Are Value Retailers Overvalued?

| About: Consumer Discretionary (XLY)

The best performing sector in the S&P 500 this year is Consumer Discretionary (NYSEARCA:XLY), up in price by 6.69% through June 1st compared to the index itself up just 1.63%. While the average stock is doing well, there is substantial diversity, with 15 of the 81 stocks down by more than 20% and 18 of the 81 stocks up more than 20%. Looking at the winners points to a strong underlying theme: Value Retailers.

I define the value retailers as the dollar stores and off-price stores, though I suppose that the universe could be defined even more broadly. There are four companies from these two sub-sectors in the S&P 500, and they are up 17-30% in 2012. The group includes Ross Stores (NASDAQ:ROST), TJX (NYSE:TJX), Dollar Tree (NASDAQ:DLTR) and Family Dollar (NYSE:FDO). I added a fifth company to the group that is the largest dollar store but not in the S&P 500, Dollar General (NYSE:DG).

These stocks are benefiting from the confluence of many factors, including a slow economy, a high or exclusive focus on the domestic consumer (note that TJX has 11% exposure to Canada and 11% to Europe), and high gasoline prices that hit consumers in the wallet. Let's take a look:

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As you can see in the table above, it's about as good as it gets: Strong sales, high margins and rich valuations. A few observations:

  • Strong one-year price returns, with a 51% gain compared to Wal-Mart (NYSE:WMT) up 22%, the S&P 500 down 3% and the Consumer Discretionary sector up 6%.
  • Over the past five years, these stocks have tripled while the market has declined 17%, WMT has rallied 33% and XLY has increased 5%.
  • Sales growth over the past year has been strong at 10%
  • EPS have grown faster at 23%
  • Net profit margins are higher than their 5-year average
  • PE valuation is substantial to market, sector and WMT
  • PE valuation is premium to 5-year average, in contrast to market and sector
  • EV/EBITDA is substantial premium to WMT

I think that this is a good time to pare exposure to these names. On the one hand, if the market keeps retreating, it seems like the stocks are vulnerable to selling (absolute declines). On the other hand, the stocks could lag the market should it turn around (relative declines).

The domestic focus in and of itself has helped these stocks, but the fact that the dollar has been strengthening is at play as well. A weaker dollar might hurt demand for these stocks as investors shift their focus back to multinationals.

Fundamentally, the strong dollar and fears of global recession have recently hit energy prices. Falling gasoline prices, should they persist, could lead to a shift away from a value focus by U.S. consumers.

I should note that I follow FDO most closely - it's on my watchlist. I think of the five it is probably the most attractive due to the potential to improve its margins. Management has been making improvements lately. Potential investors should be aware of an activist investor's involvement (Trian - Nelson Peltz).

It has been the best of all worlds for value retailers. If you are bearish, you might want to ring the register now, as the stocks could see some selling given their strong performance (with extended charts) and stretched valuations. WMT might be a good alternative if you need to be invested.

On the other hand, if you are bullish, these stocks might be a good source of funds for beaten up stocks from other sectors (or even within the Consumer Discretionary sector).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.