3 Best Retail Stocks for the Rest of 2014

The retail industry has become increasingly challenging and competitive over the last several years. For this reason, investors looking to make the right investments in the retail sector need to be especially selective in order to position their portfolios in the winning industry players.

Despite the increased competition and extremely different business models, companies such as Amazon (AMZN -2.56%), Costco (COST -0.24%), and Nordstrom (JWN 0.96%) have what it takes to continue thriving and creating shareholder value over the long term.

Amazon is positioned for growth
The online retail revolution is here to stay. According to official statistics, e-commerce sales have been consistently gaining participation as a percentage of retail sales over the last several years. Importantly, online retail still accounts for a relatively small 6.4% of total retail sales, which means it still has enormous room for growth in the years ahead.

US E-Commerce Sales as Percent of Retail Sales data by YCharts.

No company is a bigger beneficiary from the online retail boom than Amazon. The company has built undisputed competitive advantages in the industry through multiple sources such as brand recognition, scale, and a huge distribution network, which would be remarkably hard and expensive to replicate by competition.

Amazon is well-known for its relentless competitive drive and its customer centric approach to the business. Consumers seem to really appreciate the low prices and efficient service Amazon provides, the company has consistently ranked at the top of its industry in the American Customer Satisfaction Index each and every year from 2000 to 2013. Based on the 2013 ranking, Amazon has a customer satisfaction score of 88 versus an industry average of 78.

Source: Amazon.

The company is generating extraordinary sales growth; revenues during the second quarter of 2014 increased 23% to $19.34 billion, while product sales grew 19.6% to $15.25 million. Considering its rock-solid competitive strengths in a promising industry like online retail, investors in Amazon have valid reasons to expect sustained growth from the company in the coming years.

On the other hand, Amazon charges minuscule profit margins on product sales, and the company is heavily investing in multiple areas, so it's losing money at the operating level. Amazon is not planning to cut back on investments for growth anytime soon, so lack of profitability will probably remain a risk for investors in the company over the middle term.

Costco is a unique retailer
Costco is a fairly unique player in the discount retail business. The company makes most of its profits from membership fees as opposed to product sales, which allows Costco to sell its products at amazingly low prices, or sometimes even at a loss. Needless to say, the ability to compete effectively in pricing is a crucial advantage in the industry.

Most discount retailers are heavily criticized for paying low wages and providing poor working conditions for employees. However, Costco has an essentially different corporate culture: The company's average wage of $21 per hour is more than double the industry average, and it provides far better benefits and opportunities for professional development. This has important benefits for Costco in areas such as superior customer service and employee productivity, among other things. 

Source: Costco.

Costco customers are remarkably loyal, which shows consumers are embracing the company's innovative approach to the business. Renewal rates are consistently high, reaching an impressive 87.3% during the last quarter on a global basis, while big markets like the U.S. and Canada were even better, with a renewal rate of 90.6% during the period.

In times when most competitors are having enormous difficulties generating sales growth, Costco announced a healthy increase of 10% in sales during August, reaching $8.8 billion. This shows the company is clearly firing on all cylinders and outperforming the competition.

Nordstrom is in fashion
The ability to offer aggressively low prices is a big advantage for players like Amazon and Costco, however, that's not the only way to compete effectively in the retail business. Nordstrom is doing exceptionally well among department stores on the back of strong merchandising, differentiated customer service, and a smart, multi-channel business strategy.

Source: Nordstrom.

The company has materially outgrown competitors such as Macy's, Dillard's, and J.C. Penney over the last five years. Overall industry demand has been quite weak lately, but Nordstrom is proving its ability to deliver sound performance in a tough environment via market share gains.

Data source: FinViz.

Nordstrom has an impressive customer loyalty program with 4.1 million active members; the company added 370,000 new accounts during the last quarter, a big annual increase of 18%. Interestingly, loyalty members tend to purchase substantially more than other clients: Sales to loyalty members increased 11% in the last quarter, materially higher than the 6.2% increase in total sales during the period.

Direct sales jumped 22% during the last quarter, which shows that Nordstrom is doing a sound job at adapting to a multi-channel industry environment. The company is betting heavily on its Nordstrom Rack format for growth, this seems to be a smart decision considering that sales in this segment grew at a remarkable 18% during the quarter ending on August 2.

Key takeaway
The retail business can be particularly difficult, but it can also be very lucrative for well-run retailers with sustainable competitive advantages. Investors looking to make a smart purchase among retail stocks may want to consider top industry players such as Amazon, Costco, and Nordstrom.