Are Retail Stocks Too Expensive?

 |  Includes: VCR, VHT, XLF, XRT
by: Kyle Fishman


The retail sector has significantly outperformed the S&P 500 over the past five years, now trading at lofty valuations.

Credit card stocks may be a safer way to play the retail sector, but could still be vulnerable to a slowdown in consumer spending.

There may be other sectors that offer much better value, by comparison.

Nearly one year ago, on April 24, 2013, published an article, "Causes For Concern With Discretionary Stocks, ETFs" where they described how the retail sector significantly outperformed the broad market during the past five years and reached very high valuations, with the retail sector trading at a 65% premium to the broad market. This was "by far the largest premium going back to 1995."

As an investor in Vanguard Consumer Discretionary ETF (NYSEARCA:VCR) at the time, I made the decision to sell my position upon reading this article. I thought the article's argument made a lot of sense from a historical perspective.

I thought it would be interesting to see how their view played out, now that we can go back and see the charts one year later. Comparing retail ETFs such as VCR and XRT to the S&P 500, it looks like VCR and XRT continued to outperform all the way until the end of 2013. However, thus far into 2014, they have finally started to underperform.

When a defensive sector like healthcare VHT outperforms, it may be justified based on secular-trend factors, such as aging baby boomers and mandatory health insurance. But given the cyclical nature of retail and consumer spending, it is only natural that such an outperformance and such high valuations will ultimately correct at some point.

While the retail sector has underperformed during the first few months of 2014, it is still massively ahead of the broad market going back to 2009, when the recovery began.

Reasons to be bullish?:

-In part, the reasons for the retail sector beginning to correct in 2014 may not be exclusively due to high valuations, but also high volatility. This high volatility may work in its favor if the market continues its long-term up-trend.

-Consumer Spending accounts for two-thirds of the U.S. Economy. To suggest that the retail sector is vulnerable is equal to saying two-thirds of the U.S. economy is vulnerable. This doesn't sound very logical, because the U.S. economy is very resilient, as it has recovered from every crisis in history, including the Great Depression and World War II.

While there may be some reason to remain bullish on the retail sector, I have come to the conclusion that the sector is too risky to touch.

How does this play out for Credit Card Stocks?

MasterCard (NYSE:MA), Visa (NYSE:V), American Express (NYSE:AXP), and Discover Financial Services (NYSE:DFS) are not included as holdings in the top retail ETFs, such as VCR and XRT. However, they are directly impacted by the level of consumer spending, as they collect a small percent of each and every transaction. Like most of the retail sector, they are trading at lofty valuations. However, there are some advantages to investing in credit card stocks that make them safer bets than retail stores:

-Secular Growth Trend: With 85% of world transactions still being conducted in cash, and more payments being conducted online, there is a lot of room for growth. Credit cards may see growth, not so much through increased consumer spending in existing markets, but through increased adoption in unsaturated markets. The covenience and security that credit cards offer make them likely to continue their trend in replacing cash.

-Credit cards have a wide moat, and they are not a very capital-intensive business; MasterCard only reinvests roughly 6% of its cash flow to build its network.

While credit cards appear to be a safer bet than the retail sector as a whole, they are still risky investments and could certainly be vulnerable to a slowdown in consumer spending. Instead of trying to justify lofty valuations of any business, no matter how good it may be, investors may be wiser to look for value.

A healthy alternative to Retail ETFs:

I believe funds can be put to better work in sector ETFs that have historically underperformed during the past several years, such as VFH (Vanguard Financials) or XLF (SPDR Financials).

In addition to low valuations and historical underperformance, other reasons to be bullish on the financial sector include:

1. Interest rates have nowhere to go but up, and they're going up at a slow pace. This will allow banks to properly prepare and capitalize on the situation, so that they can increase their spreads by charging more for loans than they are paying out to obtain their floats.

2. Buffett endorsement: Warren Buffett has said that banks are "in the best shape ever," and financials make up two-thirds of Berkshire Hathaway's portfolio.

3. The past financial crisis allows an opportunity for banks to learn valuable lessons and know their risk limitations.

Conclusion: The retail sector has reached a point where it has become very volatile and overvalued, and that can be very dangerous in a cyclical sector. Investing in financials offers real value and security.

Disclosure: I am long VFH, VHT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.