It's no secret that the retail industry is facing challenges. While talk of the "retail apocalypse" may have subsided since annual store closings peaked in 2017 at nearly 8,000, the industry remains in flux. Pressure from e-commerce companies like have forced changes in the traditional way retailers do business, and with customer traffic falling in traditional strongholds like malls, brick-and-mortar chains have adapted by building their own online businesses and finding new ways to bring customers into stores. Additionally, many have resisted opening new stores or are even closing stores.

Given that environment, it's not surprising that retail stocks have significantly underperformed the broader market in recent years. As the chart below shows, they've generally missed out on the market rally following the 2016 election. However, that's caused much of the industry to be significantly undervalued according to conventional metrics like the price-to-earnings ratio, especially as the sector got a significant boost from last year's tax cut. A number of retail stocks now trade at bargain prices, and many of them pay juicy dividend yields. 

^SPX Chart

^SPX data by YCharts.

Though the chart above may dissuade investors from buying retail stocks, there are a number of reasons why investors should consider getting exposure to the retail industry. We'll take a look at those factors in a minute but, first, let's review some industry basics.

What is the retail industry?

Businesses in the retail industry sell goods, generally through stores or online portals, to the end consumer for personal use. Retail differs from wholesale, which is the sale of goods for resale by retailers -- though some retailers that manufacture their own products also have a wholesale business. Retailers sell a broad range of products, including apparel, groceries, home goods, auto parts, electronics, appliances, sporting goods, and more.

Shoppers going up and down a mall escalator.

Image source: Getty Images.

Why invest in retail?

As the chart above shows, retail stocks have underperformed overall, but that chart does not tell the complete story. In recent years, the industry has split in two. Underperforming chains like Sears Holding, J.C. Penney, and Ascena Retail Group have shrunk their footprints and even declared bankruptcy in the case of Sears. However, stronger retailers have grabbed market share from their struggling counterparts and have put up solid sales and profit growth, benefiting from a strong economy. While the industry as a whole may be challenged, several chains are growing both online and off.

Additionally, retailers are often reliable dividend payers, and a number are even Dividend Aristocrats, having increased their payouts every year for more than 25 years, giving investors access to both income and growth. Investors can also benefit from skepticism about the industry as retail stocks are generally cheap, with some trading at single-digit P/E ratios or in the low double digits. 

Finally, retail stocks are also accessible to investors. You can visit stores to learn more about the company. Consumers are also familiar with most retail brands, so talking to people about brands, especially up-and-coming ones, may give you insight that the average investor doesn't have. Famed mutual fund manager Peter Lynch has encouraged investors to buy what they know in order to gain an edge on the market, and retail affords more opportunities for this strategy than more opaque ones like energy or banking.

What are the risks of investing in retail?

The changes in retail that we've seen with the rise of e-commerce aren't over. Online retail, which continues to take share from brick-and-mortar stores, has increased by about 15% each year since the financial crisis, and now claims 10% of all U.S. retail sales. Stores aren't going to completely disappear, but the retail experience will have to change to keep up with faster delivery and innovations like drone delivery, autonomous vehicles, and things that aren't even on the horizon yet that will make online shopping even easier and more convenient.

In order to thrive in the future, retailers will have to either build out successful online businesses, reinvent the store experience, or combine elements of the online and offline experience to find new ways to add value in order to bring in traffic. Shopping in stores is still a pleasure or a necessity for some consumers, and physical retailers will be able to attract them, but it's clear they will have to adapt as shopping habits change.

More immediately, those challenges have caused retailers to make investments to drive top-line growth, but those have weighed on the bottom line, meaning profits at many large retailers have been flat. If profits don't eventually return to growth, those stocks may struggle to grow.

The biggest headwind facing the industry today is disruption from e-commerce, in particular from Amazon. Retail stocks have shuddered repeatedly as the e-commerce giant moves into a new sector of the industry, as it did when Amazon acquired Whole Foods. The growth of e-commerce has made stores less relevant for customers, causing some chains to close stores or repurpose their space by focusing on customer service, experiences, and products that aren't easily sold online. The rise of e-commerce has accompanied a decline in mall traffic, which has pressured mall-based chains in particular, like Victoria's Secret parent L Brands, and Gap, which also owns Banana Republic and is planning to spin off Old Navy. Within brick-and-mortar retail itself, there are other sector-specific challenges like fast-fashion retailers in apparel, including H&M, Zara, and Uniqlo, which have come from abroad and threatened the traditional American leaders.

