Retail Therapy Drives Stocks

Earlier this year when stocks were collapsing and recession fears ran rampant, one analyst summed up consumers’ reaction to the tumult: “The markets may have decided that the U.S. is headed for recession, but obviously no one told U.S. consumers.”

That was Paul Ashworth, the chief economist at Toronto-based Capital Economics. Ashworth, in speaking to Reuters, was referring to January’s Commerce Department report showing a robust 0.6% gain in core retail sales, a widely followed measure of consumer activity that keeps rising.

We also see consumers holding their own, benefiting from wage hikes, higher employment and housing values, and lower gas prices. That willingness to open wallets despite economic jitters is buoying the consumer discretionary sector, which includes many types of retailers, restaurants and other enterprises offering nonessentials purchased with disposable income.

For Growth Stock Strategist Chief Investment Strategist Linda McDonough, the trend spells opportunity. Her stock screens often turn up intriguing consumer discretionary companies, as most of the sector consistently reports solid results each quarter.

However, picking consumer discretionary stocks comes with a big challenge: uncovering reasonably priced prospects. These stocks have been among investors’ favorites for some time, so valuations are lofty in many cases. In others, the company lacks catalysts—compelling reasons for its stock to go higher, such as promising new products or a dynamic new management team.

But rest assured, we’re ready to pounce as opportunities unfold. Profit Catalyst Alert already recommends two top consumer discretionary stocks, Vera Bradley and Brunswick, which we’ll discuss shortly, and other prime candidates are apt to emerge eventually.

disposable income bar chart

Spotting the Values

As a group, consumer discretionary stocks roughly doubled the past five years, beating the broader market by about 40%. True, they haven’t been the top-performing category lately, as shown by a 4% increase in the one-year period ending April 14, versus a 9.9% gain for the current leader, utilities.

They did trounce the S&P 500’s 0.5% loss during that time, a real coup in the face of mounting predictions of yet another global economic meltdown. When investors are that spooked, they often quickly lose faith in sectors considered highly sensitive to economic weakness like the consumer discretionary sector.

Thanks to a hardy consumer, the sector continues to thrive even as most others fall victim to the earnings recession that began last year. In the first quarter, for example, consumer discretionary sector profits jumped 10%, while earnings declined 9.1% for the S&P 500 overall, FactSet estimates.

Years of strong returns have made consumer discretionary stocks pricey, though, with many sector components now carrying price-to-earnings (P/E) ratios well above their projected growth rates. Retail giant, for example, has a P/E three times growth estimates.

As value-conscious investors, we like the ratio of P/E to growth (known as PEG) to be less than one because it means a stock sells for a discount to growth forecasts. The further below one you go, the greater the discount.

Take luxury items manufacturer Brunswick Corp., a mid cap we added to the Profit Catalyst Alert portfolio in January. Shares of Brunswick, which makes recreational watercraft, commercial-grade fitness equipment and high-end billiards tables, has a PEG ratio of 0.85, indicating a 15% discount to projected growth. And that’s after spiking about 18% since we first recommended it.

Booming profits enable Brunswick to offer a 1.2% dividend yield, a nice bonus considering most mid caps yield little or nothing. Even juicier payouts are possible, though, as Brunswick’s dividend consumes less than a quarter of earnings despite soaring tenfold the past three years.

A 1.5 PEG ratio makes our other consumer discretionary pick, Vera Bradley, more richly valued than we’d prefer. But the premium is reasonable in this case. The well-known designer handbag and accessories supplier boasts powerful catalysts, including improved e-commerce capability and promising launches like this spring’s new additions to the popular Disney Parks handbag line.

Such developments are prompting higher ratings from Wall Street analysts, such as Tennessee-based Wunderlich Securities, which recently upgraded Vera Bradley to buy from hold with a $24 price target. That’s exactly where we see the stock headed, and it suggests nearly 40% gain potential from current prices.

vera bradley photo bike

Hard Proof

We share Paul Ashworth’s enthusiasm about stronger core retail sales. Most investors scrutinize this monthly indicator—a subset of total retail sales that omits certain volatile items such as cars, food services and gasoline—because it’s the best gauge of the economy’s main growth driver, consumer spending.

Although the January increase was later revised down to 0.2%, that’s still impressive considering the widespread pessimism at the time. Newer readings haven’t knocked investors’ socks off, but the numbers attest to consumers’ resilience. These figures show core retail sales climbing 0.1% in February and March. Economists expect small but steady gains for the next couple of years, at least.

Another compelling sign of consumer vitality is the Commerce Department’s March 28 report on personal income and outlays. The report revealed nearly a $24 billion (0.2%) increase in disposable income in February, following a 0.4% rise in January. On an annualized basis, disposable income is on track to nudge past last year’s 3.4% growth and soundly beat 2014’s 2.7% gain.

Consumer outlays are also trending upward this year, following healthy increases during the preceding two years. Plus, the Bureau of Labor Statistics estimates total spending per consumer—averaging nearly $54,000 a year at last check in 2014—will expand at a 2.4% annual rate through 2024. So we expect an ample supply of profitable consumer stocks lasting years.

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