Should You Invest in Dollar Stores?

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A lot of retailers are struggling, seeing stagnating or declining sales and tightening margins. Furthermore, a lot of Americans are in poor financial shape, as many of them are increasingly taking lower paying jobs and seeing the prices of goods they need to purchase everyday rise.

Two groups of retailers, however, have been able to buck this trend — high-end retailers and low-end retailers. This is the case because the rich are getting richer and the poor are getting poorer. While a lot of investors like the allure of high-end retailers, I think that these are generally very difficult companies to invest in because of the specific knowledge that one needs in order to find winners. For instance, why is Michael Kors (NYSE:KORS) doing so well? As investors, we can point to rising revenues and margins, store openings, promotions, and so on, but it is difficult to know why Michael Kors is performing well and why; for instance, Coach (NYSE:COH) is not. Furthermore, I don’t know if Michael Kors will be able to continue its strong performance in the long run.

Low-end retailers are different. While it is a generally slower grower with lower profit margins and less Wall Street appeal, it is pretty obvious why somebody would shop at a low end retailer — he or she has to do so for financial reasons. Millionaires typically don’t go to Dollar General (NYSE:DG) looking to save $0.30 on a box of cereal, but people who work minimum wage jobs do. Furthermore, I think I can venture a guess as to why a consumer chooses Dollar General over Family Dollar (NYSE:FDO) — it’s closer/accessible.

Thus, there are two reasons why I think investors should consider low-end retailers over high-end retailers. The first is the simplicity in the logic I lay out above. It is much easier to comprehend why somebody shops at Dollar General than at Tiffany’s (NYSE:TIF). Second, as a result, I can focus my analysis on determining discounted cash flow and growth estimates.

With that being the case, I think investors should consider buying shares in dollar stores. Currently, there are three large publicly traded dollar stores in the U. S. — Dollar General, Family Dollar, and Dollar Tree (NASDAQ:DLTR). Other than Family Dollar, the dollar stores have been growing revenues and profits steadily by about 10 percent to 15 percent per year over the past few years. Furthermore, Dollar General and Dollar Tree trade at just under 20-times earnings. Not only is this cheaper than the S&P 500, but it is cheaper than some other retailers that are not growing their profits such as Costco (NASDAQ:COST) and Home Depot (NYSE:HD). While Family Dollar’s growth has slowed, and while its profit growth has turned negative in the most recent quarter, the market has appropriately discounted this stock so that it trades at 16-times earnings.

While I think that the broader stock market is likely going to correct soon, and while I suspect that we might see a recession in the next couple of years, dollar stores should be an excellent place to hide. When people have less money or when they are afraid of potentially having less money, they spend less, but they don’t stop spending. Thus, I think that a lot of them will do more of their shopping at dollar stores. While these companies’ stocks might fall in sympathy with the rest of the market, especially in a capitulation phase of a bear market during which people sell anything and everything, they could very well take market share and actually grow their sales and profits in a recession. For this reason, they can be purchased alongside other safe-haven assets such as Treasuries, gold, and short positions on more economically sensitive stocks.

While this argument is fairly sound, I should note a couple of risks. First, dollar stores have especially low margins. This means that even a slight operational misstep could lead to a sharp decline in profitability or even to a loss. Furthermore, this makes dollar stores acutely sensitive to rising energy prices. Therefore, investors who are interested in buying shares in dollar stores should also consider taking a small position in a low-beta, low risk energy stock such as Exxon Mobile (NYSE:XOM). Here I explain why Exxon Mobile is a good long-term, low-risk energy stock.

Second, as I said before, people don’t go to dollar stores because they want to, they go because they have to. This means that when they don’t have to they probably won’t go, and when they do go they will likely spend as little money as necessary. This sounds good from an investment standpoint in a recession, but if we see an economic boom there is a good possibility that the growth we’ve seen in dollar stores will subside.

Disclosure: Ben is long Exxon Mobil.

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