In a tough market, there are good opportunities for top U.S. retail stocks . . . but only for those firms that are rewriting the rules. John Stephenson, an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto, picks three of the best U.S. retail stocks to buy now including two true industry disrupters to the bricks-and-mortar retailers and publishers and broadcasters struggling with traditional business models.
Stocks around the world fell sharply in the second week of November as investors braced themselves for a much anticipated rate hike at the U.S. Federal Reserve that could come as soon as December and would mark the first increase since 2006. During that week, the Dow Jones Industrial Average slid 3.7 per cent and the S&P 500 Composite Index fell 3.6 per cent. These were their first weekly declines since the week of September 21 and their largest since the week ended August 21. Stocks are struggling as investors fret over a likely rate rise, high valuations and a lackluster earnings season on the S&P 500.
Meanwhile, the price of West Texas Intermediate (WTI) crude oil has tumbled to near US$40 a barrel, as signs of increasing supplies and slackening demand have pummeled commodity markets. Oil inventories have swelled to the highest level on record as crude producers intensify the battle for market share, putting unprecedented strain on the world’s energy infrastructure. At the same time, a flurry of disappointing economic data has been coming out of China, a major consumer of raw materials.
Commodity weakness pulling down stocks, currencies
The drop in commodity prices has rippled through other financial markets with the share prices of miners and oil producers plunging, weighing on stock indices. Currencies of developing economies dependent on commodity exports, such as Brazil and South Africa, also slumped.
Adding to the sense of malaise has been a lackluster earnings season. While many have been quick to blame the energy sector for the disappointing quarter, it is only part of the story. Even stripping out the impact of energy, many U.S. companies with extensive international exposure are struggling, showing slight revenue declines on the back of U.S. dollar strength. American companies that are domestically focused, by comparison, have managed to buck the trend, showing a very healthy 10 per cent year-on-year growth in earnings.
Emerging markets’ five-year slump
Emerging markets have also been a losing bet, with the MSCI Emerging Market Index losing 14 per cent since 2010. This is despite the prospect of exposure to some of the fastest-growing economies in the world and with trade, technology and liberalization promising long-term growth in profits. Most of the losses in the emerging markets have come this year as the greenback has strengthened, drawing capital back to the U.S. at the expense of “soft” currencies. The developed markets, by comparison, have posted average gains of 35 per cent over the same period.
Even top U.S. retailers face challenges
American retail stocks, which have been among the stronger S&P 500 stock groups this year, are now facing difficulties, underscoring the quandary investors are struggling with. In early November the U.S. retail sales numbers for October came out, showing just 0.1 per cent growth.
At the same time, Nordstrom, Inc. cut its profit and sales forecasts and Macy’s Inc. warned that it would have to make heavy markdowns to clear unsold goods. Macy’s stock fell 20 per cent and Nordstrom fell 18 per cent on the news, while other retailers, such as Amazon.com, Inc., fell just 2.6 per cent and Starbucks Corp. dropped 3.6 per cent in the same week.
For the year, Macy’s and Nordstrom are both down more than 30 per cent. Amazon’s stock in contrast has more than doubled so far this year, while Starbucks is up 46 per cent, helping to power the S&P 500 consumer discretionary group to gains of 7.6 per cent.
A two-speed market
An ongoing problem for the market is that many smaller stocks are falling back, leaving a small number of large capitalization stocks (“large caps”) to power the market gains. In periods of market strength, smaller stocks typically lead global exchanges higher. For weeks, small caps and small-cap indices such as the Russell 2000 Index (which is comprised of smaller domestically focused stocks) have been consistently underperforming the broader stock averages. In the second week of November, the Russell 2000 fell 4.4 per cent and is now down 4.8 per cent for 2015.
Retail stocks: Investors must be choosy
For many, the strength of the American consumer coupled with lower gasoline prices (which acted as a virtual tax cut) was a potent combination that made consumer goods stocks market darlings. But with the market increasingly distinguishing between those retail stocks with a highly differentiated strategy and the rest, it’s time to start applying the same focus to your investment portfolio.
