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Top Stocks to Buy in Retail

By Leo Sun – Nov 26, 2016 at 12:00PM

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Investors who want to profit from higher consumer spending should take a closer look at American Eagle Outfitters, Wal-Mart, and Dollar Tree.

The retail sector can be an investment minefield due to e-commerce challenges, fickle consumer tastes, and constantly declining price expectations. However, investors can still find solid long-term plays in this sector if they look closely enough. To get started, let's examine three "best in breed" plays in three tough retail industries -- retail apparel stores, superstores, and dollar stores.

Image source: Getty Images.

Retail apparel: American Eagle Outfitters

American Eagle Outfitters (AEO 0.15%), which reports its third quarter earnings on Nov. 30, is a standout player in the brutal retail apparel industry. As rivals like Gap (GPS 1.98%) and Abercrombie & Fitch (ANF 1.67%) were marginalized by fast fashion retailers like H&M and Forever 21, American Eagle kept growing its comparable store sales, expanding its e-commerce abilities, and strategically reducing its brick-and-mortar footprint.

For the third quarter, AE anticipates a "low single digit increase" in comparable sales -- which would easily beat Gap's 3% comps decline and A&F's 6% comps decline in their most recent quarters. Aerie, its lingerie and activewear brand for young women, posted 24% comps growth last quarter, easily outpacing 1% growth at its main AE brand and 3% total comps growth.

Analysts expect AE to respectively grow its revenue and earnings by 4% and 20% this year. The stock currently trades at 15 times earnings, which is much lower than the industry average of 24 for apparel retailers, and it pays a forward dividend yield of 2.7%.

Superstores: Wal-Mart

Under CEO Doug McMillon, Wal-Mart (WMT 0.43%) staged an impressive turnaround over the past two years. Aggressive investments in e-commerce, raises for its employees, better training, and a reorganization of its cluttered stores brought shoppers back, although those initiatives weighed down its near-term earnings growth.

Image source: Wal-Mart.

As a result, Wal-Mart's quarterly revenue has risen annually for three consecutive quarters. Analysts expect the company to post 1% sales growth and a 5% decline in earnings this year, followed by 2% sales growth and 0.5% earnings growth next year.

Those numbers might sound mediocre, but they indicate that Wal-Mart won't be obliterated by Amazon (AMZN 3.10%) anytime soon. Wal-Mart is also fighting back against Amazon with free shipping for members, curbside pickup, expansions of its mobile app and Vudu video platform, and its purchase of e-commerce start-up Wal-Mart currently trades at 15 times earnings, which is much lower than the industry average of 22 for discount and variety stores. It also pays a forward dividend yield of 2.9%.

Dollar stores: Dollar Tree

Amazon is often cited as Wal-Mart's biggest rival, but discount chain Dollar Tree (DLTR 0.20%) is just as dangerous. That's because Dollar Tree opens stores closer to low-income neighborhoods, where shoppers are more sensitive to fuel costs. Its stores have also been expanding their selection of fresh groceries, which increase their appeal as one-stop alternatives to Wal-Mart. Dollar Tree also gobbled up rival Family Dollar last year, making it the biggest dollar store chain in the U.S.

Dollar Tree's comps rose 1.8% annually last quarter, beating analyst expectations as well as Wal-Mart's 1.2% U.S. comps growth last quarter. Analysts expect Dollar Tree's revenues to rise 34% this year (due to the Family Dollar acquisition) and 5% next year. Earnings are expected to improve 32% this year and 18% next year.

Those growth estimates look solid, but the stock's current P/E of 29 is higher than the industry average of 22. The expansion of Wal-Mart's Neighborhood Market stores, which posted 5.2% comps growth last quarter, could also eventually hurt Dollar Tree's growth.

The key takeaways

I believe that American Eagle, Wal-Mart, and Dollar Tree are safer than many retail stocks on the market, but that doesn't necessarily mean that they're ideal investments for all investors.

AE could tumble if its comps growth declines or Aerie sales abruptly peak. Investors could lose patience with Wal-Mart's turnaround plans if higher spending fails to generate decent sales growth. Dollar Tree could tumble on valuation concerns or tougher competition. Therefore, investors should carefully weigh these risks and rewards before buying any of these top retail stocks.

Leo Sun owns shares of and American Eagle Outfitters. The Motley Fool owns shares of and recommends 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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