Michael Brush

Company Focus10/31/2008 12:01 AM ET

Cash in on the Grinch economy

For retailers, this year's Christmas season could be the worst in nearly 2 decades. But investors can still find ways to win with retail stocks. Here's how.

By Michael Brush

Here's a new charge to level at Wall Street and the big banks whose woes are plaguing the economy this year: Grinch.

With commodity prices tumbling, Santa will get a break this Christmas on the cost of reindeer upkeep. He'll be flying with a lighter sleigh because a lot of his "helpers" -- moms and dads -- are feeling broke and worrying about their jobs.

A few must-have toys will still find their way under Christmas trees. But overall, it'll be a season for less giving.

"The Grinch is going to strangle Christmas this year. He's got it by the neck," predicts Mark Zandi, the chief economist at Moody's Economy.com. "It's going to be the worst Christmas since Christmas 1991."

The somber forecasts by Zandi and other experts have already brought down retail and consumer stocks. But those declines could be gifts for investors who find those that buck the trend. Apple (AAPL, news, msgs) seems to have no trouble selling iPhones, for example. And people with costly video-game players will still want the latest adventures, so GameStop (GME, news, msgs) should do well.

Discount retailers such as Wal-Mart Stores (WMT, news, msgs) and Costco Wholesale (COST, news, msgs) may benefit as shoppers hunt even harder for the lowest prices on everything from socks to stereos. And financially sound retailers like Bed Bath & Beyond (BBBY, news, msgs), Staples (SPLS, news, msgs) and Dick's Sporting Goods (DKS, news, msgs) may win in the long run as they steal business from weaker competitors.

Any of these names could defy the Grinch and bring cheer to your investment portfolio.

Pain in time for Christmas

Most retailers are going to have a hard time as consumers get hit from three sides.

First, we're now seeing job cuts across all sectors. Companies as diverse as PepsiCo (PEP, news, msgs), Merck (MRK, news, msgs) and Yahoo (YHOO, news, msgs) have announced big layoffs to trim expenses. Zandi predicts the U.S. economy will lose 200,000 to 250,000 jobs a month for the next few months, after shedding 750,000 jobs this year as of early October. In contrast, a healthy economy creates 125,000 jobs or more a month.

Goldman Sachs (GS, news, msgs) economist Andrew Tilton expects unemployment to rise to 8% by the end of the year, up from 6.1% in September. The unemployed have less money to spend on gifts, of course. But there's a second sneaky effect: Higher unemployment also puts downward pressure on the salaries and wages of people who still have jobs.

Second, even people who are working feel a lot poorer because of massive declines in stock holdings, retirement plans and college funds. "People still might have the same income, but they see the news on the stock market, and they don't go out, they rein things in," says Tim Ghriskey of Solaris Asset Management.

Finally, home values are down sharply, foreclosures are up, and lenders are tightening credit standards to play it safe as delinquencies rise.

"This credit crisis has hammered the economy, and the American consumer is getting devastated," says Robert Rodriguez of First Pacific Advisors. "We are looking at a terrible Christmas and a terrible fourth quarter, and it is going to go into next year. We still have a long ways to go through this credit crisis."

Here's the upshot of all this: University of Michigan consumer-confidence measures fell by the biggest amount in September since the university began tracking shoppers in 1978.

Christmas sales will actually shrink this year, after adjusting for inflation, for the first time since 1991, Zandi predicts.

Forget big-ticket items

Remember those Christmas ads in which a car is wrapped with a big red bow in the driveway as a present? Consumers often make big purchases at this time of year, but not so much this year.

Tighter credit means cars, motorcycles, RVs, flat-screen TVs and other high-dollar items will be off-limits for many consumers, says Citigroup (C, news, msgs) analyst Kimberly Greenberger. Gone are the easy home-equity loans that often helped pay for these items. Car loans are harder to get. Credit card limits are getting tighter.

Greenberger thinks the trend will extend well into 2009, when she predicts real consumer spending (after inflation) will drop 2%, the first annual decline since 1980.

That's bad news for companies exposed to this trend, such as General Motors (GM, news, msgs), Harley-Davidson (HOG, news, msgs), Sony (SNE, news, msgs) and even Best Buy (BBY, news, msgs), which plans to cut seasonal hiring by as much as 10,000 workers.

Strong product trends

One way for investors to play the weak consumer environment is to go with retailers whose stocks have been bashed but still stand out because of powerful demand.

Take Apple, for example. While retail sales slumped overall during much of the third quarter, Apple posted a 27% increase in revenue to $7.9 billion, thanks to record shipments of 6.9 million iPhones -- a number that blew away expectations.

Apple's true success was hidden by accounting rules that forced the company to artificially move a lot of revenue into the future. Ignore those accounting adjustments, and Apple actually took in $11.68 billion, or 48% more than reported sales.

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Apple's iPhone is so popular, only 15 months after the phone was introduced, that it beat the ubiquitous BlackBerry for sales in the third quarter. Apple is now the third-largest mobile phone supplier, measured by revenue.

"If this isn't stunning, I don't know what is," CEO Steve Jobs boasted during the company's conference call to discuss its third-quarter earnings.

Apple also has nearly $25 billion in the bank and zero debt -- which means it can afford to keep developing new products. During in the last economic downturn, it created the iPod.

Still, Apple's stock is down more than 50% from highs earlier this year, and the company has forecast weaker-than-expected revenue of $9 billion to $10 billion in the next quarter. That's probably just Jobs being conservative. If recent trends are a guide, sales of iPhones and iPods will be strong this holiday season.

Continued: Virtual escapes

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