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Don't bet against retail stocks
The bears are growling about a grim outlook for the retail sector, but they're wrong. Here are the reasons retailers will come back.
By Michael Brush
This column was updated on Oct. 6, 2005 with changes to Michael Brush's list of recommended stocks. The changes appear at the end of the column.
Worried that high fuel costs and an economic slowdown will force consumers to shut their wallets, investors have turned sour on retail stocks.
Since late July, stocks of retailers like Home Depot (HD, news, msgs) and Abercrombie & Fitch (ANF, news, msgs) have lost 14% or more. The Retail HOLDRs Trust (RTH, news, msgs), an exchange-traded fund representing many of the big retailers, has gone down 10%.
A lot of investors think these stocks are poised for even bigger declines. Amazon.com (AMZN, news, msgs), Netflix (NFLX, news, msgs) and Home Depot now have larger short interest -- a measure of how much money is betting against the stocks -- than anyone has seen in a long time.
Here are three myths leading retailing bears astray:
Myth 1: Energy costs will kill consumer spending
Everyone knows about higher prices at the pump. But consumers are about to get hit with massive home heating bills as well, thanks to record-high oil and natural gas prices. Together, warn the worriers, the two will take a big bite out of the family budget and curb consumer spending.
Not so fast. Though consumers feel a lot pain at the pump, the reality is many of them actually spend relatively little on energy. If hurricane damage to refineries creates shortages that add another 10% to our energy bills, well still be spending just 6.1% of our disposable income on energy, up from 4.9% a year ago.
Yes, higher energy costs will hit some industries hard, like the airlines. And lower-income consumers get hit harder. So they will cut back on discretionary spending -- bad for the low-end retailers. But higher-end consumers are going to weather this quite well, predicts Ed Yardeni, an economist and market strategist with Oak Associates.
Yardeni thinks economic growth and consumer spending will slow to 2% for the next six months. But growth will return to current levels of around 3% to 4% in the second quarter of 2006, in part because oil prices will stabilize at lower levels, he says. Since the stock market anticipates events about six months in advance, it shouldnt be long until retail stocks pick up to reflect the 2006 bounce back in the economy, if Yardeni is right.
Related news and commentary on MSN Money
A look at our collective family budget shows why consumers might be resilient. Household net worth -- even without real-estate prices factored in -- is at record highs, says James Paulsen, chief investment strategist at Wells Capital Management.
Unemployment is low, at 4.9%. And wages, salaries and benefits are up 6%, adjusted for inflation compared to a year ago -- one of the best growth rates in the last 30 years. Thats key, says Ed Keon, director of quantitative research with Prudential Financial.
Yes, the consumer confidence index fell sharply in September, according to the Conference Board. But it looks like the hurricane-inspired confidence freefall may be temporary. By the end of September, consumer confidence was already coming back, according to Rasmussen Reports, though not to pre-hurricane levels.
Since 1967, when consumer confidence slipped but income rose, consumer spending kept climbing 90% of the time, he says.
Myth 2: Storm-repair spending will spawn inflation
To be sure, inflation was coming back even before politicians started spending to clean up the mess caused by Katrina and Rita. But the key thing to remember is that inflation is still relatively modest.
For inflation to increase so much that the Fed has to raise rates enough to hurt growth, well first have to have another year or two of decent economic expansion. That kind of growth would actually help consumer spending and retail stocks in the interim. To get there, you have to have some good times. It will take a lot of job growth and income growth, says Paulsen. The aftermath could be one or two years from now.
Even though the Fed has hiked short-term rates 11 times, lifting the federal funds rate to 3.75%, that only returns short-term rates to levels normally seen at the bottom of a recession, says Paulsen.
Myth 3: The short-sellers reflect the market's mood
Short-selling occurs when an investor borrows a company's shares and sells them, hoping to buy them back later at a lower price. Lately, the retailers have seen a lot of that activity.
This might actually be a bullish sign for the sector, however. Some of the most successful investors welcome opportunities to bet against the crowd, because they think that once a lot of people have figured out a theme, its a sign that theme is played out.
And when heavily shorted stocks start moving up, the shorts get scared and buy back shares to cover their positions -- fueling rallies. The more shorts there are to buy back, the more potential fuel, says Phil Erlanger, a former Fidelity Investments technical analyst who now offers investing advice at Erlangersqueezeplay.com.
What will turn retail tide?
For Erlangers dynamic to play out, however, heavily shorted stocks have to move up. Many, like Netflix and Amazon.com, already are advancing, striking fear among short sellers. What might turn the trend for the laggards, such as Home Depot and Abercrombie?
Two things. First, investors will begin to realize that consumers arent as bad off as a lot of people think. Second, Erlanger points out that many retail stocks are about to enter their seasonally strong part of the year -- October to February.