Many of the traditional retailers have had disappointing third quarter sales and earnings, with many of them citing the unusually warm weather as a culprit. This season has been particularly hard on traditional consumer goods stocks with warmer-than-usual weather negatively impacting inventory levels and with reduced tourist traffic because of the high U.S. dollar. The higher levels of inventory may cause many retailers to cut prices and offer other special promotions than they initially planned for over the all-important holiday season.
What I recommend
While the six-week winning streak for stocks has been encouraging after the major selloffs in August and September, the disappointing performance of the market in early November is unsettling. With the market rallying on an increasingly narrower group of leadership stocks, it is time for investors to focus on high-grade investments. Stock prices are high, corporations are having trouble sustaining earnings growth, manufacturing is in a slump, oil is down and the U.S. dollar is up. In an environment like this, it’s increasingly important to have a much more selective and focused approach to your investments.
The rise of the Internet has upended many business models, positioning some retailers on the wrong side of the trend. Even dominant retailers such as Wal-Mart Stores, Inc. are struggling to build out their online presence. Increasingly many people in the workforce are increasingly time-starved and unwilling to spend their weekends trolling around the shopping mall looking for basic necessities. This force has dramatically altered the market for broadcasters, who are finding there is no longer a nuclear family that sits down to eat dinner together at 6:00 p.m. while watching the evening news.
The changes in the marketplace have been quite dramatic, as bricks-and-mortar retailers struggle with declining same-store sales and businesses such as print publishing face huge threats to their business model from online publishing.
Amazon.com: The ultimate retail disrupter
Nothing is more of a retail disrupter than Amazon.com, Inc. (NASDAQ─AMZN), a leading retailer of just about everything. Amazon is a market-share leader, already accounting for roughly 20 per cent of American online retail sales. The company has a very strong position in the “mobile” space—enabling consumers to shop via cell phone.
Amazon also has infrastructure advantages that have facilitated next-day and same-day delivery solutions that should allow it to continue to build market share. As well, given their consistency, operational and strategic track record, focus on innovation and customer service, and long-term shareholder orientation, the company boasts one of the best management teams in retailing. I have a buy rating and a 12-month price target of $775 per share on Amazon.com.
Netflix: Disrupting television broadcasting
Another stock that fits the bill is Netflix Inc. (NASDAQ─NFLX), which is disrupting the traditional business of broadcast television. Netflix offers the best hybrid solution to strong growth in online video viewing and in Internet-connected devices (tablets, smartphones, Internet TVs).
The company has reached a level of sustainable scale, growth, and profitability that isn’t currently reflected in the stock price. I have a buy rating and a 12-month price target of $140 per share on Netflix.
Home Depot: Where traditional retail is thriving
A traditional bricks-and-mortar retailer that is bucking the trend is The Home Depot, Inc. (NYSE─HD), which continues to gain share, and manages to leverage top-line gains to impressive earnings growth.
When people do flock to the mall, they are, increasingly, heading to home improvement stores. Spending on the home has continued to do well even in a generally slowing retail environment.
This consumer goods stock is likely to continue growing earnings and shareholders will benefit from strong returns and stock buybacks. The upward trend in home improvement spending is likely to be long-dated as the U.S. housing market is recovering. I have a buy rating and a 12-month price target of $145 per share on Home Depot.
A stock picker’s market
The stock market has become much more discerning over the last few months, with market leadership more narrowly distributed. Increasingly, to come out ahead, investors must utilize a stock picker’s approach. The gap between the winners and losers is widening and a passive approach to investing is unlikely to work. U.S. consumers are the dominant force in the economy and reports of their demise have been greatly exaggerated.
While stock market returns so far this year have been nothing to write home about, the consumer discretionary sector has been a leading sector on the S&P 500. I firmly believe that there are wonderful investment opportunities among top U.S. consumer goods stocks . . . but only for those that are re-writing the retail rules of doing business.
The MoneyLetter, MPL Communications Inc.
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