May 1, 2012
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Retailers for contrarian investors

May 1, 2012

Analysts on Wall Street are starting to look at the second half of the year, and they don't like what they see.

High gasoline prices, uncertainty over national elections in the United States and Europe, and the so-called "fiscal cliff" in the U.S. of higher taxes and steep cuts in government spending scheduled for the end of the year have some analysts lowering their estimates for the year. A round of economic data released Monday suggested consumers are cutting back their own spending, adding to broader concerns.

The upside for stocks is limited going forward, said Barry Knapp, chief market strategist at Barclays Capital, in a note to clients.

Yet contrarian investors are viewing this as a good time to move into retail stocks, especially those of companies like Amazon.com, which are building their margins despite higher transportation and expansion costs. These companies are taking steps to become more profitable now, a strategy that should pay off when consumers once again decide to spend freely, analysts said.

Here are suggestions on ways to make a targeted bet on retail:


Even with a lofty price-to-earnings valuation Amazon may still prove to be a solid long-term bet, analysts said. That's because the Seattle-based retailer is reinvesting profits in the business and expanding at a time when competitors are slashing costs.

"We continue to believe Amazon is taking significant share across the retail landscape and should be a core growth holding for patient investors," said Matt Nemer, an analyst at Wells Fargo who covers the company.

Amazon's head count is up 73 percent over the last 12 months, Nemer noted. Yet its gross margins gained 1.1 percent over the same time, a statistic that suggests the company is growing more profitable with time.

Andrew McNellis, an analyst at Evercore Partners, cited Amazon's higher gross margins when he raised his target price for the company's shares to $260. Shares of Amazon traded at $232 on Monday afternoon.

Amazon's strong year-to-date performance may make some investors want to consider holding the company through a fund or ETF instead, analysts said. That way, investors could benefit from additional gains in the stock while providing some cushion should it stall.

Amazon was up 31 percent since the start of the year through Friday, compared with a 11.5 percent gain for the broad Standard & Poor's 500 index. The company trades at a steep valuation: its price-to-earnings ratio of 186 dwarfs the S&P 500's P/E of roughly 14.

Amazon, at about 3 percent of assets, is the second-largest holding of the $129 billion American Funds Growth Fund of America, a relatively low-priced actively managed fund. Apple is its largest position, with 6 percent of assets.

The fund, which charges 68 cents per $100 invested and yields 0.7 percent, is up 14.7 percent this year. Over the last 10 years, it has beaten the S&P 500 index by an annualized 1 percent.


Companies that target middle-income shoppers may be a strong bet for investors who have a time horizon of more than a year, analysts said.

In large part, that would be a shift from how companies have traded over the past three years. Since the recession ended in 2009, companies that cater either to affluent shoppers, like Tiffany & Co., or cost-conscious shoppers, like Dollar Tree, have outperformed the broad sector. Tiffany, for instance, is up 304 percent since March 9, 2009, when the bear market bottomed.

But now could be the time that department stores and retailers like Target that focus on middle-income shoppers could push ahead. Early gains in the jobs market this year and easing of fears that the U.S. economy could be headed for another recession should boost incomes and allow middle-market consumers to trade back up to brand names and higher priced goods, said Stuart Nussbaum at WeiserMazars, a New York-based advisory firm.

Department stores are taking steps to improve their customer service as well, he noted, which could help them compete against Internet retailers.

Brian Peery, a portfolio manager with Hennessy Funds, has increased his weighting in consumer discretionary stocks in the six funds that he runs. Among his picks: Limited Brands, Gap and Target. Limited Brands, for instance, operates stores like Victoria's Secret and Bath & Body Works that are typically found in malls in the U.S. and Canada. The company's shares are up 24 percent since the start of the year as of Friday's close and trade at a P/E of 18.7.

Stores that target U.S. shoppers have another thing going for them: they tend to carry cheaper valuations than higher-end apparel makers, which are increasingly relying on sales in emerging markets for growth. Gap, for instance, trades at a P/E of nearly 19. Ralph Lauren, by comparison, trades at a P/E of 25. Coach, a company whose handbags and belts are popular in China, trades at a P/E of 22. It is up 21 percent since the start of the year.

"It's a great time to look at these (middle market) retailers with your eye on how they're going to do next year, not the next quarter," Peery said. (Reporting By David Randall; Editing by Walden Siew and Steve Orlofsky)

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