To find the retail stocks that might advance the most, I turned to Erlanger for the most heavily shorted retail stocks. From that list, I culled the stocks that either have decent long-term fundamentals or good insider buying -- two signs of potential strength ahead.
Here are the results.
More than just a retailer
Short sellers have ganged up on Amazon.com, reasoning that it's just a retailer and doesn't deserve a valuation higher than others in that group. The problem for the shorts is that Amazon.com continues to generate 26% sales growth. That is two or three times greater than the typical brick-and-mortar retailer.
Besides, Amazon.com is keeping a grip on market share, despite increasing competition. It also has exposure to high-growth areas of Internet retailing like online search, with subsidiary A9.com, and China's e-commerce space, through Joyo.com, says Robert Peck of Bear Stearns. Amazon.com stock has moved sharply against the shorts in the past few weeks, but there may be more short pain ahead. Thats because November is typically the strongest month for the stock, says Erlanger. October is usually solid, as well.
Netflix shares crashed in 2004 as competitors copied the companys mail-based DVD rental business. Since May, the stock has begun to recover -- in part because those competitors either gave up or ceased cutthroat pricing.
As the stock has climbed, shorts have returned. Theyre hoping for a 2004 redux. But it looks like they may be disappointed. Analysts, including Bear Stearns R. Glen Reid, have upgraded the stock because the company's earnings and subscriber growth showed strength. Netflix recently increased its 2006 earnings projection and predicted its subscriber base would grow to five million next year, from three million this year.
Teen-oriented clothing retailers Abercrombie & Fitch and Urban Outfitters (URBN, news, msgs) were hit hard by sellers from early August. Both have started to turn around, but shorts still have big positions. If these stocks build on their recoveries through the holidays, short covering could fuel a bigger snap back.
Abercrombies inventory buildup -- one concern of investors -- may actually be a good thing, because the chain has stocked up on supplies in popular lines where it typically runs short, says A.G. Edwards & Sons analyst Robert Buchanan. He has an eighteen-month price target of $71 on the stock.
Urban Outfitters said in the second week of September that sales were significantly above expectations -- a good sign because many retailers had a weak back-to-school season. Whats more, this chain has plenty of room to add new stores, one reason Deutsche Bank Securities has a $63 price target on the stock.
Safe at home
When the housing bubble goes pop, so will Home Depot and Lowe's Companies (LOW, news, msgs). That's the view of short sellers, who have big positions in both home fix-it retailers.
But the shorts may be in for a nasty surprise. Home Depot and Lowes are about to enter their seasonally strong months. That phase starts in the second week of October, says Erlanger.
Neither company thinks higher gas prices or interest rates will hurt business much. Lowes recently confirmed guidance for the year ahead, and Home Depot raised earnings estimates. Both chains serve consumers who make enough money to shoulder higher gas prices. And both are seeing healthy growth from new lines of business such as selling to professional contractors and performing lucrative home improvement work.
Shop with the insiders
Investors have similar housing-market meltdown fears about Restoration Hardware (RSTO, news, msgs), which sells upscale home dcor, and about Linens'n Things (LIN, news, msgs), a home-accessories store.
Anyone with a short position in Linens'n Things is playing with fire. True, the company just announced it would miss earnings estimates because of a lackluster late-summer sales. But management also confirmed rumors that it is open to a buyout -- which might tack $3.50 onto recent levels of $26.50, says Fulcrum Global Partners analyst Stacey Widlitz.
Restoration Hardware has fallen 30% since July. But the company still has more gains ahead from an ongoing turnaround. Down here, the stock looks cheap with a price-earnings ratio about half its projected growth rate. Insiders at both these retailers recently bought shares.
Insiders also bought shares recently at Sharper Image (SHRP, news, msgs), a chain that sells an array of clever gadgets. The insider buying may be a sign of a reversal in weak sales which have driven the stock lower for the past year.
Sharper Image has been cutting costs. It is launching new products like an exclusive iPod play called ZipConnect, which allows people to charge up their music players while listening to them. Sharper Image also has a new Ionic Breeze air purifier said to remove ozone. At $12.60 a share, the stock trades near book value of $12, and the company has $3 per share in cash, offering some protection against further downside.
Stock picks
Im making a few changes in my Expert Picks portfolio as of Oct. 6 to take some profits. Im covering my short positions in Zimmer Holdings (ZMH, news, msgs), Biomet (BMET, news, msgs) with a gain of more than 20% on each. Ill also close my short of Stryker (SYK, news, msgs) with a solid gain. Ill add a long position in Chesapeake Energy (CHK, news, msgs), which I wrote about in "3 energy companies the insiders are buying."
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