A Tale of Two Retailers

In my unrelenting search for Profit Catalyst Alert candidates I look at a slew of stocks. In the course of just one week I typically review over one hundred names. I take extensive notes on each one and keep long lists of those that didn’t make the cut, detailing my rationale for discarding them.

Obviously I’m not creating a model or analyzing all the financials for every single of those hundred plus names. Many simply have market caps that fall way outside of my acceptable boundaries (typically between $300 million and $3 billion) or are not profitable. Those are easy to reject. 

Yet there are many in between that look promising, such as when a new event sends revenue and profits moving in the right direction, growth looks robust, and the balance sheet is unencumbered by excessive debt. I get pretty excited when I see a name that seems to have good potential for a Profit Catalyst Alert stock. Typically it is a too high valuation that keeps these “good” stocks off my list

These lists offer a mosaic of clues to investor mood and industry trends. Biotech stocks, for example, regularly fall on the unusual volume list. Almost every one of them is unprofitable (an immediate cut from the PCA list) but eager investors are searching for the next Editas Medicine or Avexis, biotech stocks up 70% and 54% respectively year to date. Obviously investors are still willing take on risky bets, despite the recent market volatility.

These lists tip me off to industry trends that I may have missed otherwise. While I always look for stocks that excel based on unique circumstances, it is critical that I am aware of trends influencing the stock’s industry. If the housing market is in shambles, it’s tougher for a home builder to excel despite the existence of a persuasive catalyst. An industry headwind is not enough to cross a stock candidate off my list; however the valuation must be low enough to offer some protection.

My most recent discard list, for example, had a preponderance of nicely-growing but too-expensive retailers. Urban Outfitters, Children’s Place, Shoe Carnival, Five Below, Francesca’s and Steve Madden all glared up from the trash heap daring me to find an explanation to why investors are willing to pay such a high price for them.

Retailers Flying High

The concentration of so many retail stocks on the too-expensive list was too much to be a coincidence. What was the reason these stocks were bid up so much? Was it simply that the consumer has come rebounding back from the dead, wallet wide open? If so, don’t tell Restoration Hardware or Williams-Sonoma, whose stocks suffered 28% and 10%, respectively, on weak sales numbers.

So perhaps it was that consumers feel confident enough to spend on Urban Outfitter sweaters and boots from Shoe Carnival but not brave enough to spend $400 on a leather chair.

But that argument doesn’t square either. Many furniture retailers are reporting really terrific numbers. La Z Boy, Bassett Furniture and Ethan Allen all noted a recent uptick in revenue. Home Depot and Lowes reported substantial sales gains despite operating in a mature retail category.

Economics Matter …

I believe two trends are at work here.  Yes, the consumer is feeling more confident. Retail sales numbers issued by the government show improvement and many retailers are enjoying a small bump in demand.

While the bulk of improvements seen in Profit Catalyst Pick Vera Bradley are due to the introduction of new more sophisticated styles, the company surely has benefited from happier consumers.

 The catalyst I identified for each one of the retail stocks that I passed on was not distinct enough to drive dramatic and sustainable profit growth. This does not mean that these stocks will not grow earnings but rather that much of the growth is due to factors out of their control.

This is an important distinction for Profit Catalyst Alert stocks. Because profit improvements are due to company specific changes, these companies should be less vulnerable to economic swings.

… But Earnings Trends Matter More

The second and perhaps more critical influence on the direction and degree of stock movement is whether earnings estimates are increasing or dropping. Estimates for Restoration Hardware and Williams-Sonoma were cut dramatically over the past 90 days. The salt in the wound for investors was both companies missing previously lowered numbers. There is no mercy for a stock that confounds disappointment with another earnings’ miss.

All of the retail names on my too expensive list showcase rising estimates. And while this is a perfectly acceptable reason to buy a stock, the high valuations tied to these names make me very nervous. Without a robust identifiable catalyst, many of those estimates rely on a continuation of positive economic trends.

My goal at Profit Catalyst Alert is to find stocks that have enough stamina from new catalysts to sustain them during an economic or industry specific downturn. Of course find a stock enjoying a spark to earnings and an industry tailwind is the best of both worlds. I’ll let you know immediately when I find my next pick.

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