What are the tailwinds for retail stocks?

Despite those challenges, several forces support the retail industry. Overall retail sales continue to grow, and that pattern seems almost guaranteed to persist in nonrecession years as long as the U.S. population continues to grow. Historically, American discretionary and consumption spending has tended to increase over the long term, and consumers will always need to buy items like clothes, food, and furniture. The big question remains: From what companies will consumers buy these necessities?

Though e-commerce presents a challenge, it's also an opportunity. and some retailers have managed the shift better than others. Walmart, for example, has capitalized on the digital channel, with new omnichannel programs, or those that take advantage of online and offline resources. Walmart grocery pickup is now available in more than 2,000 stores; customers can shop online for groceries, then drive up to their local Walmart later that day to get their order placed into their vehicle by a store employee. Walmart also has Pickup Towers in hundreds of stores that allow for easy retrieval of online orders. Target has also been implementing similar innovations. 

Who should invest in retail stocks?

Today, the retail sector is most likely to appeal to dividend and value investors, given the sector's generally low valuations. With a few exceptions, like lululemon athletica, there aren't many fast-growing brick-and-mortar retailers on the market. Instead, the opportunity in the sector mostly lies in undervalued stocks that have been ignored or left behind by the market, as well as strong dividend payers that offer yields of 5% or more.  

How should I analyze retail stocks?

Like any other industry, retail stocks contain their own set of key metrics that investors in the sector should get to know:

  • Comparable sales measure the sales growth or decline of a retailer without the impact of new or closed stores. This metric, which usually includes e-commerce sales, gives retail investors a clear window into the performance of a company as healthy retailers should see steady same-store sales growth, at least in the low single digits. Adding new stores is an easy way for retailers to grow revenue, but it's not always in their best interest as deriving sales growth from new stores rather than the current base is more expensive. By increasing comparable sales, they avoid the costs of building new stores. 
  • Gross margin measures the percentage of revenue that retailers keep after accounting for the cost of goods sold, which includes merchandise, labor, and occupancy costs. Gross margin gives the clearest picture of how efficiently a retailer is turning over its inventory. If comparable sales rose but were largely due to markdowns, then gross margin will likely fall, showing that the increase in sales did not lead to rising profits. Like comparable sales, rising gross margin is preferable, though a dip isn't necessarily a warning sign as retailers can be contending with issues out of their control like rising minimum wages or higher merchandise costs due to tariffs on China.
  • Protection from e-commerce is also important. While this is a not a number that investors can easily look up, it's important for investors to consider. Retail models like off-price, bulk sales, home improvement and others have been particularly durable in the e-commerce era because they are hard to replicate online. Other retailers have found success with omnichannel tactics that combine elements from e-commerce and in-store retail, or have invested in things like customer service and a more personalized experience that can be difficult to do online. Sectors like department stores, which have struggled to offer customers a benefit over e-commerce, have been among the biggest losers in the modern retail era.
  • Competitive advantages are important in any industry, but in today's retail environment, it's especially important that retailers have some way of standing out from the pack, whether that be a brand, low prices, a unique model, or customer service. Paired with e-commerce protection, the most successful retailers will also demonstrate sustainable competitive advantages. 

What are the best retail stocks to buy in 2019?

Investors will want to find retail stocks that demonstrate at least some of the following: positive comparable sales, stable gross margins, barriers to entry from e-commerce competitors, and competitive advantages against other retailers or online or off. In addition to that, investors will want to look at stocks trading at a good value as the retail industry has been under pressure, and a relatively low price should help these stocks withstand any challenges ahead.

The chart below shows five such stocks that look poised to outperform the retail industry and the broader market in 2019 and beyond.

Company Comparable Sales Growth
Costco Wholesale (NASDAQ:COST) 6.8% (excluding fuel prices and currency exchange) 
TJX Companies (NYSE:TJX) 6% 
Target (NYSE:TGT) 5%  
Children's Place (NASDAQ:PLCE) 4.6% 
Home Depot (NYSE:HD) 5.2%  

Comparable sales growth in most recent fiscal year, as of May 2019. Data source: Yahoo! Finance. 

