Seeking Value Opportunities in Retail Stocks

by: Erik Dellith

The financial markets have gyrated wildly, as investors have dealt with conflicting news about the condition of the US and global economy. We see evidence of a considerable contradiction when we focus on the American consumer. On the one hand, retail sales posted the strongest growth in months. On the other hand, one reading of consumer confidence fell to its lowest level since 1980.

We see similarly mixed results with retail companies. JC Penney Co. (NYSE:JCP) on Friday posted revenue and earnings that were lackluster, compared with the year-earlier period. To compound matters, the company’s earnings expectations for the current quarter are below what analysts had previously been forecasting. By comparison, Kohl’s Corp. (NYSE:KSS), which reported earnings on Thursday, beat estimates and upped its expectations for the rest of the year. Higher-end retailers Macy’s Inc. (NYSE:M) and Nordstrom Inc. (NYSE:JWN) also provided rosier forecasts.

The question then becomes, which view is the correct one? Are conditions flat-to-down, or are they improving?

As with the overall economy, the answer is “Yes” to both. In some areas, economic activity is either holding steady or deteriorating. In other areas, there are signs of life.

This dichotomy is a key reason why I expect little in terms of significant, sustained improvement in the broader stock indices. The signs of life will provide rallies that will be tempered by signs of little change or deterioration. While such an environment provides plenty of opportunities for shorter-term traders, it can prove very frustrating for longer-term investors, especially those who focus on indexes. Specific stock selection is particularly important for longer-term investors in this type of environment.

The latest government retail sales figures bring our attention to this sector. Announcements by companies such as Kohl’s and Macy’s suggest that there are opportunities here, but the JC Penney results also send up cautionary flags. Today, we build a screen to help us highlight potential investments in this arena.

Building The Screen

Our first step is to focus on the retail portion of the Services sector. We can choose from several different areas, including apparel, catalog and mail order companies, drug stores, grocery stores, and home improvement stores. Today, we focus on department and discount stores.

When I developed this screen on Saturday, the department and discount retail stores industry consisted of 19 companies. With so few companies, our search criteria quickly bring us down to a manageable number of names for further research.

Based on current economic and market conditions, we are looking for companies that have two key characteristics: relatively cheap valuation and an expectation for future growth. There are many ways to accomplish this. The example explained below is only one possibility. In building our screen today, we focus on the growth portion first.

We want companies that are growing their earnings faster than their peers. Thus, we require companies to post EPS growth rates in the most recent quarter (MRQ) that are faster than the industry average. This reduces our list to only 9 names. Since today’s list is so small already, I present it here:

  • Dillard's, Inc. (NYSE:DDS)
  • Dollar Tree, Inc. (NASDAQ:DLTR)
  • Duckwall-ALCO Stores, Inc (DUCK)
  • Fred's, Inc. (NASDAQ:FRED)
  • Kohl's Corporation (KSS)
  • Macy's, Inc. (M)
  • Saks Incorporated (NYSE:SKS)
  • Tuesday Morning Corporation (NASDAQ:TUES)
  • YesDTC Holdings, Inc.

Further, we would like to see that analysts expect growth to continue. So, we require that the anticipated pace of earnings growth in the future either be equal to or exceed the average annual earnings growth rate each company has posted over the last five years. That leaves us with only six companies, knocking out Dilliard’s, Dollar Tree, and Saks.

A problem we encounter at this point, however, is that there are no long-term growth estimates for three other companies, so we omit them. At this stage, we lose Duckwall-ALCO, Tuesday Morning, and YesDTC.

Next, we turn our attention to valuation. The recent weakness in the equity markets may have left many stocks at “low” valuations, but we want to highlight some of the names that are “lower”. We want companies that have relatively attractive price tags. To accomplish this, we focus on stocks that have P/E ratios less than the industry average. This leaves us with Kohl’s and Macy’s, which have P/E ratios of 11.9 and 10.6, respectively, much less than the triple-digit industry norm, according to data from Reuters.

Both Kohl’s and Macy’s are also priced at significant discounts to their peers on the basis of P/Sales ratios, as well. KSS stands at 0.72, and M at 0.42, relative to the industry average of 16.6.

Going a step farther, and examining valuations based on expected future performance, we see that both Kohl’s and Macy’s have PEG ratios of less than 1.5, a reading low enough to suggest that the shares still have more room to the upside. But while Macy’s valuation is relatively appealing, with a PEG of about 1.3, Kohl’s is still priced considerably cheaper. With a PEG ratio of 0.8, Kohl’s appears to be priced deep enough in value territory to appeal to even the most conservative value investors.

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