2 Overvalued Retail Stocks to Avoid

Retail is not a defensive sector. In the event of another global slowdown, retailers are likely to suffer and severely underperform the market, because of their sensitivity to consumer spending. And with a dreadfully slow recovery, the entire European continent in crisis, and fears swirling about subdued growth in Asia, another recession is a real possibility. Given the current international dynamic, high valuations, and uncertain outlooks, here are two handpicked retail stocks that look like especially risky investments.

Good company, bad investment
Amazon.com
(Nasdaq: AMZN  ) is synonymous with e-commerce, and it's certainly not going anywhere anytime soon. Unfortunately, while Amazon stock has performed tremendously of late, past performance doesn't guarantee future results, and a great company is not necessarily a great stock.

Amazon is certainly a great company. It has fundamentally changed the way people shop, leveraging the magic of the Internet to make shopping easy, quick, and even informative. Its virtual marketplace is changing the way e-commerce itself is conducted.

But Amazon also trades for around 180 times earnings and has substantially lower margins than much of its competition. For context, the average industry multiple is 41 times earnings (which is itself a high number). Granted, as the Fool's Alex Planes notes, this is part of the corporate strategy to squeeze out the competition. Still, Amazon couldn't approach the margins of, say, a Michael Kors (NYSE: KORS  ) , which sports a net margin of 11.3% to Amazon's 1.1%, even if it wanted to. Margins may head even lower as states go after sales taxes, which, because of Amazon's virtual structure, are collected in only five states. But seven more states will begin collecting taxes by 2016, and more are sure to follow.

High valuations and low margins are bad omens for investors, no matter how innovative a company is or how far the economy has come.

Bad company, worse investment 
Of course, that's not to say Amazon has struggled -- in fact, it's been absolutely dominant! It has already forced big-box bookseller Borders into bankruptcy. It remains a serious threat to the future of Barnes & Noble (NYSE: BKS  ) , a company that's arguably still alive only because it scrambled to enter the e-reader market with the Nook. Amazon's innovation has competitors playing catch-up; even big-box retailers outside the bookstore business, such as Best Buy (NYSE: BBY  ) , are being threatened. Recently, Best Buy's founder and former chairman of the board, who still controls 20% of the enterprise, is rumored to have been orchestrating an attempt to take the floundering company private.

That said, Best Buy is trying desperately to cut costs. It recently announced 2,400 layoffs, on top of the 50 store closings it said it was going to institute earlier this year. But that may not be enough.

As Fool writer Anders Bylund notes, competition may prove to be the ultimate obstacle. Top- and bottom-line growth at Best Buy have both markedly decelerated in recent years. This is not coincidental; Best Buy has been called the "showroom for Amazon," meaning that customers will come to Best Buy to look at products and then subsequently purchase them through Amazon more cheaply. On top of the formidable Amazon, Target and Costco are also moving more heavily into the electronics market. In short, unless your style involves taking large, pointless investment risks for no reason, Best Buy is best avoided.

Retail is not only subject to cyclicality; fads, styles, and competition can arise from nowhere, as Best Buy well knows. That's not to say there aren't some attractive growth possibilities in the sector. We just want to make sure we consider companies that don't suffer from eroding competitive advantage and insane valuations, like Amazon. The stumbling growth and dozens of store closings exhibited by Best Buy are also no-nos. We can do better than that!

For an examination of some more promising companies that don't have absurd multiples or crumbling fundamentals, check out our free report "3 American Companies Set to Dominate the World."

I believe Amazon.com is one of the most overvalued publicly traded companies in the market today, which is why I've rated it an "underperform" on my CAPS page and have it as one of my three Top Picks.

Fool contributor John Divine owns none of the stocks mentioned in the story above, in this universe or any other. You can follow him on Twitter, @divinebizkid, and on Motley Fool CAPS, @TMFDivine. The Motley Fool owns shares of Amazon.com and Best Buy. Motley Fool newsletter services have recommended buying shares of Amazon.com. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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