Why you should invest in Costco Wholesale

Few brick-and-mortar retailers have demonstrated the kind of strength and consistent growth that Costco has over the last decade. The warehouse retail giant has outperformed the S&P 500 during virtually any time frame over the last 10 years, and the company continues to expand both by adding new stores, growing comparable sales, and building its nascent e-commerce business. 

Costco has opened 21 new warehouses in the last year, including 16 in the U.S., and is also seeing solid growth in its e-commerce segment, sales of which have increased 25.5% through the first half of its fiscal year.

Costco has avoided many of the pitfalls of other retailers for a number of reasons. First, the company's membership model locks in a key revenue stream independent of shopping habits and incentivizes customer visits. Most of Costco's profits actually from its membership fees, which start a $60 a year, and the company runs its retail operation at near breakeven, offering rock-bottom prices to entice members. With a 90% renewal rate in North America and 88% globally, it's clear that Costco's customers are happy with the service. 

The business model also benefits from selling bulk merchandise, which is difficult to do online. Though the company faces competition from Amazon Prime and online outfits like Boxed, its model of charging bargain prices for bulk goods has continued to draw heavy customer traffic to its stores.

At a five-year average P/E of 29, compared to the S&P 500 average of 21.5, Costco is more expensive than most brick-and-mortar retailers as well as the market average, but the company has clear competitive advantages as well as a path to growth, which should help it continue to deliver results for investors.

Why you should invest in TJX Companies 

TJX Companies, the parent of TJ Maxx, Marshall's, HomeGoods, and other smaller chains, dominates the apparel retail sector. With its off-price model and myriad strip-mall locations, the company has found the formula for being a successful apparel retailer in the Amazon era.

Off-price retailers, including Ross Stores and Burlington Stores, have thrived during the age of e-commerce because their business model is difficult to replicate online. TJX explains that it charges between 20% and 60% below full price by capitalizing on opportunities like department store cancellations, manufacturers who have extra product to sell, and closeout sales to deliver savings for its customers. Because TJX cycles through inventory faster than the average retailer and sells it at a discount, it's a difficult model to do profitably online, which would involve photographing every item of clothing and paying for shipping, and potentially returns, for discounted clothing. 

TJX has seen strong performance lately at its MarMaxx division, which encompasses U.S. Marshall's and TJ Maxx locations, where comparable sales increased 7% last year. Its fast-growing HomeGoods chain also saw solid results with 4% comparable sales growth.

TJX added 236 stores around the world last year, bringing its total count to 4,306, but the company has big plans for expansion, seeing room in the market for 6,100 stores globally. That includes 3,000 Marmaxx locations in the U.S., up by about a third from its 2018 total, and 1,400 HomeGoods stores, nearly double the 2018 figure. 

If the company can continue to deliver solid comparable sales growth and open new stores, profit should continue to move higher. At a five-year average P/E ratio of 21, TJX looks affordably priced for a company with a strong set of competitive advantages delivering steady growth.

Why you should invest in Target

There's no question that big-box chains like Target have come under pressure from Amazon and other e-commerce companies. However, Target is changing with the times, making adjustments, and is poised for growth as its 5% comparable sales increase last year -- its best performance since 2005 -- indicates. 

Target's biggest move recently may be its 2017 acquisition of Shipt, the Instacart rival, for about $550 million. That, along with its earlier acquisition of transportation tech company Grand Junction, has allowed it to offer same-day delivery in 200 markets across the country from more than half of its stores. Those investments along with in-store pickup options like Drive Thru, where shoppers get their orders placed inside their trunks, have helped drive accelerating sales growth. In 2018, digital sales jumped 36%, marking the fifth consecutive year that they grew by more than 25%, and Target's stores have also been key in driving digital sales as stores fulfilled nearly three-quarters of digital sales in the fourth quarter.

Meanwhile, Target's plan to invest $7 billion in store improvements is paying off: Traffic consistently rose in 2018.  The company has also capitalized on rival bankruptcies of the likes of Toys R Us, by refurbishing toy departments ahead of the holiday season, and its "cheap-chic" image has helped it forge partnerships with brands like Vineyard Vines. Target's also opening small-format stores in underserved neighborhoods in big cities and college towns, which have been some of its highest-volume openings. 

