Rising Star Buys: Limited Brands and Wet Seal

This article is part of our Rising Star Portfolios series. Sean is co-manager of the Dada Portfolio.

Retail is back, guys. You can read our full explanation, but here's a quick rundown of the vital facts:

  • Unemployment is still startlingly high -- but even with an underemployment rate of almost 20%, the other 80% of households earns 96% of the wealth anyway.
  • Our debt levels are still alarming, but households have already done a lot of deleveraging in the past couple of years, and now our savings rate has reached at a 12-year high.
  • Low consumer confidence and general pessimism towards the economy have held a lot of spending back, but the stock market is up 61% from the bottom in 2009. That means that people are feeling better about wealth preservation, about their retirement accounts, and about the future in general.

Put all that together, and the picture starts to show American spending power coiled up like a spring. And like the other type of spring (the season, we expect the economy to start sprouting again. However, not everybody comes out of hibernation at the same time. Upper-class consumers will be the first to peek their heads out. We're already seeing hugely positive results out of luxury brands like Coach (NYSE: COH  ) , which reported sales growth of 20% this quarter, and high-end department stores like Nordstrom (NYSE: JWN  ) and Saks (NYSE: SKS  ) , which reported same-store sales of 5.8% and 5.7%, respectively.

But while those are interesting ideas, they're not my favorites. The Dada Portfolio will buy Limited Brands (NYSE: LTD  ) and Wet Seal (Nasdaq: WTSLA  ) . Here's why.

From macro to micro
My macro thesis has a few implications, but I feel strongest about the resurgence of high-end consumption in the short and mid-term. In looking for specific plays, I'm focusing on two major criteria: a) strong brands and b) pricing power. These are really just two faces of the same coin, but we identify them separately, because they represent different angles of thought.

A strong brand is important because the consumers making discretionary purchases are doing so very deliberately. People have been saving up, and they're now ready to splurge on that iPad. But this is a stage of consumer surplus, where people feel like they can buy things they don't necessarily need; not consumer excess, when wallets are kept permanently open. Thus, it's important to pick the brands that people are willing to home in on.

As for pricing power, as an agnostic regarding QE2, its eventual impact, and the ever-present debate over inflation and deflation, I want a company that will do fine no matter which pundit wins the day. Strong pricing power gives us that hedge.

Quite frankly, I would have been happy with the Claymore/Robb Report Global Luxury ETF. It offered low fees and diversified exposure to exactly the kind of names that fit both my criteria: Hermes, LVMH, Tiffany (NYSE: TIF  ) , and so on. High-end jeweler Tiffany alone saw earnings jump 27% this past quarter. But alas, the aptly tickered "ROB" fund shut its doors in September. Still, I think I might have found something even better.

It's sexy time
You may not know Limited Brands, but I'm sure you'd recognize every one of its Victoria's Secret models. Yes, Limited Brands is the company behind the famed lingerie brand and its less provocative counterpart Bath & Body Works. With about 3,000 company-owned retail stores, Limited still manages to bring in a mind-bogglingly high revenue of $789 per square foot of retail space in 2009. For comparison, Abercrombie & Fitch (NYSE: ANF  ) managed only $339 of revenue per square foot in 2009, and at its very best, only $500 in 2007 and 2008. Perhaps even more amazing is Limited Brands' 10% comparable-store sales growth this quarter. Now that's the brand power I'm talking about.

No, really. It's sexy time now
For the past decade, the company's top line has essentially gone nowhere, even as Limited Brands underwent a huge transformation. In 1998, the company actually operated more than 5,600 stores, but brought in almost the same amount of revenue as it did in the past 12 months, a period in which it had just half as many stores. Still, the top-line stagnation has Wall Street skeptical, so Limited commands a trailing free cash flow multiple of only 12. That's much lower than I would expect from such an incredible operation. Why, then, would I expect any change?

How about the fact that Limited Brands had absolutely nothing to do with any international markets until just three years ago. I don't know what cave management's been living in all this time, but the first non-U.S. Victoria's Secret store just opened three months ago, in Edmonton, Canada. With international models from Brazil to Germany to Namibia, it would seem like expanding the Victoria's Secret experience to other countries would be a no-brainer. Fortunately for prospective investors like us, we're walking in at the very unveiling of this gold mine. We will be purchasing $800 worth of shares, representing a 5% holding in the Dada Portfolio.

Bonus!
I'm also going to sneak in a second pick here: Wet Seal.

This one's simple. Trading at a P/E of just 4, and a price-to-tangible book of 1.2, this company's been left for dead. I'm not a particular fan of its eponymous clothing line for teenage girls, but you don't have to love a company to make money off its stock.

Does Wet Seal deserve such a low valuation? Comparable-store sales were down 0.1% this quarter; that's not good, but it's not deathbed-terrible either. Margins and sales per square feet are at the low end, but positive and still chugging along. Most telling, though, is its last-12-months inventory turnover of 7.3 times per year. That's really not bad at all. Abercrombie & Fitch manages only 2.7 times, and trades at a trailing earnings multiple of 34.

With only a $330 million market cap (yet $140 million of cash and no debt), Wet Seal swims under most radars, but it hasn't escaped the notice of some elite small-cap value guys like Royce and Columbia Wanger. The latter investor owns a huge 11% chunk of total shares outstanding. Now you can add Dada to that list with a 3% stake, or -- drumroll, please -- $500 worth of shares. (The fine print should say that this investment represents 3% of our portfolio, not 3% of all Wet Seal's shares outstanding. We do what we can.)

Learn more about Dada
With these two picks, we'll be more than doubling our total invested assets, to $2,300 out of our $17,000 real-money pot. This isn't the last you'll hear of my American consumer thesis, though. There are a couple of other names out there that I'm hungrily staring at, but for one reason or another, they don't seem ripe just yet. Visit our Foolsaurus page here to find out more about the Dada Portfolio, and keep an eye on our Twitter feed, @TMFDada, for updates. And as always, feel free to leave a comment here or hop on our discussion boards if you have any questions and thoughts!

The Dada Portfolio is a part of the Rising Star series of real-money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz.

Sean does not own shares of any of the mentioned companies. Coach is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Coach. 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.


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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 January 16, 2011, at 4:01 AM, itconsultant wrote:

    Hi Sean,

    The P/E for this company is not really 4!.

    If you looked at Q4 earnings release, you will find

    "Net income, including a non-cash tax benefit to reverse a deferred tax valuation allowance of $71.3 million, was $80.8 million, or $0.79 per diluted share, as compared to $4.3 million, or $0.04 per diluted share, in the prior year quarter. Excluding the tax benefit and $0.5 million in asset impairment charges, net income was $10.0 million, or $0.10 per diluted share, in the fourth quarter of fiscal 2009".

    So, really the company earned 23 cents in Fiscal 2009 and not 92 cents. If you then replace the earnings of the three quarters of Fiscal 2010 for 2009, the EPS is 19 cents on a trailing 12 month basis. That gives us a P/E of 20!

    I understand the company has a lot of cash and if you take that out, the P/E would be 12.5. ( Not sure if you can take out all the cash as a lot of it is needed for working capital)

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