Are Retail Stocks a Bargain or a Bust?

Has a weakened U.S. consumer created a buying opportunity in retail and discretionary consumer stocks, or should investors run screaming for the exits? In this article, we've asked two Morningstar equity analysts who specialize in consumer products to debate the issue and offer up a few stocks that they consider bargains in the current environment.

The Bear Case, by Matthew Reilly
Why Consumer Spending Is in a Downturn
I think the U.S. consumer is in trouble, and the full extent of potential trouble has not been priced into the stocks of many American retailers and discretionary consumer product manufacturers. Many ripple effects from problems in the housing and mortgage markets have not yet filtered through to many consumers' spending habits, but I think we will soon see these become a factor.

The so-called "wealth effect" could have an impact, since two formerly rock-solid sources of asset appreciation have stalled--housing prices and the stock market. With both thrown into turmoil recently--for what seems to be an indeterminate period of time--I think consumers will likely act less wealthy when they shop. This might make a second plasma television at Best Buy (NYSE: - ) or Circuit City (NYSE: - ), an eighth Coach (NYSE: - ) handbag, or a new set of Craftsman power tools from Sears (NasdaqGS: - ) a resistable temptation that not too long ago would have been thrown into the shopping cart.

Many homeowners with adjustable rate mortgages are also seeing their rates increase, a factor that Estee Lauder (NYSE: - ) recently indicated would pressure spending on their products in the coming quarters. Management also indicated that this would likely lead to a weak holiday season. We have seen many signs of weakness lately in the cosmetic world (an area that a man would certainly call discretionary), as companies such as Physician's Formula (NasdaqGS: - ) and Bare Escentuals (NasdaqGS: - ) have reported both disappointing results and shaky outlooks over the past few weeks.

Another huge challenge for retailers in the current consumer spending environment is the lofty levels to which they must compare their results over the next couple of years. The American consumer has seemingly defied gravity, spending through everything from the Iraq War to Hurricane Katrina. One big reason for this is strong employment levels, which is often cited as a main reason that the good times for retailers should continue.

I would argue, however, that we should look at employment using concepts developed by retailers. We are currently at what many would call full employment, even in excess of what at one time was considered full employment. It is extremely difficult for me to imagine that we will see this number improve in the near future, given the enormous weakness in the housing and homebuilding markets, along with mortgage turmoil and a general slowdown in the financial sector. In other words, the levels of employment in previous years have created very difficult comparisons for this year and years to come.

That is why I don't see this as a good time to dive into stocks that are dependent on strong consumer spending, especially discretionary items. The tough housing market will no longer allow homeowners to use their equity as a cash machine, and food inflation seems to be accelerating, driven in part by the ethanol boom. And there is always the cost of oil, which has undergone sharp increases over the past few years and faces an uncertain future. Though it is next to impossible to pick a bottom for stocks, I think it is possible to see a downturn in cyclical industries and avoid or underweight an at-risk sector.

A Few Safe-Havens
Where would I recommend looking to invest instead? I think that companies selling consumer staples with strong international footprints are a good idea, as they provide both a defensive bent and upside potential. The defensive bent comes from the recession-resistant nature of the products these companies make: spirits in the case of Diageo (NYSE: - ), confectionary at Cadbury Schweppes (NYSE: - ), chips and drinks at PepsiCo (NYSE: - ), and soup and food products from Campbell Soup (NYSE: - ), as well as a vast array of consumer products from Procter & Gamble (NYSE: - ). These are good stocks for uncertain times and are also good long-term investments, given the secular growth trends we see in a number of foreign markets.

Most specialty retailers and discretionary consumer manufacturers should be relatively underweighted in portfolios until there is at least some brighter news concerning the American consumer on the horizon. Specifically, I would look for the first signs of recovery in the domestic housing market, coupled with stability in the broader stock market. That may be a shrewd way to avoid what may be lingering downside.

The Bull Case, by Kimberly Picciola
Why Pessimism Has Created Bargains
I believe the fallout from the housing market has caused investors to become overly fearful regarding the fate of the American consumer. I concede there is more uncertainty today surrounding the consumers ability to spend on discretionary items than there has been in the recent past, and certain segments of the population and sectors within the retail industry are feeling the pain from macroeconomic pressures. However, I think much of the pessimism regarding the consumer has been priced into the market, and there are several quality retail stocks with attractive valuations.

Since personal consumption accounts for more than two thirds of the American economy, the level of scrutiny the consumer has received in recent months is no surprise. The subprime market has imploded, adjustable rate mortgages continue to reset, and credit markets have tightened, causing angst that spending on discretionary items may dry up. Despite the doom and gloom, defaults on subprime mortgages remain in the low-single digits. Additionally, I estimate that around a mid-single-digit percentage of American households will be affected by their first mortgage reset in 2008. I think the impact on consumer spending will be limited; about two thirds of these loans are subprime borrowers, which I believe are not the heaviest of spenders. While the consumer living paycheck to paycheck is likely feeling pinched by recent events, the lowest 40% of wage earners make up just 20% of total consumer spending, according to a 2005 consumer expenditure survey by the U.S. Department of Labor.

I would argue that the market is too focused on only a small piece of the consumer pie and is underestimating two bright spots favoring American consumption: a low unemployment rate and solid income growth. The unemployment rate continues to be at a historic low, standing at 4.6% as of July 2007. This is significantly lower than the roughly 7% unemployment rate Americans faced at the time of the consumer-led recession in the early 1990s. I believe strong employment has been a key reason why consumer spending has remained healthy over the past few years, despite macroeconomic pressures beyond housing, such as high gas prices and rising interest rates, which weigh on shoppers' wallets.

In addition to a steady job market, income growth has outpaced consumption, which supports American's spending habits. Real disposable personal income increased by 3.4% in the first two quarters of 2007 over the third and fourth quarters of 2006, while consumption only went up by 2.9% over the same period, according to the U.S. Bureau of Economic Analysis.

Despite these bullish signals, investors have punished retail stocks. The retail index is down nearly 7% so far this year, compared with the S&P 500, which is up 1.5% over the same period. Additionally, when looking at a forward price to earnings ratio for a number of our quality retail stocks, it appears there is already downside risk reflected in current stock prices. The average 12-month forward P/E for Home Depot (NYSE: - ), Lowe's (NYSE: - ), and Sears is around 13. This is below the S&P 500, which trades at roughly 15 times projected forward earnings and is also lower than the average P/E for Diageo, Procter & Gamble, Campbell Soup, PepsiCo, and Cadbury Schweppes at around 18. For long-term investors, I think there are a number of quality retail stocks trading at a discount to what their businesses are intrinsically worth.

Where to Look For the Biggest Bargains
So which stocks would I buy? I would start with the two largest home improvement retailers: Lowes and Home Depot. Both have been directly affected by the decline in the housing market and expect the weakness to continue into 2008. Even after assuming weak sales for the two retailers in 2008 and only a modest increase in 2009, I believe the market is overly down-and-out on these stocks and that both would be great long-term holdings. Other quality retail names that I believe are solid long-term investments include Bed Bath and Beyond (NasdaqGS: - ), Best Buy, Darden (NYSE: - ) and Sears Holdings.

I think the markets have overreacted to recent events, particularly in the retail sector, and the fallout in the subprime market will only affect a small percentage of Americans. In my opinion, this is an opportunity to buy some quality retail stocks on sale.