The upshot of those moves is a retailer that's on the upswing with both comps and profits, trading at a five-year average P/E of just 16.2. Target's also a Dividend Aristocrat, raising its dividend for 45 years in a row.  

Why you should invest in Children's Place

Children's Place is in the midst of a transition. For years, the stock was one of the best to own retail, marching from less than $50 a share in 2015 to more than $160 in 2018. But the stock has tumbled steeply since then.

Children's Place shares have come under pressure as rival Gymboree declared bankruptcy and said it would close all of its stores. Gymboree is Children's Place's closest competitor, and about 70% of Children's Place's stores overlap with Gymboree. Adjusted earnings per share fell from $2.52 to $1.10 in the fourth quarter as Children's Place sped up efforts to clear out inventory in preparation for Gymboree's liquidation.

While Gymboree's liquidation clearly presents near-term challenges for Children's Place, over the long term, the company will almost certainly benefit from the disappearance of its closest competitor. Children's Place also capitalized on the bankruptcy by acquiring the intellectual property behind the Gymboree and Crazy 8 brand, giving it another avenue for growth.

Children's Place is the largest pure-play specialty apparel retailer in the U.S., giving it a brand advantage, and prior to the Gymboree news, the company had been driving steady profit growth, rising comps, and e-commerce sales, as it slowly closed its underperforming stores. Comparable sales rose 4.6% overall last year, and e-commerce sales made up 27% of total sales by the end of 2018, showing that it's developing a healthy online business.

After the recent sell-off, the stock looks like a bargain if profits turn out to be temporarily suppressed by the Gymboree bankruptcy. Meanwhile, management is committed to returning capital to shareholders through share buybacks and dividends, giving investor a solid income stream while they wait for Children's Place to digest the effects of the Gymboree liquidation.

Why you should invest in Home Depot

Though a slowing housing market has cooled off Home Depot stock over the last year, there are plenty of reasons to believe that the nation's leading home-improvement retailer is one of the best retail stocks to own now. 

The stock has ridden the housing recovery over the past decade to gain more than 700% as of the end of 2018, outperforming rival Lowe's. Though its business is highly sensitive to the macroeconomic environment and the housing market, the company is making smart moves that should help it thrive over the long term, beyond any near-term housing woes.

Unlike Lowe's, Home Depot has resisted opening new stores over the last decade, essentially holding its store count around 2,200. Instead of spending money on opening new stores, Home Depot is investing in store improvements, e-commerce, and returning capital to shareholders. As a result, the company has steadily delivered increasing comparable sales, improving margins, and a rising dividend, along with share buybacks.

The company has invested in technologies like cloud computing, artificial intelligence, machine learning, among others, and it was named one of Fast Company's 50 Most Innovative Companies in 2017. As a home-improvement retailer, Home Depot is also well protected from broader e-commerce threats as it's not easy to deliver things like lumber and appliances, and the contractors who make up a significant portion of its customers have the necessary means to take such items away from the store.

Coming off a year in which comparable sales grew 3.7%, the company sees that key metric increasing by 5% this year. By 2020, the company is targeting a return on invested capital of 40% and an operating margin of 14.4%-15%, up from a projected 14.4% this year. 

With a modest valuation and a fast-growing dividend, Home Depot stock looks cheap for a piece of one of the strongest companies in retail.

An underrated opportunity

Retail stocks have gotten short shrift from investors in recent years, as the conventional wisdom about the "retail apocalypse" has taken over and investors have flocked to faster-growing industries like tech stocks. However, well-run retailers like the ones above remain substantially profitable, and are growing both comparable sales and profits.

The fallout in brick-and-mortar retail has favored better operators who have taken the opportunity to grab market share and build out their own e-commerce businesses. 

Moreover, the consumer economy remains strong with the unemployment rate near all-time lows, gas prices down, and the economy continuing to expand despite some concerns about a recession. That should help push the retail stocks above even higher this year as they benefit from increasing consumer spending and rivals retrenching and closing down stores. Though some retailers may be in the midst of an "apocalypse," others are thriving. Investors can take advantage of low valuations and the overlooked opportunity in this group of retail stocks.