Retail stocks usually don't generate explosive returns like high-growth tech stocks, but they're often more volatile than conservative consumer staples plays. Retailers' fortunes change on a dime because of economic headwinds or abrupt shifts in consumer tastes and spending. Fierce competition can also quickly commoditize niche markets.
Those challenges often scare investors away from retail stocks. However, I still believe retail stocks are smart investments for many investors for four simple reasons.
1. They outperform the overall market
Past performance doesn't guarantee future returns, but we should note that the retail sector has a solid track record of beating the S&P 500. Here's how the Dow Jones U.S. Retail Index has fared against the S&P 500 over the past 10 years.
During that period, the Dow Jones U.S. Financial Index advanced just 60% because of the financial meltdown in 2009 and the resulting low-interest rate environment. The Dow Jones U.S. Oil and Gas Index fell about 9% because of unstable oil prices, while the Technology Index grew just over 80%.
2. Investing in what you know
Legendary investor Peter Lynch championed the idea of "investing in what you know" instead of fancy financial, tech, or energy stocks that you personally knew nothing about. Retailers are easily accessible, because investors can simply visit their stores.
A trip to the mall a few years ago would have revealed that anchor department stores JCPenney (JCPN.Q) and Sears (SHLDQ) weren't attracting as many customers as higher-end players like Dillard's (DDS -4.33%). Over the past five years, shares of JCPenney and Sears have respectively fallen over 70% and 80%, while shares of Dillard's have risen 7%. You might also have noticed that big-box retailers like Best Buy (BBY -1.91%) were becoming big showrooms for Amazon (AMZN -1.40%) -- which would have been an indicator to sell the former and buy the latter.
Studying how these businesses are faring by visiting their stores can help you make informed decisions about their stocks. However, Lynch also warned that investors had to back up these observations with solid research.
3. The biggest retailers are great defensive plays
When investors flee to safety, they often buy utility, telecom, or big consumer staples stocks with generous dividends. However, retailers like Wal-Mart (WMT -2.33%) have massive moats that are fairly resistant to recessions.
Wal-Mart's scale enables it to generate profits on thin margins while smaller retailers struggle to match its prices. Its forward yield of 2.7% should also satisfy conservative investors who prefer income-generating stocks.
4. They're easy to analyze
Retail stocks are fairly easy to analyze. As long as a retailer's comparable-store sales, gross margin, and sales-per-square foot all rise while inventory is declining, its top- and bottom-line growth should remain on track. E-commerce sales should also be rising, enabling retailers to gradually shutter brick-and-mortar stores to boost their margins.
Problems are also easy to spot. For example, if a retailer's total revenue growth is outpacing its comps growth, that means it's opening new stores to prop up its top-line growth. If sales in those new locations don't pick up after a year, the retailer will be left with a lot of underperforming stores that will weigh down its future comps growth.
If comps are rising but margins are falling, it indicates the company is trying to boost store traffic with big discounts -- which could cheapen its brand appeal if it's a high-end retailer. If comps and margins are falling as inventory is rising, it means nothing is luring customers back to the stores -- which is exactly what happened to teen apparel retailer Aeropostale before it filed for bankruptcy earlier this year.
The key takeaway
The retail sector is a huge one, and it consists of many sub-industries and niche markets. However, I believe investors can find a lot of decent investment opportunities in the sector by simply walking around a mall or shopping center. That hands-on advantage, in my opinion, gives everyday investors an edge they couldn't likely obtain with companies in many other industries.