Opportunities in Discount Retail: Growth, Quality and Value

There is no such thing as the best stock for everyone. Depending on your own investment strategy, goals and risk tolerance, some companies may be more adequate than others for your portfolio. Here are three discount retailers for investors looking for growth, quality and value.

Amazon for growth
(NASDAQ: AMZN  ) is unquestioningly the most disruptive force in the retail business. The company is willing to operate at razor thin profit margins in order to gain market share versus the competition in different categories, like Jeff Bezos said:

"Your margin is my opportunity."

Amazon has increased sales at an average compounded growth rate of more than 30% over the last 10 years. Excluding the unfavorable impact from foreign exchange, net sales grew 25% in the last quarter compared with second quarter 2012. This is still extraordinary growth for a company of Amazon´s size.

Amazon is all about innovation and growth, the company has been investing heavily in building its warehouses, digital content and cloud computing among other areas, and this is taking its toll on profit margins, which have now become negative.

If you are looking for a company with superior growth prospects, an innovative culture, strong competitive drive and a visionary CEO, then Amazon is the way to go.

On the other hand, this kind of growth doesn't come cheap: Amazon is trading at a price to sales ratio above 2.1 while traditional discount retailers like Costco (NASDAQ: COST  ) and Wal-Mart (NYSE: WMT  ) carry ratios in the area of 0.5

Costco for quality
Costco´s competitive strategy is smart and effective: the company makes most of its profits from membership fees while selling its products at zero profit or even at a loss. This generates amazing advantages when it comes to cost competitiveness, which is especially valuable in items like food and fuel.

Costco puts lower prices above variety when it comes to building inventory, and this is another differentiating factor versus the competition. Judging by the membership renewal rates above 85%, customers are quite happy with this business model and the benefits of shopping at Costco.

Costco strives to keep its costs as low as possible on different items, but there is one remarkable exception: salaries and employee benefits. Management understands that attracting the best talent can have fantastic benefits over the long term, even if it means having to spend more than the competition in certain areas like salaries and benefits. 

This kind thinking separates Costco from competitors like Wal-Mart, and it's producing big rewards for shareholders. Happy customers and happy employees mean happy investors as earnings per share increased by 18.2% in the last quarter on the back of a 7% increase in same-store sales excluding the impact of changes in gasoline prices.

As of the last quarter Costco owned 627 warehouses, 449 of them in the United States. The company has plenty of room for expansion in the middle term, especially considering strong customer satisfaction and same-store sales performance.

Amazon is not in a very comfortable position to compete against Costco in areas like fuel and groceries, but the online retailer has been rapidly growing its Amazon Prime program and it now reportedly has more than 10 million members. Investors in Costco may want to keep an eye on the competitive dynamic versus Amazon, just in case the online retailer starts hurting Costco like it has done to many other retailers.

Wal-Mart for value
Wal-Mart is up by less than 3% in the last year, materially lagging competitors like Amazon and Costco which have risen by 20% and 22% respectively over the same period. The good news for Wal-Mart investors is that the stock is quite cheap at current levels.

Looking at P/E and dividend yield from a historical perspective, Wal-Mart is trading at attractive valuation ratios with a P/E of 14.5 and a dividend yield of 2.5%. The same goes for a comparison versus Costco, which trades at P/E ratio of 25.5 and yields 1% in dividends.

On the other hand, Wal-Mart versus Costco is not an apples-to-apples comparison as the two companies have different business models and financial performance has been quite dissimilar lately. Wal-Mart reported disappointing results for the last quarter, and it reduced its guidance for sales growth for the rest of the year to between 2% and 3% versus a previous forecast for a 5% to 6% increase.

Management blamed poor economic conditions for the weak results, but a toughening competitive landscape is definitively a considerable risk to watch when it comes to Wal-Mart. Besides, the company has relied on low workforce expenses for a long time, but that strategy may be getting exhausted as Wal-Mart is facing raising labor costs to adequately compete in a challenging environment.

Wal-Mart is still a sound company with considerable scale advantages, and it has been able to stand the test of time: the company has raised its dividends for 39 consecutive years, including an 18% increase for 2013.

Investors looking for a contrarian play on a solid company trading at attractive valuations may want to consider buying some Wal-Mart stock from the bargain bin.

Bottom line
The discount retail sector is offering alternatives for different kinds of investors. Amazon is the disruptive growth play in the sector, Costco offers outstanding quality due to its smart business model and strong financial performance and Wal-Mart is the way to go if you want to bet against the herd and buy at discounted prices.


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