Investing in Retail Stocks

Many investors buy retail stocks because it allows them to own portions of the businesses where they shop. But just because you like shopping at a particular store doesn't mean it's a good portfolio investment.

The COVID-19 pandemic benefited some retailers and hurt others. E-commerce sales boomed as consumers avoided stores, and sales of certain products soared. Spending that would otherwise have gone to travel or entertainment instead funded home improvement projects and electronic gadgets.

Retailers battled shortages and supply chain constraints for much of the pandemic as they scrambled to meet consumer demand. That problem has now flipped: Sky-high inflation and fears of a recession are beginning to change consumer behavior, leading to excess inventory.

Retailers able to nimbly adapt will thrive in the late-pandemic era. Let's delve into some of the top retail stocks and what you need to know about investing in retail companies.

4 industry-leading retailers

Four publicly traded retailers leading their industries

There are hundreds of publicly traded retailers, but these four have risen to the tops of their industries:

1. Amazon

As the preeminent e-commerce retailer, Amazon (AMZN -1.35%) got started by selling books and now operates a marketplace enabling the online buying and selling of almost everything. Amazon's 2017 purchase of Whole Foods Market also gives it a ready-made network of brick-and-mortar retail stores to further engage customers.

Amazon enjoyed soaring demand in 2020 and 2021 as shoppers shifted their spending online, prompting the company to aggressively expand capacity. Now that demand is cooling, Amazon is focused on boosting productivity and trimming expenses as it runs up against rising supply chain costs.

Amazon's profits plunged in 2022, but the bottom line has started to recover in 2023. With its immense scale, the online retail giant is well positioned to lead the e-commerce market in the long run.

Smaller players without the scale and logistical muscle of Amazon will struggle mightily to cope with surging supply chain costs, and the company also has a highly profitable cloud computing business to help shore up the bottom line.

One potential headwind for Amazon is a lawsuit filed in September by the Federal Trade Commission and 17 state attorneys general. The company has been accused of anti-competitive behavior, particularly related to its marketplace services. While Amazon is in the crosshairs of regulators, the company continues to dominate the e-commerce industry.

2. Home Depot

The home-improvement retailer is best known for its big box warehouse stores and extensive inventory. Serving both do-it-yourself homeowners and professional contractors, Home Depot (HD -1.44%) is consistently expanding both sales and earnings. The company has built a substantial e-commerce presence while largely holding would-be competitors at bay.

Home Depot's sales soared during the pandemic, with the sharp rise in consumers taking on home improvement projects. That demand has now begun to falter. The company expects comparable sales to decline by 2% to 5% in 2023. Consumers continue to spend on smaller projects, but spending in big-ticket categories is weakening.

Home Depot may be facing these headwinds for a while as elevated interest rates eat away at household spending power. But in the long run, the company has plenty of room left to grow within a fragmented industry.

3. Lululemon Athletica

As a pioneer in athletic apparel, Lululemon Athletica (LULU -0.41%) initially focused on making yoga clothing. The company has gradually courted a wider set of customers who want to stay fit and dress comfortably.

Store closures due to the pandemic hurt Lululemon's results early in 2020, but the retailer has strongly recovered and maintained that momentum into 2023. Comparable sales surged 11% in the second quarter of 2023, and direct-to-consumer sales shot up 15%. Profits rose even faster as the company expanded its gross and operating margins.

The popularity of athleisure has staying power, and Lululemon leads the industry. The retailer is on track to reach annual sales of $12.5 billion by 2026 -- double its sales in 2021. This growth will be driven by increasing sales of men's clothing, doubling down on direct-to-consumer, and expanding internationally.

While a tough economy could push back Lululemon's growth plans, the retailer has so far been largely unscathed by high inflation, rising interest rates, and growing caution among consumers. That's a testament to the company's powerful brand.

4. Ulta Beauty

Tapping into the trend of providing experiences that lure shoppers into stores, Ulta Beauty (ULTA -2.05%) 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.

Ulta's sales were severely affected by stay-at-home orders in 2020, but the retailer was able to muddle through a difficult year. Sales have bounced back strongly, and Ulta has enjoyed robust growth in 2022 and 2023. Comparable sales shot up 8% in the second quarter of this year.

Total revenue should top $11 billion in 2023, based on the company's guidance, and an operating margin in the mid-teens is a testament to how well the Ulta model works. A recession would likely hurt sales and profits in the short term, but Ulta's long-term growth prospects are very much intact.

Identifying top retail stocks

How to identify the best retail stocks

Finding high-quality retail companies requires looking at some key aspects of the company's retail business. The strongest retailers perform well based on these key metrics:

Sales growth

The best retail companies consistently expand the revenue they generate from the products they sell. Retailers can increase sales both by building more stores in new locations and by boosting sales at existing stores.

Same-store sales, or comparable-store sales, is a retail-specific revenue metric that evaluates revenue growth for stores in business for at least a year. The best retailers produce strong same-store sales numbers and robust overall sales growth.

Earnings growth

A retailer can generate revenue but remain unprofitable. Most retailers can lower prices or offer promotions that persuade more people to buy more things, but if their prices are too low, they lose money on each sale.

The top retail companies have loyal customers willing to pay premium prices, and these companies can also minimize costs to maximize profits. Investors should be cautious about buying shares in retailers that struggle to increase their earnings as measured by absolute values and earnings per share.

Performance during key times of the year

Much retail business is seasonal, and many retailers do a large part of their annual business during the holiday season in November and December. Strong holiday sales can compensate 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.

Although the end of the calendar year is most commonly the high season for retailers, it's not the only one. For instance, retailers focused on younger shoppers typically see big spikes in sales during the back-to-school season.

Examining sales trends can help you understand the degree to which a retail business is seasonal. Strong performance by a retailer during a key season can indicate that the company is outcompeting its rivals.

Size of store network and real estate holdings

In addition to knowing a retailer's number of stores and its locations, investors can pay attention to retailers' real estate holdings. Retailers that maintain networks of physical stores may have extensive real estate assets.

While maintaining and improving stores can be costly, the retail floor, backrooms, and other spaces retailers own or lease have value. Even when a company's retail operations aren't particularly profitable, the value of its underlying real estate can comprise a huge portion of the company's overall worth.

Investors can also evaluate how efficiently a retail company uses its real estate. Computing metrics such as sales per square foot can indicate how profitably a retailer leverages the space it owns to sell its products.

Strength of e-commerce sales

Previously, retail companies either had physical stores or sold their goods online, rarely both. Today, many companies have both e-commerce portals and brick-and-mortar locations.

As e-commerce has increasingly gained popularity, many retailers' online sales have grown much faster than their overall sales. The best retailers use their network of stores to their advantage by offering services such as in-store pickup and local delivery. Retail businesses without a strong online presence will likely have increasing difficulty competing with their peers.

Balance sheet strength

When considering investing in a retailer, look for plenty of cash and manageable debt on its balance sheet. The pandemic caused steep sales declines and big losses for portions of the retail sector, and retail businesses that were financially fragile before the crisis have not fared well. Major retailers, such as JCPenney and Neiman Marcus, were forced to declare bankruptcy, unable to cope with the sudden drop in demand for in-person shopping.

Related investing topics

Are retail stocks right for you?

Are retail stocks right for you?

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

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