Inflation Flashes The Buy Signal For 2 Stocks And A Yellow Light For 2 Others

Includes: GPS, HD, PHM, TPR
by: Efficient Alpha

Consumer price data is released on Tuesday with expectations for a 0.5% gain on a month-over-month basis. The gain of 0.6% last month was almost completely attributable to the 9% gain in gasoline with the core reading rising just 0.1% for the month. Despite fears of drought-induced inflation and Fed dollar debasing, prices should be fairly subdued for the rest of the year. Global growth and fiscal cliff fears will probably keep other economic data tame and have a moderating affect on inflation.

Momentum in housing could increase with higher prices

There are two sectors that surprised last month and may lead to some good investment themes if data is confirmed this month. Housing jumped 0.3% last month after four months of zero or one-tenth of a percent gains. With housing starts recovering to just over 700,000 annualized against a long-term average closer to 1.4 million to satisfy demographic demand, it seems supply-demand characteristics are quickly turning to the sector's favor. Few doubt the recovery in housing but the rebound over the next year may still surprise to the upside.

PulteGroup (NYSE:PHM) reports earnings on October 25th with expectations for a gain of $0.20 versus a loss of $0.34 in the same quarter last year. The $6 billion homebuilder easily beat expectations in the second quarter with a gain of $0.11 versus expectations of a $0.05 gain in net income per share. The street has been kind to the homebuilders, pushing Pulte up 252% in the last year. While the future looks better, earnings have just begun to rebound and the group is looking expensive even on a forward basis.

If the company meets expectations for the third quarter, trailing price-to-earnings will still be 21.7 times. Earnings still need to rebound more than 50% to get the shares back to their long-run average valuation of 10 times trailing earnings before the bursting of the housing bubble. The company recently launched a campaign with realtor site Zillow (NASDAQ:Z) to give away a $350,000 home. The company is offering an additional sweepstakes entry for those visiting a PulteGroup community.

While shares of Home Depot (NYSE:HD) have shot up 70% over the last twelve months, the stock may be a stronger play on the housing recovery. The company will benefit from both the increase in new home construction as well as the aging of existing supply. Earnings are not reported until November 13th but are expected to increase 17% to $0.70 from $0.60 per share in the same period last year. The trailing price-to-earnings of 21.3 is comparable with its main competitor, Lowes (NYSE:LOW).

The company is extremely well run with an operating margin of 10.1% well above the industry average. The shares pay a dividend yield of 1.95% which is also strong relative to others in the group. CEO Frank Blake threw a little cold water on sentiment last week, telling investors that it could still be two years before a full recovery in housing. Answering questions about the company's recent pullout from China, the CEO said that the focus would be on growing the brand on the internet rather than new geographic markets.

Clothing retailers catch a break

Apparel prices fell a full half percent last month after four months averaging 0.38% gains each month. Another drop in prices this month could mean that retailers are sharing the windfall from lower cotton prices with customers. Cotton prices have plummeted more than 30% from last year's weather-related surge that squeezed the margins of retailers and manufacturers alike. The relief could not come at a better time, as retailers are trying to get consumers back in the shopping mood before the holiday shopping season. Those names with high brand identity may not have to participate in the price cutting and will still benefit from higher traffic.

Shares of The Gap (NYSE:GPS) have doubled over the last year on the hopes that consumers will continue to open their wallets in the face of stagnant real wage growth and high unemployment. Earnings are expected on November 15th with consensus for $0.54 per share versus a gain of $0.38 per share in the same period last year. Despite a strong brand name, valuation looks a little expensive at 20.2 times trailing earnings, well above the five-year average of about 15 times.

The operating margin of 10.3% is about average for the group and a 1.4% dividend yield does not make up for the possibility of overvaluation in the shares. The company recently named Rebekka Bay as its new Creative Director and Head of Global Design. Bay was previously creative director at COS and has over 17 years experience in the industry. The company's share buyback program of $1 billion should help to support the price but investors may want to look for better value.

Coach (COH) may be a better value and should benefit as other retailers cut prices while higher brand identity enables the company to keep prices higher. The company reports earnings on October 27th with expectations for a gain of $0.73 per share against $0.73 in the same period last year. While the company will not benefit from falling cotton prices as much as apparel retailers, the increase in shoppers should boost revenue.

The company's operating margin of 31.7% is above peers in the group while the trailing price-earnings of 15.3 is well under the industry average of 20.5 times. The shares also pay a dividend yield of 2.23%, strong for a retailer. The shares took a hit earlier this year when the company dropped the use of coupons at its outlet stores but sales in china jumped 64% on expanded distribution and the company plans on increasing global square footage 12% in the next year. Even a rebound to just 18 times trailing earnings, still below the five-year average of 20 times, would mean an 18% pop in the share price.

Despite momentum in the housing recovery and cheaper input prices for clothing, investors should not ignore fundamentals like relative valuation and margins. Look for plays in housing that benefit from the increase in construction as well as the aging supply on the market. In retailers, watch quarterly earnings closely for changes in input prices relative to prices on the rack to judge competition among brands. Names like Coach, with strong brand identity and the ability to keep prices higher will be able to increase margins and earnings.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.