The markets are clearly starting to price in the potential for a double dip recession. How much lower could the markets go if the economy indeed slows further is certainly open to debate. It likely depends on your view of how weak the economy gets and what the outlook is beyond that.
However, despite recent market actions, most updates from economists I have read still suggest they are for the most part only predicting a 1 in 3 chance of recession in the near term. In other words, there is a 2/3 chance the economy does not decline from here. This could be an optimistic view given declines in markets on recession risks which can some times become self-fulfilling. However, I'm certainly not ready to throw in the towel on sectors that are already trading at record valuation lows.
You might believe the market is now reflecting a more balanced outlook and want to invest in consumer stocks with huge potential- if we don't double-dip. You might be willing to look through a recession or you might just want to play a bounce. If so, I believe consumer electronics and apparel are perhaps two of the best sectors to invest in.
Consumer electronic retailers have gotten pummeled the last few weeks as the space is usually viewed as extremely economically sensitive. Also, data and anecdotal reports the last few months suggest sales were in the doldrums due in part to tough appliance comparisons from last year’s government stimulus-driven purchasing and also to continued weak TV demand. Despite this, there are several reasons I think this group should outperform the market by a wide margin if the U.S. economy doesn’t double-dip. Actually, perhaps even if it does:
Some category sales remain quite strong: While TV sales and some other CE categories remain weak, tablets, eBooks and mobile phones remain strong. This helps RadioShack (RSH) the most, especially as the company is able to increase its allocation of tablets from Apple (AAPL). Also, I believe other computer sales are still quite strong at retailers like Best Buy (BBY). Anecdotally, I personally confirmed this with several Best Buy and mom-and-pop CE stores in the Northeast this past weekend. Certainly not statistically significant, but historically I have found anecdotal observations like these are directionally correct.
Comparisons become much easier in this holiday season: The industry will be facing much easier comparisons this holiday season than seen over the last 12 months. This is especially true for Best Buy, which is up against declining same store sales (SSS) of 3%-4.4%. Even some of the most bearish analysts are predicting a return to sales growth in 3Q and 4Q for Best Buy and at least 4Q for RadioShack. If this forecast is correct, the momentum would continue into 2012 as well.
Valuations are Already Suggesting Consensus Earnings Forecasts are Way to High. In other words, expectations are extremely low for earnings. Looking at valuations based on 2011 earnings estimates (let alone 2012 which investors will start to focus on more in the coming months), some companies like Best Buy were, as of Monday morning, trading at +10 year lows (as far back as my research went). I would not surprise me if these were all time valuation lows. Best Buy is trading under 7x...and that’s a P/E, not an EBITDA multiple! On EBITDA, Best Buy is trading at only 2.7x! RadioShack trades at a P/E of 7.5x and EBITDA of 3.2x. H.H. Gregg (HGG), the only growth retailer in the space, trades at a P/E of 12.2x and 3.5x EBITDA. Gamestop (GME) trades at a P/E of 7x and 3.3x EBITDA.
Based on these valuations, companies in this subsector do not need to beat earnings expectations for the stocks to do well. In fact, I think they could rally sharply by simply meeting estimates and maintaining guidance during their next financial reports. I believe valuations are roughly half what they would be if the market was confident in the consensus forecast and not panicking over a potential recession. Similarly, buying at these levels gives you a huge cushion if we enter a recession and earnings indeed fall. In that scenario, I suspect investors will still do well in these stocks if you are willing to hold for 9-12 months, assuming it takes that long for the market to look through to the next expansion.
Specialty apparel retailers have also been hit hard the last few weeks on the potential for weaker sales this holiday season if the economy slows further. This slowdown in sales would come even as companies’ cost of goods has risen dramatically on higher commodity costs (i.e., cotton). Even before these recent concerns, this space has had mixed sales trends, with weakening traffic over the last few months offset by discounts to keep sales growing year-over-year.
There have been clear market share winners this year, including Abercrombie & Fitch (ANF), Ann Taylor (ANN), The Buckle (BKE), Chico’s (CHS) and Zumiez (ZUMZ). There have also been clear market share losers, including Aeropostale (ARO), Coldwater Creek (CHS), Gap (GPS), Pacific Sunwear (PSUN) and Talbots (TLB). While market share dynamics can certainly help support or hurt each retailer individually in a recession or out of one, there are a few reasons to be optimistic about this group as a whole heading into 2012:
So far, price increases are not meeting heavy consumer resistance. Retailers have been raising prices this spring selectively and in a larger way with new fall merchandise that started hitting stores last month. So far, the price increases are not being met with consumer resistance as we feared. According to the International Council of Shopping Centers (ICSC), higher prices made up about 1% of the 4.6% year-over-year increase in sales in July. Apparel companies like Levi Strauss, VF Corp. (VFC) and Phillips- Van Heusen (PVH) have all recently had positive comments about the reception price increases are having with consumers.
Cotton prices are plummeting back to 2010 levels. Even before the most recent recession worries arose, cotton prices were on their way back down from their peak this spring at over $225/pound. As of Monday, the spot price had fallen all the way to $99.58. While this is still up from a year ago when the spot price was near $81, the recent decline should allow to retailers to reduce apparel costs as they start to place orders for late spring/summer 2012. Thus, the industry should have some built in margin support/growth early next year.
Valuations, while not as low as CE retailers, are still attractive. Currently, apparel retailers are trading at just under 13x consensus 2011 forecasts and 4.5x EBITDA. This is well below the trailing 5-year averages of a 17x P/E and 7x EBITDA. This is one space that has seen significant buyout activity over the last couple of years as well, with buyout multiples ranging from 6.8x-8.6x EBITDA. While valuations could certainly go lower if recession worries grow, any macro data or company-specific updates that suggest 2011 industry earnings forecasts are largely intact should lead to about a 50% increase in valuations over the near term.