Dividend.com’s Cheatsheet to Finding the Best Retail Stocks

Retail stocks span a variety of sectors, covering everything from traditional brick-and-mortar shops to online catalogs, which makes this one of the most diverse families in the equity market. Because of this wide reach, the retail industry can be challenging to analyze for both beginners and seasoned professionals.

Economic and nonfinancial factors that affect the retail industry (a topic that we cover in-depth later on), including interest rates and fashion trends, have vastly different impacts on the different sub-industries; for example, discount stores and grocery chains have fairly inelastic demand for their products compared to jewelry and electronics stores, which means that the former group might be good at weathering recessions but the latter will outperform when recovery takes root.

Knowing the various factors impacting the retail industry is only half the battle, being aware of each sub-sector’s nuances is challenging, but equally important.

The retail industry spans far and wide, and as such, the simplest way to go about grasping its scope is to look at the products for sale. Retail companies sell products that fall into one of these three broad categories:

The industry can further be categorized into the following sub-categories:

Durable Goods – Also known as “hard goods,” these products have an expected lifespan of over three years and can be found in electronics and appliances, sporting goods, and furniture stores.

Consumables – Also know as “soft goods,” these products have an expected lifespan of less than three years and can be found in clothing and apparel stores.

Food Products – These everyday products can be found in grocery chains, supermarkets, warehouses, and specialty stores. For the most part, this category is often lumped in with Consumables.

Department Stores – This includes companies that offer a diverse lineup of both “hard” and “soft” goods for sale, such as Wal-Mart (WMT ) and Target (TGT ).

Discount Stores – This includes companies that also offer a diverse product lineup, but are more focused on lower-priced goods such as Family Dollar Stores (FDO) and Ross Stores (ROST ).

Demographic – This includes companies that target a particular consumer segment, for example luxury retailers like Coach (COH) and Tiffany & Co. (TIF ) focus on wealthy individuals.

Ecommerce – This includes companies that specialize in online distribution and deliver products to the customer’s doorstep such as Amazon.com and eBay.

To find the top retailers in each of these categories, check out the National Retail Federation’s Database.

Dividend investors can utilize retail stocks in a number of ways; however, it is important to first recognize the varying degrees of cyclicality that companies in this industry tend to exhibit. Consider the table below, which compares the most popular investment factors of the retail industry, as represented by the S&P Retail Select Industry Index, relative to that of the broad stock market, as represented by the S&P 500 Index.

Retailers that are focused on durable and luxury goods tend to struggle during recessions and bear markets since households and corporations will generally cut down on discretionary spending. Likewise, when economic prosperity returns, companies in the “discretionary” space will surge as improving confidence among consumers and businesses bolsters retail spending.

Retailers that are focused on everyday consumables and food goods tend to be relatively stable during recessions and bear markets since households and business still need to consume staple goods, including everything from toothpaste to toilet paper to groceries. Likewise, when economic prosperity returns, companies in the “staples” space will tend to lag behind those in the “discretionary” space because improving conditions prompt consumers and businesses to start spending more on durable and luxury goods.

Consider the cumulative returns of two ETFs below, which represent these two families of retailers: the broad retail industry is represented by the State Street SPDR S&P Retail ETF (XRT) while the consumer staples industry is represented by the State Street Consumer Staples Select Sector SPDR (XLP).

The varying degree of cyclicality in the retail industry is showcased quite clearly in the graph above. Notice how XRT, which includes more discretionary companies, took a steeper dive in 2008 compared to XLP, which includes staple companies, as economic conditions worsened and broad equity markets sank. Looking ahead to 2011 and beyond, notice how XRT has had a commanding lead over XLP, showcasing the fact that improving economic conditions bolster consumer spending for discretionary goods more so than staples.

The takeaway here is that not all retail stocks move in tandem throughout the progression of the economic cycle. While it may seem like a nuance at first, this phenomenon is actually quite practical for more active investors. Why? Because investors have an opportunity to focus on different sub-sectors within the retail industry depending on where we are in the economic cycle. In other words, there is likely a sub-sector that may be flourishing when others are struggling at any given point in time.

The U.S. Census Bureau releases the Retail Sales Report usually around the 13th of every month, recapping the prior month’s sales. This report tracks the dollar value of all merchandise sold within the retail industry by sampling companies of all sizes across a slew of categories. This data is released only two weeks after the month it covers ends, making it one of the more timely economic indicators that investors on Wall Street keep a close watch on. This report contains two main components:

1. Total Sales – This is reflected in both dollar amounts and as percent (%) change from the prior month.
2. Ex-Autos – Because motor vehicle sales are disproportionately large compared to other consumer goods covered in this report, the final monthly figure excluding auto sales is also reported.

