On Friday morning, the Commerce department reported that consumer spending fell slightly — by 0.1 percent — in April. This fits with a larger pattern that has been emerging throughout the first half of 2014, namely retail sales have been weak and retail companies have generally been underperforming with a couple of exceptions.
If you look at retailers broadly through the SPDR Retail ETF (NYSEARCA:XRT), you’ll find that retail stocks have significantly underperformed the broader market. This fund is down over 5 percent year-to-date versus the S&P 500, which is up about 4 percent.
A look at some individual companies is even more telling. Many retailers are seeing profit declines even if their net sales figures are rising. Companies that fall into this category include:
Furthermore, there are several retailers that are growing their sales, but which are growing their profits at substantially lower rate. Costco (NASDAQ:COST) and Chipotle Mexican Grill (NYSE:CMG) fall into this category.
This is due to margin contraction: input costs such as agricultural commodities and energy costs are rising, and retailers are put in a position in which they either have to raise prices or accept lower profits.
But not only are quality retailers (from an investment standpoint) such as Costco and Panera suffering, but there are many retailers with their own individual problems. For instance, we are all aware of the difficulties that Target (NYSE:TGT) has been having after the December data breach, and this company is going to suffer so long as consumers are concerned that their credit card information will be stolen if they buy something at a Target store. We also have specific sub-sectors of the retail industry that are suffering, such as the office supply sector and the sporting goods sector. Last week, Staples (NASDAQ:SPLS) and Dick’s Sporting Goods (NYSE:DKS) reported weak earnings, and while these situations have possibly created some intriguing contrarian speculation plays, I think they also serve to shed light on this troubled industry.
The fact that retail sales in April came in so weak indicates that the economy might not be bouncing back from its first-quarter contraction of 1 percent. Many analysts blamed the first-quarter contraction on poor weather, but we should note that when the April retail sales data was released March figures were revised upward, reflecting a very strong quarter of +1 percent. This means that it is quite possible that the economy is worsening!
It also means that the underperformance of the retail sector in the early part of 2014 is being driven by higher input costs more so than declining sales. So what happens when sales decline, as we saw in April?
The bottom line is that investors need to be very cautious when investing in the retail space. Here are a few tips: first and foremost, look for companies bucking the trend. There are several retailers that are growing their sales and profits substantially, and there could be interesting trading opportunities out there. One such opportunity is Michael Kors (NYSE:KORS), which reported strong sales on Wednesday despite the fact that its peers are suffering. I think the stock is inexpensive at 29-times earnings, although keep in mind that Michael Kors is a fad, and so I would watch the stock carefully and sell if there is any sign that the company’s products are no longer cool.
I would also look to a company such as Target, which as I mentioned has had its own problems. But longer term, the company has done a remarkable job of growing its sales and profits, returning capital to shareholders, and creating a loyal customer base. The problems that Target has now are not going to matter in 5 or 10 years, so if you are looking for a retail stock that is largely recession resistant, and which is well managed Target might be a good contrarian bet right now. Also keep in mind that while consumers are concerned about the safety of their credit card information at Target, the fact that Target suffered an attack will likely make it extra diligent in the future, and therefore I think the risk of another data breach at Target is lower than it is at other retailers.
Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.