Investors' 10 retail stocking stuffers

By Michael Brush

The next time you're out shopping for holiday gift deals, stop and take a look around.

You may be standing right inside one of the biggest bargains on Wall Street.

Retailers selling products from flat-screen TVs to housewares and teen fashion to skimpy underwear have been hammered by investors frightened that an economic slowdown and high gasoline prices will take a big bite out of consumer spending.

But if you're among those hunting for a hard-to-find Wii game console, you may have already figured out that you aren't the only one ready to open your wallet this holiday season. If you think this suggests better profits down the road for the right retailers and bounces in their stocks, you're probably right.

"Consumer-related stocks were the first to get hit, and we believe they will be among the first to come out of it," says Dennis Bryan, an analyst at First Pacific Advisors, which has recently been buying a few retail names. (We'll get to those in a moment.) "Once investor perception changes, it is like a spring, and you get that snap back."

Priced for a recession

Credit Suisse Group (CS, news, msgs) analyst Omar Saad calculates that retail stocks have fallen so hard because investors are pricing in a 70% chance of recession, which is "considerably higher than the risk embedded in the stocks of most other industries."

If I'm right that people are too gloomy on the outlook for the economy, these retail stocks will come roaring back once it becomes apparent that the overly depressive types got it wrong.

That's because retail stocks are "high beta," a fancy Wall Street term that means they have a habit of coming back stronger than most stocks when sentiment improves, just as they recently fell harder than the overall market when investors turned sour.

Saad and his colleague Paul Lejuez at Credit Suisse think the way to get the biggest bang for your buck is to buy the higher-beta retailers that have been crushed the hardest. They should see the biggest snap back. They include these retailers on their shopping lists: Polo Ralph Lauren (RL, news, msgs), Under Armour (UA, news, msgs), Phillips-Van Heusen (PVH, news, msgs), Lululemon Athletica (LULU, news, msgs) and Coach (COH, news, msgs).

For long-term positions, I'd go with so-called value names that have gotten nailed by a double whammy: the negative sentiment toward retail stocks in general and some company-specific problems. Such problems can be fixed.

With that in mind, here's my holiday guide to five retailers going for bargain prices right now. These retailers should bounce back and reward you handsomely if you give them some time.

Circuit City's comeback

As any good holiday bargain hunter knows, the best time to score a deal is when a product is on the shelves in the deep-discount section because nobody else wants to buy it. That's not case with the flat-panel TV or game console you might want to put under the tree this Christmas. But it sure applies to one of the consumer-electronics giants where you might be buying them: Circuit City Stores (CC, news, msgs).

Investors seem to think Circuit City has already lost the battle against Best Buy (BBY, news, msgs) and that it's only a matter of time before it disappears. That's why they've knocked shares of Circuit City down to $7.90 recently from $30, where it traded in 2006.

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But I'd buy Circuit City now for a double or a triple over the next three years. I think that's a likely outcome in part because Circuit City was recently on the "buy" list of Robert Rodriguez of First Pacific Advisors, who has a knack for knowing when to buy troubled retailers. He's suggested two or three of them for my column that then went on to triple or more.

What's going to make Circuit City come back? It slipped because prior management failed to reinvest well in the business. But now under new management, the consumer-electronics giant is in "major turnaround" mode, says First Pacific Advisors analyst Bryan.

Circuit City is now headed by Philip Schoonover, who worked for a decade at Best Buy, so he might be able to put in place some of the Best Buy magic. He's taking steps such as modernizing Circuit City's supply chain and deploying work-force-management systems to make better use of employee time and improve customer service.

The changes have been disruptive, so the chain has suffered. But Bryan thinks that when the dust settles, Circuit City should be able to lift operating profit margins to 3% from recent levels of 1%. That may not sound like much, but on the $14 billion or so in sales Circuit City should have a few years from now, it works out to $1.70 per share in earnings. Put a typical retail-sector price-earnings ratio of 14 on that and you have a stock that could trade in the low- to mid-$20 range in a few years.

Meanwhile, you have a good margin of safety with this stock because Circuit City has $2 a share in cash and little debt.

Continued: More retail leaders to consider

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