The graph above illustrates how auto sales account for a big chunk of the monthly sales figure, which is why many investors will prefer to analyze the ex-auto sales figure instead of the total one. If retail sales are growing, investors can interpret this as a sign that consumers feel confident about the current and near-term state of the economy. If retail sales are growing, but at a slowing pace, investors can interpret this as a sign that consumers are gradually becoming more worried about the economy. Given these somewhat predictive powers of the retail sales report, many consider this release to be a “leading” economic indicator, meaning that it signals changes in the economy before the GDP report would actually reflect them. In other words, retail sales data may be interpreted as a “preview” of coming changes in economic activity.

One of the drawbacks of the retail sales report is that it accounts only for physical merchandise, which means that retail services are not captured in this figure. Another drawback is the inherent volatility of this monthly sales data, which can make spotting trends and reversals quite difficult at times. In an effort to make such analysis easier, investors can download the data and break it down by sub-sector to focus in on a particular corner of the industry as opposed to only looking at the aggregate.

The graph above illustrates how the various sub-sectors included in the retail sales report can at times exhibit very different trends. In the example above, notice how Grocery sales continue to steadily increase given the largely inelastic demand for these sorts of goods. Also, take note of the cyclicality of Clothing Stores compared to Building Materials; the latter group’s sales have been growing at a much slower pace largely because consumers are less comfortable with making big-ticket item purchases in times of economic uncertainty.

When taking a deep dive into any industry it generally helps to start with a top-down approach so you get a clearer “Big Picture” perspective before starting to compare company-specific metrics. Specifically, when it comes to analyzing the retail industry, it’s good practice to start by examining the biggest macroeconomic trends at hand.

The following set of indicators is useful for gauging longer-term macroeconomic trends and is helpful to identify where we currently are in the business cycle. We want to know where we are in the business cycle so we can take advantage of the retail sub-sectors that are historically best adept at performing well during a particular phase.

GDP: Gross domestic product is easily one of the most followed and important indicators because it is an aggregate measure of total economic production. Furthermore, because the GDP report covers personal consumption, government purchases, corporate profits, and the foreign trade balance, this indicator sheds a lot light on the overall investment landscape. Seeing as how GDP encompasses all economic production, it shouldn’t come as a surprise that retail sales are closely correlated with this indicator. Consider the graph below, which showcases the quarterly percent changes of GDP and retail sales, both of which have been adjusted for inflation:

First, notice how highly correlated these two indicators are, as evidenced by their tendency to closely follow the trajectory of one another. Second, and more importantly, notice how retail sales are inherently more volatile, which emphasizes the cyclical nature of this industry.

Investors cannot get any stock-specific insights from monitoring GDP, but it will help them form a more educated opinion on the current state of the economy. If GDP growth appears to be slowing or even turning negative, investors may wish to consider adding exposure to defensive retail stocks, including grocery and discount stores, and decreasing exposure to cyclical ones, including automotive and jewelry stores.

Interest Rates: The interest rate cycle is inherently tied to the economic cycle as both the availability and affordability of credit play a major role in driving business investments as well as personal consumption expenditures. If financing for major purchases is becoming difficult to procure, or interest rates are rising, investors can expect for consumer discretionary spending to decline.

Employment: The health of the consumer is synonymous with the health of the labor market; after all, consumers are likely to spend more if the job market looks promising and they feel confident about their household’s finances. When unemployment is high, investors can expect for discretionary retailers focusing on durable and luxury goods to perform worse than those focused on consumer staples like everyday household goods and food.

CPI: The Consumer Price Index is the benchmark indicator for tracking inflation. Keeping an eye on CPI likely won’t help you pick the next winning retail stock, but it will give you a better sense of when potential interest rate policy changes may come since the Federal Reserve tracks this inflation indicator very closely. The CPI report is also quite detailed and offers insights about the rate of inflation across an array of expenditure categories, which could be useful when analyzing certain retail sub-sectors.

Personal Consumption: The Personal Income and Outlays Report measures how much consumers are bringing home and how much they are spending on goods and services. The disposable personal income figure is one of the more important components in this report because it looks to measure the amount of money that households actually have left for discretionary spending after savings and paying income taxes. If disposable income is rising, investors can expect for consumers to grow their expenditures overall and likely spend more at higher-end retailers or on durable goods.

