Retail Needs Reality Check
In recent months, several retail stocks have gone from recession clunkers to recovery darlings.
The S&P 1500 Retailing Group Index has jumped 36% from March lows, with the charge led by some of 2008’s worst performers. The Department Stores Industry Index has gained 48% from March lows, while the Apparel Retail Industry Index has advanced 51%. With retail sales down sharply from year-earlier levels, many question whether such eye-popping rallies are justified. Both bulls and bears can find data to support their arguments, but we are not excited about the sector.
Bulls note that consumer confidence has been trending upward since March. In May, U.S. retail sales rose an estimated 0.5% from April, the first advance in three months, helped by higher gasoline prices and steep discounts for automobiles. In addition, the average Quadrix Overall score of the 224 U.S.-traded retail stocks is better than about 58% of the 4,248 stocks in our Quadrix universe.
Wall Street analysts have taken note of the positive news. Over the past month, upward revisions for current-year profits have outnumbered downward changes for 28 of the 35 retail stocks in the S&P 500 Index.Looking ahead to the next fiscal year, 29 of those retail stocks have positive net revisions.
Yet headwinds threaten to slow retail’s recovery. Unemployment climbed to 9.4% in May, a level not seen since 1983. Gasoline prices, though well off last year’s exorbitant levels, have jumped about 30% since the end of April. Complicating matters, consumers are strapped with heavy debt loads at the same time banks are lowering credit limits.
Moreover, while U.S. retail sales rose sequentially in May, they remained weak, down 10.8% from prior-year levels. Electronics and appliance stores, clothing retailers, and department stores posted some of the biggest year-to-year declines. Only a few corners of the market — health and personal-care stores (5.0%), restaurants (1.2%), and food stores (0.6%) — managed year-over-year sales gains in May.
All things considered, it seems too early to leap into most retail stocks. Many consumers, stung by the destruction of wealth, are still limiting purchases to necessities.
Supermarkets and drugstores should continue to generate some sales growth, but that consistent growth is no guarantee of strong market returns, as defensive names often lag when the rest of the sector is doing well. At the same time, the current economic environment is risky for retailers dependent on discretionary spending.
Rather than relying on such big-picture considerations entirely, investors should focus on finding individual stocks with both compelling growth stories and reasonable valuations. We currently recommend two retailers, both market leaders with solid capital-gains potential and defensive characteristics.
Our top retail pick, CVS Caremark ($31; CVS), is a Focus List Buy and a Long-Term Buy. In the past six months, the drug retailer’s sales have grown 10%. Yet shares trade at just 12 times the current-year profit consensus, a 44% discount to the average retailer in the S&P 1500 Index.
Wal-Mart Stores ($48; WMT), which sells both discretionary and nondiscretionary items, has also delivered better-than-expected sales growth this year. We review this stock, a Long-Term Buy, in Analysts' Choice.