Is Retail In Retreat?

|
Includes: FDN, PMR, PNQI, RTH, XRT
by: Morningstar

By Robert Goldsborough

As fourth-quarter earnings reports have started coming across the wire, several themes already have begun emerging. One of the biggest themes, however, has been not company-specific, but rather a government report showing surprisingly weak retail sales numbers for December and a downward revision for November's numbers.

According to United States Commerce Department data, retail sales fell nearly 1% in December on a month-to-month basis (and were down fully 1% month-to-month excluding autos), while consumer core sales (retail sales less autos, gasoline, building materials, and food services) were down 0.4% month-to-month. The news surprised both the markets and economists, who had forecast basically flat retail sales in aggregate and a 0.4% rise in consumer core sales on a month-to-month basis. And it indicated that consumers enjoying lower gasoline prices did not take that extra cash in their pockets and spend it at other retailers.

Some economists contend that the retail weakness simply is a matter of the calendar and timing differences involved in making seasonal adjustments to economic data. By other measures, they suggest, such as the Federal Reserve's Beige Book or the National Retail Federation's data, retail spending is solid.

My colleague Robert Johnson, Morningstar's director of economic analysis, acknowledges that on a headline basis, the retail sales numbers didn't look great, but he notes that on a year-over-year basis, retail sales growth continues to be strong, exceeding 4% on a nominal basis and growing close to 3.5% on an inflation-adjusted basis. Going forward, he doesn't see dramatic improvement ahead in retail sales, but he does anticipate generally solid data.

Although the retail sector has outperformed the broader market over the past few months, the most recent news in the retail space has pressured the share prices of many retailers a bit. For investors who see this as a buying opportunity in a generally well-valued broader market, there are several exchange-traded funds that investors can consider.

An Overview of Retail ETFs
There are three passively managed, unleveraged ETFs devoted to the retail industry: SPDR S&P Retail ETF (NYSEARCA:XRT), Market Vectors Retail ETF (NYSEARCA:RTH), and PowerShares Dynamic Retail ETF (NYSE:PMR).

Easily the largest and most liquid retail ETF, XRT also offers broad exposure, tracking an equally weighted index of 102 U.S. retail firms. Because XRT's index is equally weighted, heavyweights like Wal-Mart (NYSE:WMT) sit shoulder to shoulder in the fund with relative pipsqueaks like women's fashion specialty retailer Cato Corp. (NYSE:CATO). As a result, large-cap companies make up just 15% of assets, while mid-cap firms comprise 30.5% of the fund. Small- and micro-cap companies make up 35.5% and 16% of assets, respectively. XRT holds both defensive retailers, such as Wal-Mart, Costco (NASDAQ:COST), and Walgreens Boots Alliance (NASDAQ:WBA), and nondefensive retailers, such as specialty retailers and apparel stores. XRT also holds Amazon (NASDAQ:AMZN), but it does not hold home-improvement retailers such as Home Depot (NYSE:HD) and Lowe's (NYSE:LOW). The fund's 0.35% price tag is appealing, but given the exposure to smaller firms, would-be investors should expect higher beta exposure relative to a more traditional, market-cap-weighted ETF that tilts toward larger firms.

RTH tracks a market-cap-weighted benchmark of 25 retail companies. That means that the largest firms, such as Wal-Mart, CVS Health (NYSE:CVS), Amazon, and Walgreens Boots Alliance, hold the most sway. RTH is devoted almost entirely to large-cap names, with mega-cap retailers making up 35% of the fund and large-cap companies comprising another 59% of assets. Unlike XRT, RTH holds home-improvement retailers, which gives the fund more exposure to the housing market than XRT. RTH charges 0.35%.

Finally, PMR is a small, thinly traded strategic beta ETF that tracks an enhanced index of 30 retailers. The index evaluates firms based on price momentum, earnings momentum, quality, and value, among other factors. The index rebalances and reconstitutes quarterly, ensuring higher turnover. In addition, PMR has a pronounced small-cap tilt, devoting almost 27% of assets to small-cap firms, 11% to micro-cap companies, and another 21.5% to mid-cap retailers. PMR's performance has lagged that of RTH in the trailing one- and three-year periods ending Jan. 16, 2015 (RTH has not traded for five years), and while it has nicely outperformed XRT in the trailing one-year period, it’s underperformed XRT in the trailing three- and five-year periods. It's not clear whether investors can count on outperformance from this fund going forward. PMR charges a relatively high expense ratio of 0.63%.

What the Economic Outlook for 2015 Means for Retail ETFs
In general, Morningstar's analysts anticipate a healthier and stronger U.S. consumer in 2015 and beyond, which portends well for retail ETFs. A strengthening consumer in particular would favor ETFs with small- and mid-cap tilts, as they hold fewer defensive names and more discretionary, higher-beta firms. So that dynamic could make XRT and PMR more appealing options. At the same time, investors should pay close attention to some retail trends that are less favorable for smaller players. Some of these include the need for retailers to have both a brick-and-mortar business and an e-commerce presence--a requirement that in general requires firms to be larger and have more scale--and a broader trend of the millennial generation spending less money on high-priced items found at specialty retailers offering apparel or luxury goods and instead spending more on experiential items and more expensive places to live. Although any generational shift plays out over a much longer-term time horizon, it's worth watching closely.

E-Commerce Growth Continuing Unabated
In addition to disappointing December results, traditional bricks-and-mortar retailers continue to face challenges from online shopping. Many traditional retailers have struggled to keep up with Amazon's strong fulfillment capabilities and price competition. Although Amazon continues to grow and take share from traditional retailers, it also has problems of its own, as it continues to search for ways to grow its business profitably. In the first few weeks of 2015, the firm's share price is down sharply.

Over the longer term, we have some concerns about smaller retailers' ability to compete with Amazon from a fulfillment standpoint. Morningstar's equity analysts note that a variety of retailers have increased their emphasis on logistics and delivery speeds, but even so, only a few retailers at this time can match Amazon's capacity and geographic reach. The transition to e-commerce is continuing slowly for bricks-and-mortar retailers, as many of their fulfillment centers were not designed for e-commerce.

For investors, what this means is that smaller-cap retail names--which are found more in XRT and PMR--may well find themselves more susceptible to the growth in online shopping. So while broader macroeconomic trends--a stronger consumer with more disposable income--could benefit those funds, e-commerce growth could come at the expense of some, if not many, of the smaller firms in those ETFs.

Other Options
Because retail makes up a large chunk of the consumer discretionary industry, investors seeking broad exposure to the retail space also could consider a consumer discretionary ETF. Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY), which charges 0.16% and holds about 85 companies, is a large and liquid fund that devotes about one third of its assets to retailers. Similarly, Vanguard Consumer Discretionary ETF (NYSEARCA:VCR) costs just 0.12%, holds a broader portfolio of 382 firms, and also invests about a third of its assets in retail firms.

Investors interested in ETFs with meaningful exposures to Amazon can consider one of two Internet ETFs, both of which devote between 7% and 8% of assets to Amazon: First Trust Dow Jones Internet (NYSEARCA:FDN) (0.60% expense ratio) and PowerShares NASDAQ Internet (NASDAQ:PNQI) (0.60% expense ratio). Internet and catalog retailers like Amazon make up between 20% and 25% of the assets of each ETF.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.