Looking For Good Buys

In an uncertain economy, it may be too early to bail out on retail stocks

Federal Reserve Chairman Ben Bernanke kicked off the holiday season early by delivering a present to the nation’s retailers. Cutting the fed funds rate by half a point in September breathed new life into Wall Street’s outlook for the retail sector-because lower interest rates generally mean that consumers will have more money to spend, which will in turn spur economic growth. After edging downward over the summer, the S&P retail index spiked immediately following the announcement of the interest rate cut and closed up 4.6% the day of the announcement.

But it will take time to see if lower interest rates will have their intended effect, so there’s no guarantee the holiday shopping season will be a joyous one. The housing recession, a tougher borrowing climate, a declining dollar, and slowing job growth could all pinch consumer spending and pull down the profitability of retailers both large and small.

Some experts believe that there will be an overall slowdown in the sector. Morgan Stanley analyst Gregory Melich predicts that retail sales will grow by only 3% in 2008, the slowest rate in five years. But the good news is the retail sector is diverse. Yes, the subprime mortgage mess has hurt home improvement chains like Home Depot (HD), which saw earnings drop nearly 15% in the second quarter compared with those of a year earlier. Through early September, shares of Home Depot, a component of the Dow Jones industrial average, were down 13.3%, while the Dow was up 5.2%.

A possible good sign for luxury retailers: unabated spending by more affluent consumers boosted earnings of luxury accessories retailer Coach Inc. (COH) for the quarter ended June 30 by 43% over the same period a year earlier. “You’re going to see pockets of retailers that are doing very well,” says Scott Krugman, a vice president with the National Retail Federation.

Retail stocks can be gauged like those in other sectors, by looking at, for instance, their price-to-earnings ratios or cash flow. But stores also have a unique set of vital signs on which investors should focus. One key measurement is same-store sales, which tracks the year-over-year sales trends in stores that have been open for at least one year-thereby filtering out growth achieved by building new stores. An upward trend in same-store sales means that a chain’s merchandise is popular and its brand is strong. As a result, it allows a given company the ability to increase revenue without the expense of building new stores. You’ll also find same-store sales numbers in the earnings reports for restaurant stocks.

Yet despite the uncertain economic outlook, there still may be some buying opportunities in the retail sector.

The Deerfield, Illinois-based drugstore chain is a strong defensive play, says Theodore Parrish, co-portfolio manager of the Henssler Equity Fund (HEQFX) at The Henssler Financial Group in Kennesaw, Georgia. “People are still going to buy their medicine,” he says, even if consumer spending on discretionary items heads south.

That bodes well for all drugstores, including competitors such as Rite Aid (RAD) and

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