Big-Box Retail Can Fit Any Portfolio

When it comes to retailers, it's tough to find safety, income, and growth potential all in the same place. The exception to this rule is in the big-box retailers Wal-Mart (NYSE: WMT  ) , Target (NYSE: TGT  ) , and Costco (NASDAQ: COST  ) , all three of which are very different investments from one another.

Wal-Mart is probably the safest and best income play of the three, while Costco arguably has the most compelling future growth potential, and Target is a very nice combination of the two. Let's examine these three companies, see how they compare as long-term investments, and which may be the best for your investment goals.

Safety
All these characteristics matter differently to investors at different stages of their own growth cycles. For instance, younger investors tend to have a much greater risk tolerance and are willing to ride out more volatility in exchange for higher potential returns. Older investors, who generally prefer to avoid extreme fluctuations, tend to focus on protecting principal and creating a steady, reliable income stream. 

Now, when I say "safety," I'm not referring to the risk of a company going out of business or producing a devastating loss for its shareholders. All three of the companies mentioned are well beyond that point. Safety, in this case, refers to a low volatility, consistent profitability, and the likelihood of steady, predictable future growth.

An excellent measure of stability in an investment is its historic volatility, which measures the percentage by which a stock will deviate from its average price in an average month. For instance, a stock with 20% volatility whose average price is $50 would be expected to stay between $40 and $60 in a given month.

Wal-Mart has a historic volatility of 13.1%, compared with 15.9% for Target, and 17.2% for Costco, which is why I said above that Wal-Mart is the most stable. However, none of these are particularly volatile compared with other popular retail stocks. For example, the very popular (but specialized) retailer Coach has historic volatility of 30.2%.  Now, let's see how these big-box retailers compare in terms of creating income for shareholders, and which has the best growth potential going forward.

Income and growth potential
Wal-Mart pays a good but not great dividend yield of about 2.4%. However, more important to investors is what the yield could grow to in the future. Over the past decade, Wal-Mart has increased its dividend from $0.52 to $1.88, which translates to an average of more than 15% each year!

I don't know about you, but if I were approaching retirement and worried about my investments keeping up with inflation and a higher cost of living, a 15% annual raise would sound pretty good to me. Now, this is by no means guaranteed, but a company's past behavior with its dividend seems to be a very good predictor of how it will pay out in the future.

While Wal-Mart has some potential to grow (overseas, in particular), it is the closest to full maturity of any of the companies here. Wal-Mart is already America's No. 1 grocer, and there is a Wal-Mart store in virtually every town in the U.S. that could financially justify its presence.

Target pays a slightly higher dividend of 2.6%, and has also increased its payout significantly over the past few years. Until recently, Target has not paid out much of its income, so calculating its average annual increase doesn't make a whole lot of sense.

However, Target's current payout ratio is around 30% of its profits, which has increased from 13% a decade ago, and indicates a couple of things. First, Target has been transitioning from a growth stock to a value stock. Second, a 30% payout ratio leaves a lot of room to increase the payout in the future.

Target does have some growing to do, especially in Canada, where the company has been aggressively expanding. In fact, the company expects to open about 125 new stores in Canada this year, to complement the 1,800 or so that are in the U.S.

Costco is the company that has the most potential to grow, and the 1% dividend yield indicates that it intends to invest more of its profits into growing its business in the hopes of having more to distribute to shareholders down the road. The company operates 634 of its warehouse-type stores, which is by far the smallest total here. Costco also has about 37 million paying members, a revenue stream that the other two don't have. 

Last year, Costco announced that it intends to expand more aggressively than it had been in recent years, with the goal of opening 27 to 30 new stores annually, up from an average of about 16 over the past few years. As of the most recent quarter, the company was on track to beat that goal for 2013.

It is worth mentioning, however, that although Costco still has tremendous potential to grow, it also has the most to lose if things don't go well. Shares currently trade for a very high valuation of 27 times earnings, so if growth slows abruptly, the stock price has a lot of downside.

So, which is best for you?
The company that makes the best fit for your portfolio depends on several factors such as risk tolerance, time frame, and income expectations. As a buy-and-holder with no pressing need for current income, I lean toward Costco in this space, as I think it has the potential to be just as big as Wal-Mart, and the growth currently priced into the shares is very reasonable. If you need income, either of the other two would work, as you'll likely see their dividends rise for years to come.

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