Stock Strategist

Five Retail Stocks to Keep on Your Radar Screen

Mitchell P. Corwin, CFA, CPA

With "Black Friday" (the day after Thanksgiving, also known as the biggest shopping day of the year) just a few weeks away, retailers are ramping up for the holiday season. In fact, the largest domestic retailer,  Wal-Mart (WMT), has already launched its holiday marketing campaign. Retailers face some difficult headwinds this year, and this might explain the early start.

Last year, holiday spending increased by a mediocre 3%, down from a more robust 5% gain in 2003. However, the tepid increase in 2004 didn't tell the whole story. Higher-income consumers, buoyed by a strong overall economy and robust stock market, spent freely. This boosted the fortunes of higher-end retailers such as  Nordstrom (JWN) and Neiman-Marcus. The lower- and middle-income consumers were pinched by higher fuel and home-heating prices, causing them to spend judiciously, seeking the best deals.

Fast forward to today. If higher fuel prices weren't a large enough burden on consumers last year, prices at the pump are up another 45% in 2005. Couple that with higher interest rates on credit cards and mortgages, little growth in overall wages, a flat stock market, and the expected 30%-70% rise in home heating bills this winter, and it's no wonder why many retailers are already campaigning for their share of the consumer's shrinking wallet.

Could this holiday season be a repeat of 2004? Could 2005 be worse? Will high-end retailers continue to be the only source of strong growth? We do not profess to know how consumer spending will play out this holiday season. However, should consumers hold back on purchases this holiday season, we think it will be more important than ever for retailers to offer a compelling reason for consumers to shop at their stores in the future.

We at Morningstar have identified retailers that we think have distinct competitive advantages. We have assigned those firms either a wide or narrow moat rating based on how sustainable we think those competitive advantages are over time. For retailers, competitive advantages typically come in the form of either unbeatable low prices or a well-established brand that stands for differentiated merchandise, superb customer service, a unique experience, or a combination of these factors.

It's not easy for a retailer to earn an economic moat, as switching costs are virtually nonexistent in the industry. This narrows the list of companies we favor quite a bit. The next step is to determine which of those companies we think are providing an adequate margin of safety that will protect us if we're off a bit on our predictions of future cash flows. Listed below are five retail stocks that have wide or narrow moats and that we think are currently selling at attractive prices:

Wal-Mart Stores (WMT)
Economic Moat: Wide
Consider Buying Price: $49.40

From the  Analyst Report: The company continues to steamroll department stores, smaller discount chains, specialty retailers, and, most recently, grocers. Wal-Mart's scale provides massive amounts of operating leverage, and its enormous share of the U.S. retail market gives the company unprecedented leverage over its suppliers. These are the sources of the firm's wide economic moat.

Petsmart PETM
Economic Moat: Narrow
Consider Buying Price: $26.20

From the  Analyst Report: We believe that Petsmart, as one of two national pet-supply retailers, is well positioned to capitalize on this growth. Its superstore format allows the company to stock more than 12,900 items and to provide grooming, pet training, and other services, which drive customer traffic. Smaller pet stores cannot match the breadth of Petsmart's offering.

TJX Companies (TJX)
Economic Moat: Narrow
Consider Buying Price: $20.80

From the  Analyst Report: With prices that are 20%-60% below those at department stores and specialty retailers, fashion-craving, value-conscious consumers flock to TJX for brand-name apparel and home goods. It is the nation's largest off-price retailer, which gives it a scale advantage over its competitors.

Gap (GPS)
Economic Moat: Narrow
Consider Buying Price: $20.00
From the  Analyst Report: Gap's turnaround efforts are still showing progress, and although 2004 results are a reminder that no apparel retailer is going to have a great outcome every single selling season, we still believe management's efforts to streamline operations, reverse overexpansion, and pay more attention to customer preferences bode well.

Michaels Stores MIK
Economic Moat: Narrow
Consider Buying Price: $29.30

From the  Analyst Report: With nearly 1,100 stores and $3.4 billion in sales, the company has a considerable size advantage. Only four other major arts-and-crafts retailers in the U.S. have more than $200 million in sales, and each are significantly smaller than Michaels with respect to number of stores and total sales. Michaels has substantial scope to increase share in this highly fragmented, growing $30 billion market.

Mitchell P. Corwin, CFA, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.