a price-earnings ratio of 19.9, compared with an industry average of 29.3. It boasts a strong balance sheet, a high ratio of cash flow to debt and improving margins. “We also like the company’s history of cost containment,” says Straus.
The Icon Fund is beginning to scale back its other retail positions, however. Pacific Sunwear’s surge this year stems from solid sales gains and a promising expansion strategy. But at $22.60 a share in late September, the company no longer looked drastically undervalued to Straus, so Icon trimmed its position from 3 percent of its total assets to 1.9 percent to make room for additional specialty apparel retailers.
Straus recently pared Icon’s holding of Best Buy from 4 percent of assets to 2 percent. To be sure, he says, “the consumer-electronics industry is showing strong leadership, and Best Buy continues to be a core holding in the fund.” Nonetheless, he has taken some profits on the stock and channeled them into other consumer-electronics companies.
One is Electronics Boutique Holdings. Although the stock was up 80 percent through September, Straus still sees it as 40 percent below fair market value. “The company has sharply increased sales over the past five years and had a return on equity of 15 percent or better for three consecutive years,” he says.
Unlike actively managed Icon and Fidelity Select Retailing Portfolio, the Rydex Retailing Fund for the most part passively tracks the Dow Jones U.S. total market retailing index. Rydex’s managers seek to add value at the margin by modestly overweighting stocks that they believe have superior prospects and underweighting or even omitting index stocks that they expect to underperform.
The Rydex fund has a modest overweighting in Lowe’s -- a well-managed beneficiary of the home-improvement trend. “Lowe’s has a consistent earnings growth rate of nearly 30 percent,” points out Rydex Retailing Fund manager David Malmgren. Retailers that have been bounced from the fund because of their apparently poor prospects include Borders Group, Williams-Sonoma and Dress Barn.
Icon’s Straus is finding fresh opportunities among midcap specialty retailers; they account for roughly 22 percent of the fund’s assets, up from 5.4 percent in February. The portfolio manager recently allocated 1.3 percent of the fund’s assets to Christopher & Banks, a Minneapolis-based retailer specializing in women’s apparel. Straus says the company has shown consistently strong sales growth -- roughly 28 percent per year on average over the past five years -- and sustained that growth even in the face of the 2001'02 recession.
In the latest fiscal year, sales reached $338 million. Christopher & Banks’s balance sheet has no long-term debt. And based on Meridian’s rigorous valuation model, derived from classic Graham and Dodd precepts, the company’s shares were about 35 percent undervalued in late September.
If that’s right, the stock could turn out to be a pretty good holiday present for Straus.
