4 Picks From the Market's Hottest Sector

Ah, Black Friday. Millions of Americans awake before sunup, shrug off the tryptophan hangover, and patriotically dash into the arms, err, aisles, of eager retailers. But while the masses are frantically exercising their right to consume, investors with a penchant for the discretionary sector would do better to first pause and consider.

True, some retailers' stocks look attractive this season. Others, however, likely already reflect any coming good news. And scratch the surface of a third group, and it's a lump of coal to the core.

For my take on the sector, along with some specific recommendations of where (and where not) to hang your portfolio's stocking, grab some leftovers and read on.

Consumer rising?
First, let's consider the overall economic backdrop.

On the positive side, a recent Barron's article observes that U.S. consumer debt is down by about $1 trillion, or 7.4%, from the all-time high of 2008. Also, discretionary spending as a percentage of total spending is scraping along 50-year lows, auguring a rebound. Perhaps most encouraging, consumer-initiated loan inquiries have ticked up in both of the past two quarters, indicating a renewed willingness to spend.

Finally, I'll toss in an item not mentioned by Barron's -- the wealth effect created by QE2. With the market up more than 14% since the end of August, consumers have to be loosening their purse strings, no?

OK, all this sounds cheery, especially when we lay on the National Retail Federation's call for a 2.2% rise in holiday sales. But consumer discretionary has already sprung ahead as the best-performing S&P 500 sector year to date. Has the news really been that strong? And does private equity -- hardly famous for great timing -- know what it's doing, or should the recent buyouts of Gymboree and J. Crew be taken as contrary indicators?

According to an October online poll, households with incomes of $50,000 and above will spend nearly 3% more than in 2009, versus about 1% less for those who aren't as well off. That finding is consistent with bullish forecasts for same-store luxury sales, not to mention a strong historical correlation between stock market returns and high-end retail.

Unfortunately, the market has been onto this trend for a while now. Which means we'll have to look harder to find ways to exploit it without overpaying.

Buy, window shop, or avoid?
First off, if you're looking to play this trend through the big-box retailers, Target (NYSE: TGT  ) clearly outshines Wal-Mart (NYSE: WMT  ) . The former saw same-store sales rise during Q3, versus a decline for behemoth Wal-Mart's U.S. locations. Plus, Target has offered investors a superior Q4 forecast, with comps seen up 2%-4%.

All said, it appears safe to conclude that Target is benefitting from its more affluent customer base. And with solid margins and a forward price-to-earnings ratio of just under 13, there's plenty of room for price appreciation.

Another closely watched area is Internet-based spending -- after all, holiday retail online sales are expected to jump 11% compared to last year. Amazon.com (Nasdaq: AMZN  ) is arguably the most obvious, and the largest, beneficiary, but it's hard to get comfortable with the stock's valuation. Instead, I'd suggest investors take a look at eBay (Nasdaq: EBAY  ) . The company is riding high on the growth of its PayPal unit, and its marketplace revenue could be poised for a turnaround. Plus, the shares sport a much more sober valuation.

Narrowing our retail focus, "affordable luxury" retailer Coach (NYSE: COH  ) and athletic and apparel purveyor Nike (NYSE: NKE  ) both make my list as beneficiaries of a wealthier-consumer spending spree. I've previously touted the merits of both companies, and I believe that long-term fundamentals remain intact.

Problem is, the shares of both have enjoyed a major run in recent months, and now trade at forward multiples north of 17. While not wildly expensive, such valuations could be the worst of both worlds -- little downside protection and limited upside potential.

Instead, investors might consider Macy's (NYSE: M  ) , trading at a forward P/E of 11.5, and lifestyle retailer Guess?, changing hands at a forward multiple of 14.7. Smacked with losses during the Great Recession, Macy's clearly has a lot to prove. But third-quarter comps were up nearly 4%, and after structural changes, 40% of inventory is unique to Macy's, giving consumers a reason to walk in the door. Notably, that bargain-basement P/E allows room for investors to further warm up to shares.

As for Guess?, the company is cash-rich, virtually debt-free, boasts industry-crushing profit margins, and recently beat Q3 analyst forecasts while simultaneously raising its full-year profit estimate. Plus, the company raised its dividend 25% and announced a special payout of $2 a share. How's that for a stuffed stocking?

But one caveat
There's nothing wrong with getting excited about an upturn in certain sectors of seasonal consumer spending, and I've tried to suggest companies that are poised to outperform beyond the holiday rush. But if the stock market tumbles, the affluent consumer could once again join his poorer brethren in the bunker. In other words, make your holiday purchases with all the enthusiasm that gift-giving deserves, but buy your stocks cautiously.

If you'd like more investment ideas, check out our free report, "5 Stocks The Motley Fool Owns – And You Should Too."

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. Wal-Mart is a Motley Fool Inside Value choice. Amazon.com, Coach, eBay, and Nike are Motley Fool Stock Advisor recommendations. Wal-Mart is a Motley Fool Global Gains pick. Motley Fool Options has recommended a bull call spread position on eBay. Motley Fool Options has recommended writing covered calls on Guess?. The Fool owns shares of Coach, Guess?, and Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 26, 2010, at 1:40 PM, seeker113 wrote:

    Find the title of such articles very attractive. But generally feel the treasure is buried in the hay stack. Requires more time and concentration than I generally can afford. Would wish to see said 4 stocks here, 5 elsewhere, etc., clearly listed at start. Sure would direct my attention and help my feeble power of concentration.

    With all due respect!

  • Report this Comment On November 26, 2010, at 2:03 PM, lenny16 wrote:

    seeker113 , i agree

  • Report this Comment On November 26, 2010, at 3:57 PM, liltramp2 wrote:

    I really gotta question buying Macy's. The place is always on sale. I must get at least two glossy mailbox stuffers a week. Who in their right mind ever buys anything from Macy's that is not on sale/ If they're always on sale I gotta ask are they making money even in the sales and just making more money on those few days when there isn't a sale or are they having sales because they're not making money?

  • Report this Comment On November 26, 2010, at 4:11 PM, fiesta0923 wrote:

    I regret not buying macys when it was below $10. They are working with dunnhumby who has done terrific research for tesco and kroger in the past. Don't know what a buy/sell point is for them now though.

  • Report this Comment On November 26, 2010, at 5:13 PM, langco1 wrote:

    it was time to buy retailers two months ago now its time to start selling....

  • Report this Comment On November 26, 2010, at 7:49 PM, Boslie69 wrote:

    I agree with lanqco1.

  • Report this Comment On November 27, 2010, at 12:41 PM, j398112 wrote:

    eBay is going to turn around?? What illegal substance have you been smoking? Ebay is the classic case of killing the golden goose with short-term thinking - it keeps changing and changing its fees and services to squeeze more out of its sellers. So its sellers have been fleeing to Amazon and their own websites - never to return.

    Moreover, Its paypal operation has begun to adopt the same questionable practices. Screwing your customers may make for short-term gains but its not much of a business plan for long-term growth.

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