Consumer Confidence: The monthly Consumer Confidence Survey is a valuable indicator to keep an eye on because it measures the sentiment of the consumer by reaching out to average households. Investors look to this indicator because it provides a fairly realistic view of how everyday consumers actually feel about the economy, which gives insights into their spending habits. If consumer confidence is rising while the economy is still lagging, investors may consider this as a signpost for improving retail sales on the horizon.

The sheer variety of companies that fall under the retail sector umbrella makes it harder to analyze them with a standardized approach because each of the various sub-industries has its own set of nuances to keep track of. Nonetheless, there are certain fundamental metrics that investors should keep a close eye on, which have inherent value when it comes to offering insights to aid the retail stock selection process.

Same-Store Sales: This metric measures how one particular store, or a group of locations, have performed on a period-to-period basis. Also referred to as “S.S.S” or “comps,” the same-store sales figure compares the revenues earned over a certain time period, generally one quarter or a year, with the same period in the past. For example, first quarter 2013 same-store sales compares the revenues earned this quarter to the revenues earned during the first quarter in 2012; as such, this statistic is applicable to stores that have been open for at least one year. A growing same-store sales figure is generally a healthy indicator that the company is managing to improve the profitability of its existing locations.

It’s important to look at this metric because it gives better insights into how a company is growing its revenues. Same-store sales allows investors to gauge what portion of new sales are coming from growth at existing locations compared to the opening of new locations. By analyzing this figure closely, investors can get a better idea of whether or not a particular retailer is really growing “organically” by improving operations at existing locations or if they are merely expanding the number of new locations.

Sales per Square Foot: This metric measures the average revenue generated for every square foot of retail space. This figure essentially represents the average amount of sales that a retailer gets for every square foot of space it occupies. Investors can gain valuable insights into the company’s management by analyzing this figure and comparing it to that of its peers.

By looking at sales per square foot, investors can see how efficiently the management team is utilizing the available space. For example, if Store A and Store B are in the same sub-sector and Store A has higher sales per square foot, investors can extrapolate that Store A’s management team is doing a better job of marketing and driving sales than Store B’s management.

Gross Margin: This metric measures just how much gross profit a company retains for every dollar of revenue that it generates. The higher the gross margin, the more a company makes on each sale. For example, a 25% gross margin means that the company retains $0.25 from every $1 it gets in sales. Gross margin is calculated by dividing the profit, which is revenues minus cost of goods sold, by the same revenues figure.

The level of gross margin can vary quite a bit across sub-sectors in the retail industry, so it’s important for investors to analyze trends rather than attempt to make direct comparisons of gross margin figures. A declining gross margin is generally considered a warning sign to investors since it suggests deteriorating profitability; however, when looking deeper into the numbers, it becomes apparent that this isn’t always the case.

Gross margin can decline for a number of reasons. First and foremost, a drop in sales will be reflected in a declining gross margin. Second, an increase in cost of goods sold can also lead to a decline in gross margin; this is often the case when businesses transition from “growth stocks” to “value stocks,” and as such, their expansion results in more sales along with a higher cost of doing business.

Inventory Turnover: This metric measures how many times a retailer is able to sell and replace its inventory over a certain period. The figure is calculated from dividing the cost of goods sold by the average inventory; the result is a ratio that represents the number of times per period that a company is able to sell and “turnover” its entire inventory. Because some retailers focus on durable goods and others on consumables, the inherent difference across the lifespan of these products means investors need to compare this ratio against relevant sub-sector averages and peers.

A low inventory turnover ratio suggests that sales are slumping and/or excess inventory is building up. A high inventory turnover ratio is not necessarily healthy, however, as it suggests inefficient purchases on management’s part and a potential loss of sales due to shortages. As a general rule, retailers that sell consumables should have a higher turnover ratio than retailers who sell durable goods.

• http://www.stores.org/
• http://www.trefis.com/
• http://estimize.com/
• http://blog.nrf.com/
• http://blogs.forrester.com/category/retail
• http://www.interbrand.com/en/best-global-brands/
• http://www.rankingthebrands.com
• http://brandirectory.com/

As this guide highlights, the retail industry spans a variety of sub-sectors, each of which has a particular set of nuances. In addition, investors must always be aware of economic and nonfinancial factors that affect these retail companies. As always, we encourage investors to do their research to find the best retail stock.