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Investing in Retail Stocks

Updated: Feb. 16, 2021, 12:21 p.m.

Many investors buy retail stocks because they afford opportunities to own parts of the businesses where they as customers shop every day. But just because you like shopping at a particular store doesn't mean it's a good portfolio investment.

The COVID-19 pandemic is complicating the retail stock picture further. Many retail stores were forced to close or modify their operations while stay-at-home orders were in place. E-commerce boomed, unsurprisingly, as customers avoided actual stores; demand for some products also plunged. Wide availability of COVID-19 vaccines is right around the corner, which should eventually make consumers more comfortable with visiting stores again. It all adds up to a complicated landscape for retail stock investors.

Below, we'll highlight some of the top retail stocks and tell you what you need to know about investing in retail companies. You'll also learn how to decide which retail stocks to buy.

Top retail stocks

There are hundreds of publicly traded retailers, but a few have risen to the top of the industry. Among these are:

  • (NASDAQ:AMZN): The preeminent e-commerce retailer Amazon got its start selling books but now operates a marketplace that enables the online buying and selling of nearly everything. Amazon's purchase of Whole Foods Market also gives it a ready-made network of brick-and-mortar stores to further engage customers. Amazon stock is positioned to perform well as consumers accelerate their shift to online retail.
  • Home Depot (NYSE:HD): The home-improvement retailer is known best for its large-format warehouse stores and extensive inventories. Serving both do-it-yourself homeowners and professional contractors, Home Depot's growth rates in both sales and earnings are consistently strong, and it has built out a substantial e-commerce presence while largely holding would-be competitors at bay. Home Depot is benefitting from growing demand driven by increased consumer interest in DIY projects during the pandemic, but a prolonged recession or downturn in the housing market could hinder the company’s performance.
  • lululemon athletica (NASDAQ:LULU): A pioneer in athletic clothing, lululemon initially focused on making apparel for yoga practitioners. The company has gradually begun courting a wider set of customers who want to stay fit and dress comfortably. lululemon’s sales and profits slumped when the company temporarily closed stores amid the pandemic, but its direct-to-consumer business has been growing rapidly. Over the long term, more people working from home could lead to more swapping of business casual attire for more comfortable clothes.
  • Ulta Beauty (NASDAQ:ULTA): Tapping into the trend of offering experiences to lure shoppers into stores, Ulta offers in-store salon treatments to its customers. The concept has taken off, and its stores were attracting plenty of customers before the pandemic struck. The company's sales have been severely impacted by stay-at-home orders, and may remain somewhat depressed until the pandemic is brought under control. Once that happens, Ulta should be able to pick up where it left off.
  • Walmart (NYSE:WMT): The biggest retailer in the U.S., Walmart became famous by offering "always low prices." Despite its many store locations, Walmart understands the importance of also having a strong online presence. Its recent investment in e-commerce capabilities has paid off -- Walmart’s online sales have soared during the pandemic, and its grocery pick-up and delivery services are tailor-made for the current environment. The company’s Walmart+ membership program provides free delivery for online grocery orders, which is likely helping the retailer to snag new customers.
  • Wayfair (NYSE:W): The pandemic has been a boon for the online furniture retailer Wayfair. Despite rapid revenue growth, the company was posting big losses before the pandemic struck. That growth has now accelerated enough to put the company squarely into the black. The stock has soared as a result, with many investors betting that the good times are here to stay.
Blue Wal-Mart shopping carts stacked together

Image source: Getty Images

What are retail stocks?

Retail stocks fall into the consumer discretionary sector, which is made up of companies that sell people things they don't absolutely need but still want. The retail industry includes the following businesses:

  • Department stores
  • Clothing stores
  • Stores that sell computers and electronics
  • Home improvement stores
  • Auto parts stores
  • Stores specializing in home furnishings
  • Internet-based companies that sell products to people through computers or mobile devices

You're probably familiar with all of these types of retailers. One additional category is distributors, whose job it is to move products from the company that manufactures them to the retail store that sells them to you.

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How to pick a good retail stock

Finding high-quality retail stocks requires looking at some key aspects of the retail business. Strong retailers perform well in several of the metrics discussed below:

Sales growth

The best retail companies consistently grow the revenues that they generate from the products they sell. The greater the year-over-year percentage change in total sales, the better an investment that the retailer's stock is likely to be.

Retailers increase sales by both building more stores in new locations and boosting the sales at their existing stores. One revenue metric, called same-store sales or comparable-store sales, evaluates revenue growth for stores that have been in business for at least a year. Ideally, a retailer will see both strong same-store sales numbers and robust overall sales growth.

Earnings growth

A retailer can generate revenue but still not be profitable. Most retailers can lower prices or offer promotions to persuade more people to buy more things, but if their prices are too low, then they'll lose money on each sale. Top retail companies have loyal customers who are willing to pay premium prices, and these companies also are able to minimize their costs in order to maximize their profits. Investors should be cautious about buying shares in retailers that struggle to grow their earnings, as measured by both the earnings' absolute values and earnings per share.

Performance during key times of the year

Much of the retail business is seasonal, with many retailers doing a lot of their business for the year during the holiday season in November and December. Strong holiday sales can make up for weaker business conditions at other times of the year. Many retailers also offer lucrative promotions to shoppers during the holidays to further boost their seasonal sales.

While the end of the calendar year is most commonly the high season for retailers, it's not the only one. For instance, retailers that focus on younger shoppers typically see big spikes in sales during back-to-school season. Examining sales trends can help you to understand the degree to which a retail business is seasonal; strong performance during a key season can indicate that one retailer is outcompeting its rivals.

Size of store network and real estate holdings

Retailers that maintain networks of physical stores may have extensive real estate holdings. Maintaining and improving stores can be costly and shrink profits. However, the retail floor, back rooms, and other spaces that retailers own or lease have value. Even when a company's retail operations aren't doing particularly well, the value of its underlying real estate can comprise a huge portion of the company's overall worth.

In addition to knowing a retailer's number of stores and its locations, looking at how efficiently the company uses its real estate is also useful. Metrics like sales per square foot can show you how profitably a retailer leverages the space that it owns to sell its products.

Balance sheet strength

With the pandemic causing steep sales declines and big losses for portions of the retail sector, retail businesses that were financially fragile before the crisis are not faring well. Already, major retailers like J.C. Penney and Neiman Marcus have declared bankruptcy.

When considering an investment in a retailer, look for plenty of cash and manageable debt on its balance sheet.

E-commerce sales versus brick-and-mortar sales

It used to be that companies either had physical stores or sold their goods online. Now, many companies have both an e-commerce portal and brick-and-mortar locations.

As e-commerce has increasingly gained popularity, many retailers have seen their online sales grow much faster than their overall sales. The best retailers use their networks of stores to their advantages, offering services like in-store pick-up and local delivery as ways to provide more accessibility and convenience for shoppers. Businesses without strong presences online will have increasing difficulty keeping up with their peers.

Are retail stocks right for you?

It's always fun to invest in companies that you know and love, and retail stocks often fit the bill. Focus on the retailers with the strongest business fundamentals -- like low debt levels, healthy cash flows, and strong competitive positions -- and you'll give yourself the best chance to make money.

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