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Grocery store stocks do not receive a lot of coverage in the market, and have underperformed in the recent rally for the most part. This trend is likely to continue as rising commodity costs crimp margins and hurt earnings across the board, while a few should be able to gain market share and set apart from the rest.

Although food is a necessity in any economic condition, consumer spending is a major determinant in the quantity bought, as well as where shoppers head. Less traditional grocers such as WalMart (NYSE:WMT) and Target (NYSE:TGT) will continue to put pressure on the conventional grocery stores that are unable to compete on a pricing basis. Also, the bulk distributors such as CostCo (NASDAQ:COST) and BJ’s Wholesale (NYSE:BJ) are also a going concern for the traditional grocers.

The fierce competition, slowing consumer spending, and rising commodity prices further constricting gross margins are unable to withstand the benefits from consumers choosing to have more meals at home, a factor that has hurt many of the restaurant stocks.

Looking at many of these companies it appears that the impact of the conditions described above has not been priced into future earnings expectations, and the stocks have room to fall. The main things to look for in the individual companies are competition, product mix, target market, and supplier price negotiation. The well managed companies will be less impacted by rising commodity costs, and will not pass as much on to customers due to above par operational efficiencies.

There are 10 grocer stocks that have a market cap exceeding $300M and trade more than 50,000 shares a day; Casey’s General (NASDAQ:CASY), Pantry (NASDAQ:PTRY), Kroger (NYSE:KR), Ruddick (RDK), SuperValu (NYSE:SVU), Safeway (NYSE:SWY), Whole Foods (WFMI), Winn-Dixie (NASDAQ:WINN), Weis Markets (NYSE:WMK), and a Brazilian firm, Companhia Brasileira de Distribuicao (NYSE:CBD).

On a strict valuation basis, Whole Foods trades 22X forward earnings and Winn Dixie trades 34X forward earnings, the two most expensive in the group although many see Winn Dixie as a potential acquisition target and Whole Foods is a niche player. Therefore, Weis Markets, Ruddick, and Casey’s General look to be the priciest on an earnings basis.

Pantry looks to be a nice value and growth play in the group trading 5X trailing earnings, 0.05X sales, 1.66X cash, and a PEG of 0.35. However, the firm is highly leveraged with Debt/Equity of 2.88, which could be a concern as earnings growth slows.

Kroger, Pantry, and Casey’s General look to be the most well managed firms based on profitability ratios such as ROA, ROE, and margins.

Through the process of elimination, Ruddick, SuverValu (SVU) and SafeWay look to be the names in trouble, and therefore the best targets to short. Weis Markets is one to be shorting on a technical analysis basis, as shares are showing bearish divergence and have gotten way ahead of itself.

CBD would be the high risk/high reward play as it is growing extremely fast in Brazil, and has rallied substantially off its lows.

While Grocery Stores may not be the flashiest group of stocks to trade, there is the potential of nice gains based on a simple comparison in the group. A pair trade strategy could be employed, going long a non-traditional name like CostCo and short one of the weaker names like SuperValu.

Whether the economy is recovering or not, it is clear that struggles are ahead for the traditional grocery stores, and the valuation is not reflective of that yet, giving investors the potential to be ahead of the Street.

Disclosure: No ownership of the stocks mentioned above.

Source: Grocery Stocks: Fallout Coming in Highly Competitive Industry