Noted for their simplicity and other advantages over mutual funds, exchange-traded funds have become a popular investing tool. ETFs hold a collection of stocks that share certain elements and allow investors to get in early on what they believe are tomorrow's big trends.

Investors who believe the beaten-down retail sector presents an opportunity today can buy shares in Retail HOLDRs, which holds a diverse set of retail stocks, including top holdings Costco (NASDAQ:COST) and Lowe's. But the broad diversity of many ETFs also limits your upside -- and investors may dilute stellar returns away from that one amazing company in the crowd.

Fear not, Fool -- in this edition of "ETF Teardown," we'll use some nifty tools to drill into the best investments in retail. To help, we'll use Motley Fool CAPS, our tool for screening and ranking stocks and stock pickers.

The power of tags
To help investors quickly locate great stocks, the 5,500 stocks rated in CAPS can be "tagged" with descriptors that group the company with others sharing certain qualities -- "Home Builder," for example, or "Women's Apparel."

The "Retail" tag pulls up 25 companies tied to various forms of retail sales. The 21.5% drop in this collection of investments over the past year essentially matches the 21.7% loss the S&P 500 index has suffered over the same period.

Getting down to the nitty-gritty
Here are some retail stocks I've gleaned from CAPS today.

Company

CAPS
Rank (Out of 5)

Retail Segment

American Eagle Outfitters (NYSE:AEO)

*****

Teen apparel

Best Buy (NYSE:BBY)

***

Electronics

Dollar Tree (NYSE:DLTR)

**

Discount Variety

J.C. Penney (NYSE:JCP)

**

Department Stores

American Eagle Outfitters
American Eagle has its work cut out for it this holiday season. It will be competing for fewer consumer dollars against large discounters such as Target (NYSE:TGT) and Wal-Mart Stores (NYSE:WMT). With sales expectations lowered across the retail board now that consumers have become more cost-conscious, American Eagle won't be hiring as many seasonal staffers to sell those fashionable tops and tees. And fewer working teens mean less spare money to spend on the latest clothes -- and thus, the vicious cycle is complete.

But some investors see a silver lining around American Eagle's stock -- namely, a solid balance sheet and relatively low valuation. Seeing no debt and an earnings multiple of just less than 10 -- below many of its peers -- 95% of the 2,692 CAPS members rating American Eagle believe the stock is going to outperform the broader market going forward.

Best Buy
Electronic-gadget pusher Best Buy was chastised for reporting second-quarter profits that sank 19%, but the company wasn't blaming a tough economy. In fact, revenue rose on sales of flat-screen TVs, laptops, and cell phones. Instead, higher costs in rolling out new growth initiatives, such as the new Best Buy Mobile concept, are the culprits.

Same-store sales increased by a respectable 4.2% in the second quarter. And even though comps are expected to face a more challenging second half, nearly 88% of the 2,627 CAPS members rating Best Buy remain bullish.

Dollar Tree
Even though Dollar Tree's latest 2008 profit projection didn't score big points with analysts, it's difficult not to find something positive about sales that ballooned by more than 12% and profits that grew by 15% in the second quarter.

Though the company estimates that third-quarter same-store sales will continue to increase in the lower single digits, evidence is showing that the boost retailers got from the government stimulus checks is wearing off. But even despite the cloudy outlook for the longer term, 163 of the 186 CAPS members rating Dollar Tree believe the company will beat the market.

J.C. Penney
Over the long haul, department-store mainstay J.C. Penney has been a big winner, but mall traffic has decreased, and the current retail environment isn't like it was in the catalog days of old. Management admits that times are bad, and the 4.3% drop in comps for the most recent quarter backs up that pessimism.

Putting items on sale has helped support revenue, but doing so comes at the expense of margins for the retailer. The company's approach of hunkering down and riding out the rough retail environment has earned some favor with investors, but it hasn't captivated the majority. Only 77% of the 660 CAPS members rating J.C. Penney expect it to beat the S&P going forward.

Lead a horse to water ...
Plucking individual stocks from the retail sector is, of course, a high-risk endeavor. Investors should always perform their own due diligence on companies rather than take a recommendation. Even the best stock pickers can be horribly wrong.

Do you agree that there's value in retail? Or is there more nastiness to come? Give your opinion at Motley Fool CAPS.

Best Buy is one of many industry-leading companies picked by the Motley Fool Stock Advisor service. To see all of  the stocks that have helped Tom and David Gardner beat the market by 41 points on average, take a free 30-day trial.

Fool contributor Dave Mock loves doing the teardown part -- it's the put-back-together part he hates. He owns no shares of companies mentioned here. Dave is the author of The Qualcomm Equation. Wal-Mart and Best Buy are Inside Value selections. Costco, Best Buy, and American Eagle Outfitters are Stock Advisor selections. The Fool owns shares of Best Buy and American Eagle Outfitters. The Fool's disclosure policy also doubles as a bottle opener.