The consumer discretionary sector of the economy consists of businesses that sell nonessential goods and services dominated by media companies, retailers, restaurants, leisure, apparel and autos. The recent trend of improving retail sales is good for consumer discretionary stocks, but rising oil prices and interest rates could be significant headwinds.
Rising rates are not necessarily bad for the consumer if wages are rising as well. However, with the economy reaching full employment and the participation rate remaining low, job growth should continue to slow and retail sales could have a tougher time accelerating when compared to the past several years.
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The Trump victory has brought hope of lower corporate and personal taxes, less regulation and a strong U.S. dollar. These changes do not benefit all sectors and its constituent stocks equally, as we saw with the change in leadership of sectors pre- and post-election. While rising rates are a headwind for rate-sensitive discretionary companies (automobiles, for example), a strong U.S. dollar is a tailwind for most domestic-oriented retailers, as it strengthens purchasing power. In addition, a lower corporate tax rate would help domestic-focused companies disproportionately more. Combine that with an improving growth rate from overall retail sales and there is potential for positive performance for certain retailers, the sector’s largest industry group.
Here are two stocks that may have further room to advance.
Target Corp. Target (ticker: TGT) is the second-largest mass merchandise retailer in the U.S. The company generates 26 percent of sales from household essentials, 21 percent from food and pet supplies, 19 percent from the high margin apparel category, 17 percent from electronics and toys and 17 percent from home furnishings. In 2015, the company sold their pharmacy business to CVS Health Corp. ( CVS), which now operates pharmacies within Target. 3.4 percent of sales are made online and are growing 25 to 30 percent per year. Twenty-two percent of customers use the company’s growing Red Card credit card program, which offers a 5 percent discount on most purchases and free online shipping.
One catalyst for Target that is perhaps underappreciated is the company’s growing flexible store format that targets dense urban areas. The square footage of these stores is typically one-third the size of a traditional Target store, and while rents per square footage can be higher, these stores also have very high sales per square foot and help drive the the credit card and online business.
Target currently operates 30 of these flexible stores with a goal of operating hundreds in the coming years. Many of the stores will serve a younger demographic that is currently single, but these stores offer the opportunity to build a lifelong relationship with a sophisticated millennial buyer who will one day purchase gift cards, furniture for their first home and baby clothes. These categories are all signature categories for Target, which offers an opportunity for margin expansion over time.
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Also underappreciated is the capital discipline within the company. Target’s return on invested capital was 16 percent in the January 2016 fiscal year versus 12.4 percent in 2015. The company has repurchased 30 percent of their shares outstanding in last 10 years. The company’s dividend yield is 3.3 percent and the dividend is projected to grow 7.72 percent per year for the next three years. The price-earnings ratio of 14 is a 30 percent discount to the market and the stock offers the opportunity for 10 to 12 percent capital appreciation per year for the next three years in addition to the dividend.
Leggett & Platt. Missouri-based Leggett & Platt ( LEG) is the largest supplier of components for mattresses, sofas and car seating in the U.S. Seventy percent of the company’s sales are in the U.S. and 81 of their 130 plants are also in the U.S. Operating margins have expanded from 8.7 percent in 2006 to 13 percent in 2016, despite lackluster trends in their key furniture components.
While the auto business (15 percent of the company’s sales) may be nearing a peak, the furniture industry is just starting to benefit from the growth in single-family homes. Single-family home sales are down 50 percent on an annual basis from the heydays of 2005-2007. If President-elect Donald Trump delivers on his promise of more U.S. manufacturing jobs, the labor market is likely to tighten further, potentially further driving the economy and therefore the demand for homes, provided payments remain affordable.
Leggett & Platt has been an excellent steward of capital. The company’s return on invested capital has improved from 6 percent in 2006 to 19 percent currently, and it has repurchased 25 percent of its shares outstanding over this period. The dividend yield of 2.8 percent is projected to grow 5.4 percent per year for the next three years. The P/E of 20 is not at meaningful discount to the market, but the company does offer the potential for above average earnings growth, especially if much of the incremental free-cash flow growth is used to repurchase shares. You should expect a 6 to 8 percent capital appreciation per year for the next three years for Leggett & Platt in addition to the dividend.
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It is important to note that changes brought about by the Trump administration will benefit some sectors and stocks more than others. Careful stock selection will be important when investing in the consumer discretionary sector.
Disclosure: Leslie Thompson and clients of Spectrum Management Group own TGT and LEG.
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Is Now a Good Time to Invest in Consumer Discretionary Stocks? originally appeared on usnews.com
