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At the end of September, I pointed out how many stocks in the Consumer Discretionary sector were extremely oversold. I certainly didn’t mean to suggest that the group was a buy in any way, but rather that investors might want to reconsider their exposures within the sector. This is the time of the year when investors begin to harvest tax losses and institutions look to prune their portfolios of losers so that they won’t embarrassingly appear on end-of-year reports.

So far this month, the Consumer Discretionary sector, especially after the strong day on weak numbers today, is up 0.67% relative to the S&P 500 (Financials are bouncing back even stronger). In the Mid-Caps (S&P 400), the relative performance is a bit stronger (+1.03%), while, quite strangely, in the Small-Caps (S&P 600), the sector is underperforming by 1.19%. I will offer my quick hypothesis: Tax-loss selling in the Small-Caps is more severe relative to liquidity. The underperformance of the sector year-to-date is an astounding 15.37%. Financials, by the way, are even worse at a relative -19.9%. In contrast, while the Consumer Discretionary stocks lag the S&P 500 significantly, the margin is 11.51% (still a huge difference).

Looking back at the same measure of degree of “oversold”, 88 names at the end of Q2 were “extremely oversold”. 2 weeks later, that number has declined to just 43 (of just under 600 names in the sector with market capitalization in excess of $100mm). So, how should the investor play the sector? I guess I gave it away in the title, but I believe that there are several great opportunities to reduce exposure.

I would divide the group broadly into three very different categories. Please pardon the technical jargon, but let’s call them the Dogs (more here than at the SPCA), the Duds (my focus area) and the Studs (if you own them, be grateful – if not, don’t chase). Lets define them as follows: Of the 588 names in the sector with market caps in excess of $100mm, how many of the stocks are down 20% or more (Dogs), between -20% and + 10% (Duds) and better than the S&P 500’s + 10% (Studs). Note that these are through 10/10:

Wow! Talk about FAT TAILS! For all you folks who are trying to generate alpha (I imagine a lot, given that this article is being published by Seeking Alpha), the extreme divergences in performance within the sector really jump out. I ran the same analysis on the Financials and generated a much more normal distribution: 24% Dogs, 62% Duds and just 14% Studs. I included a few examples, but clearly if you didn’t like consumer, hopefully you expressed that by avoiding Coffee rather than Burritos!

While I think that one can still sell or short some of the Dogs, I would be very careful. I have written about Starbucks (NASDAQ:SBUX) in recent months and do expect another drop down. While it is down 25% year-to-date, it is still expensive and not too oversold. Kudos to Todd Sullivan on his work there! For the most part, though, these names have paid a steep price already, and, in many cases, it is probably too late to sell. Wait for a rebound. Some of these will fly – maybe Chico’s (NYSE:CHS).

On the Studs, I would be very careful as well. In 2004, names that were growing in a slowing economy worked extremely well. Ironically, SBUX was one of those names! Growth investors have a tendency to crowd in, “paying” up for increasingly scarce relative growth. In fact, I am still contemplating buying one of the names in that group about which I have previously written, Bright Horizons Family Solutions (NYSE:BFAM). There are some names in there that might make sense to dig deeper to test the sustainability of the recent moves, though, as the price they pay for failing to meet expectations will be severe. I would offer True Religion (NASDAQ:TRLG) as an example. This is one that I initially liked a lot but decided wasn’t very well positioned despite several growth initiatives, as I don’t see this as a $150 blue jeans environment no matter how many stores they open!

Where I think that a lot of sales can be made are from the Duds. I am short O’Reilly (NASDAQ:ORLY), Texas Roadhouse (NASDAQ:TXRH) and Penske Auto (NYSE:PAG), all about which I have shared my short thesis quite recently. Cheescake Factory (NASDAQ:CAKE) and Tractor Supply (NASDAQ:TSCO) could just as well fit the bill. Specifically, I am looking for stocks from this group that are near 52-week lows but not too far from their 52-week highs, that are underperforming the market over the past month and quarter (trailing) and that aren’t “oversold” significantly. All of these measures are technical in nature. Fundamentally, I want to see estimates for 2008 that are declining (hopefully just modestly). As far as valuation, I don’t care if they are super expensive, but I want to avoid very low valuations obviously. The point is to find a stock in which further weakness could bring on a significant amount of selling as it makes a 52-week low.

As I think about the sector, I look back to where this all started: Housing. It takes a while for everything to play out. The builders peaked in mid-2005, and housing activity showed negative growth year-over-year in early 2006. No one seemed to really notice except for investors in home builders until early 2007. Now we have a Housing Depression. Housing-related stocks rolled over beginning mid-2006 (Bed, Bath & Beyond (NASDAQ:BBBY), Willliams-Sonoma (NYSE:WSM), Home Depot (NYSE:HD) all come to mind). While various aspects of the sector have been weakening for some time, I think that a lot of it had to do with gasoline prices. Now we get the more secondary and tertiary effects. I think restaurants and certain retailers, even those that might seem immune, are in the line of fire. I am especially leery of companies who are achieving growth through store openings rather than getting more people into their restaurants/stores or getting them to spend more when they are there. There is a lot of saturation in many markets (in my recent ORLY short thesis, I described my process of using Google Maps to check out their recent entries into crowded markets – give it a try as it’s free!). While many companies have the financial ability to access capital to play the “build it and they will come” game, this is a terrible time to engage in that strategy (I call it pissing away shareholder’s equity). The customer is weakening, the competition is great, and capital appears to be getting scarcer for those who don’t have it. Do you really believe that some of these names should command a premium valuation to the market given their method of achieving growth weighed against the likelihood of doing so? Well, they do, as the Duds have an average forward PE of 21 and a median of 17.6. I suppose that investors view the forward estimates as “temporarily low” so they are willing to pay up. I say let them hold onto these names while the market figures out that it was the historical earnings that were inflated by the housing bubble!

As the table above indicates, my title, if taken at face value, can be dangerous – there are many divergent groups within the sector. There has been tremendous change thus far this year, and my call is that many of the Duds could become Dogs.

Disclosure: Short ORLY, PAG and TXRH

Source: Time to Sell the Consumer Discretionary Sector