By Michael Vodicka
There is a big difference between a good pullback and a bad pullback in a stock.
A bad pullback happens when earnings fall more than shares, actually increasing a stock's valuation in spite of prices dipping lower. This is a classic "value trap" to which many investors who don't follow earnings estimates fall prey.
But a good pullback is the exact opposite. A good pullback happens when shares crash lower, but earnings and estimates hold steady or remain mostly unchanged. This can have a big effect on valuation and creates a compelling opportunity for investors to buy a stock at a temporary discount as the market overreacts to short-term news.
And this is exactly what is happening with one of my favorite retail stocks right now.
After the company provided revenue guidance at the low end of expectations, shares fell 8% in one day, pushing its total loss to 45% in the past four months. But in the meantime, earnings per share ((NYSEARCA:EPS)) are almost unchanged in the past 90 days, with the current-year estimate down only about 1% -- from $2.52 to $2.49. Take a look at the huge pullback below while earnings remain mostly unchanged.
Dollar Tree Inc. (NYSE: DLTR) is an extreme-value retailer that sells most of its products for just a dollar. As you can see on the chart, shares saw big gains in 2012 before it started to fall in July, mirroring the trend of the previous three years that lifted Dollar Tree and many of its peers to new all-time highs.
But if you missed that great run, then don't worry. With shares down in the short run, there are a few key reasons Dollar Tree is still in position for big gains.
The main reason is because value-driven consumption is still well in play. One of the biggest changes that resulted from high levels of unemployment and stagnant wage growth in the past few years has been on consumer spending habits. Consumers simply don't have as much discretionary income as they've had in the past, so they want to stretch limited financial resources as far as possible with great discounts and value at stores like Dollar Tree. This dynamic has fueled the company's gains and will continue to provide a tailwind moving forward.
It's also important to consider the timing of the recent decline. The holidays are easily Dollar Tree's strongest season. That has already started with Halloween and will likely continue through Thanksgiving, Christmas and the New Year. Even though the company announced revenue guidance to the low end of estimates, Dollar Tree is effectively managing expectations and setting itself up to deliver upside sales and earnings surprises as it benefits from a seasonal boost.
Those macro and seasonal conditions are complemented by the previously mentioned pullback, which has considerably sweetened the valuation picture. Shares are trading with a forward price-to-earnings (P/E) ratio of just 16, a sharp 25% discount to the industry average of 20. The discount shows up on the chart, where Dollar Tree has fallen sharply relative to peers like Family Dollar (NYSE: FDO) and Dollar General (NYSE: DG) in spite of little movement in earnings for these stocks as well. Take a look...
And if you're not fully convinced of this great investment opportunity, then here's something reassuring: The pullback in Dollar Tree has caught the attention of Goldman Sachs (NYSE: GS), the world's most powerful and infamous investment bank. Taking note of the same divergence pattern between earnings and share price, Goldman recently added Dollar Tree to its very exclusive Conviction Buy List with a price target of $48, representing 20% upside from current levels. A powerful financial institution like Goldman jumping on the Dollar Tree bandwagon only stands to drive investor interest and demand.
Risks to Consider: Wal-Mart (NYSE: WMT) recently broadened its presence in the discount-retail industry with a mini-sized version of its mega stores. Although Dollar Tree is still one of the top four dollar stores in terms of market share, pricing and product competition from Wal-Mart's scales of economy could weigh on its growth trajectory.
With consumers searching for value during high rates of unemployment and wage stagnation, Dollar Tree has spent most of the past three years trending higher. The recent pullback in shares was an overreaction to slightly lower revenue guidance that had a minimal effect on earnings projections. If Dollar Tree returned to the industry average valuation, then shares could easily jump to $50, a 25% gain from current levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.