Today's biggest bargain: Retail stocks

By Robert Walberg

Rising fuel prices, higher interest rates and a cooling housing market are finally hitting consumers. Maybe not in how they spend -- yet -- but definitely in how confident they are about the future. The sharp drop in the May Consumer Confidence data proved as much.

Anxiety over consumer spending is the primary reason retailing stocks have stunk over the past month. Those fears were exacerbated by Tuesday’s weaker-than-expected data and by news that Wal-Mart’s same-store sales numbers for May were below plan. Not surprisingly, the company cited the impact of high gas prices on its customer base for the soft numbers.

But as I’ve noted in this column before, betting against the American consumer’s spending appetite is rarely a good idea. Yes, gas prices are above $3 a gallon. However, we are entering the busy summer travel season and the annual anticipation of huge demand often leads to a temporary, but usually unsustainable, spike in gas prices. My guess is that prices are at or very near their high point for the year.

Bargain hunting

Let’s take a moment to remember the good news. Unemployment is low, income levels are on the rise, consumer debt is being repaid at a faster-than-normal pace and more tax cuts are on the way. And even though consumer confidence was below expectations, the reading was still comfortably above 100 and we were coming off the highest reading in several years. A dip in confidence from the prior month was almost a certainty.

Against that backdrop, now is the time for investors to start doing some bargain hunting in retail. The first place to start is with those companies that have seen their stock prices drop sharply from their highs, even while earnings estimate from analysts are on the rise. Four names that top my list are teen apparel king Abercrombie & Fitch (ANF, news, msgs), luxury goods leader Coach (COH, news, msgs), home improvement stalwart Lowes (LOW, news, msgs) and best-of-breed electronics retailer Best Buy (BBY, news, msgs).

These stocks are down an average 18% from their 52-week highs, with most of the declines coming in the last couple of months. However, none of these companies have guided estimates lower (yet) or suggested in any way that they won’t meet analyst estimates for the balance of the year. Is the operating environment tougher than last year? Probably, but the stock-price corrections and continued strong earnings mean now is a good time to start buying.

Deep discounts

Another way to play a turnaround in retail is to look for those stocks that have been hit the hardest. Two quality names in apparel retail that fit this description are Chico's FAS (CHS, news, msgs) and Urban Outfitters (URBN, news, msgs). Battered by merchandising missteps and disappointing sales, Chico’s and Urban Outfitters are down more than 50% from their 52-week highs.

Urban Outfitters is suffering from merchandising miscues and hard-to-beat results from the previous year, but the chain is relatively small with plenty of opportunity for new store openings to fuel double-digit growth. Management has a decent track record of matching merchandise to customer desires, so expect the current problems to be corrected as soon as the company can work off unsold inventory. With the stock trading down sharply, near its 52-week low, long-term investors will want to start bargain hunting. Look for the stock to return to the mid-$20s over the next 12-18 months for a gain of more than 30%.

Chico’s same-store sales numbers are easing off the gaudy levels posted over the past several years. The good news is that its recent stock-price drop more than addresses the changing environment. To help boost sales, the company is aggressively ramping up its highly successful White House/Black Market chain.

Chico’s and Urban Outfitters have delivered industry-beating margins, sales growth and return on equity. Both companies also have ample cash on hand and little to no debt. As fears over higher fuel costs wane and the market begins to shift its focus to the second half of the year -- when retailers tend to benefit from strong seasonals -- look for these two underperformers to stage recovery rallies.

Update

What you hold going into a big market correction is less important than what you hold coming out of it. Given my belief that retail is oversold, I will add all of these names to my StreetPatrol portfolio. I will also add two tech names that have been hit hard during the correction. With valuations more compelling I’ll now add RF Micro Devices (RFMD, news, msgs) and Qualcomm (QCOM, news, msgs). Meanwhile, I’ll close positions in Cardinal Health (CAH, news, msgs), Barr Pharmaceuticals (BRL, news, msgs) and Southwest Airlines (LUV, news, msgs).

At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.