In order to find businesses to buy, investors can think more like consumers. Think about the places where you shop, for example, to come up with valuable stock ideas.
Perhaps two companies that might immediately come to mind are Costco (COST +1.26%) and Home Depot (HD +3.63%). Which of these top retail stocks should be in your portfolio?
The case for Costco
NASDAQ: COST
Key Data Points
Costco is the world's third-biggest retailer, with fiscal 2023 net sales of $238 billion. The company's 876 warehouses sell a wide range of high-quality merchandise at extremely low prices. That has created a compelling shopping environment for consumers looking to find value.
But what allows Costco to stand out, and what has helped make it a winning investment historically, is the company's unique business model. Not just anyone can shop at a Costco location. You need to pay an annual fee to become a member, and there are now 73 million households with memberships.
This membership-business model has some benefits for Costco. For starters, it generates a high-margin, recurring, and predictable revenue stream. In the fiscal 2024 second quarter (ended Feb. 18), the renewal rate was 92.9% in the U.S. and Canada, showcasing how well this model resonates with consumers.
Another benefit is that memberships drive customer loyalty. People will be more inclined to shop at a Costco because they pay membership fees to do so.
This system has given Costco tremendous competitive strength in the form of scale advantages. The business buys items in bulk from its suppliers, who have no choice but to sell their products to Costco on favorable terms to the retailer. This results in lower prices for shoppers, a setup that continues as Costco's revenue keeps rising.
The case for Home Depot
NYSE: HD
Key Data Points
Home Depot is the leader in the home improvement industry, with fiscal 2023 sales of $153 billion. This puts it well ahead of its smaller rival, Lowe's, which generated revenue of $86 billion last fiscal year.
While these seem like big sums of money, investors will find it encouraging that the industry is truly massive, estimated to be worth about $1 trillion. This gives Home Depot a small, 15% market share. The result is that there should be steady and consistent revenue gains over the very long term, particularly as Home Depot leans on its broad-inventory availability and omnichannel capabilities to better serve customers.
Yes, it's fair to say that Home Depot is struggling right now. Demand was strong during the depths of the pandemic. But things have cooled in the higher-rate and inflationary environment, one characterized by macro uncertainty. After same-store sales fell 3.2% in fiscal 2023, management believes this metric will drop 1% in the current fiscal year.
That might not be what investors want to hear. But the positive perspective comes from understanding that Home Depot benefits from some strong industry tailwinds. The median age of a home in the U.S. is about 40, a figure that has trended higher over time. Moreover, there is a housing shortage. Both of these factors should help drive renovation activity well into the future.
Final thoughts about valuation
Both Costco and Home Depot have solid investment merits. But the question posed earlier was to pick a single business that should be in your portfolio. I think the answer depends on one variable.
Based purely on quality, I think Costco wins. But if we consider valuation, it's a totally different story.
As of this writing, the warehouse club operator's shares trade at a price-to-earnings (P/E) ratio of 47.9. Costco shares have rarely been more expensive since the turn of the century more than two decades ago. That leaves no margin of safety for prospective shareholders.
Home Depot sells for a P/E multiple of 22.2. That's about in line with its trailing-10-year average valuation. I think over the next five years, the home improvement chain will be a better stock to own than Costco.
