Falling Bargains at Low-End Retailers

Bad news for the economy has been good news for discount retailers, one of the
best stories to emerge out of the consumer sector during 2011. Still, investors
need to proceed with caution given that valuations for the major players in this
group have begun to look expensive. The recent outperformance of the discounters
stems from a number of factors. The combination of high unemployment, tighter
credit restrictions and elevated prices for food, gas and other staples has
prompted consumers to save money in any way possible a trend that has led to
strong performance for the purveyors of off-price merchandise. Long-term
demographic trends also have provided a strong underpinning for the sector's
performance. The year-to-date numbers tell the story: Company Ticker YTD (12/27)
Family Dollar FDO 18.2% Dollar Tree DLTR 49.1% Dollar General DG 35.3% Big Lots
BIG 26.1% TJX Corp. TJX 51.3% Ross Stores ROST 55.1% SPDR S&P Retail ETF XRT 10%
SPDR S&P 500 ETF SPY 1.6% Notwithstanding the recent better-than-expected
employment data, it's difficult to envision the broader trends that have
supported the shares of lower-end retailers dissipating anytime soon. And even
if they did, the shift in consumers' preference for these stores is likely to
prove sticky. Changing consumer behavior has fueled strong earnings for the
major players in this segment, and earnings should remain in an uptrend as long
as discounters continue to take market share from Sears (NASDAQ: SHLD ),
Wal-Mart (NYSE: WMT ) and other large competitors. In fact, all of the companies
in the table above have seen their earnings estimates rise in the past 90 days
a far cry from the downward-trending earnings expectations for the market as a
whole. But that doesn't mean these stocks still are a good buy after three
years of outstanding performance. The problem is these stocks are no longer the
bargain-basement special they were three years ago. While all of these stocks
have experienced rising earnings, their valuations have risen even faster
setting up the possibility of execution risk in the year ahead. A look at the
table below reveals that with the exception of Big Lots (NYSE: BIG ), all of the
stocks discussed here are trading at substantial premiums to their historic
average valuations: Company P/E 5-Year Average P/S 5-Year Average P/B 5-Year
Average Family Dollar 18.5 16.3 0.81 0.63 6.38 3.78 Dollar Tree 22.5 17.1 1.60
0.96 7.09 3.86 Dollar General 20.6 19.8 1.01 0.82 3.12 2.67 Big Lots 14.0 14.4
0.49 0.51 3.31 2.87 TJX Corp. 18.8 16.0 1.09 0.79 7.78 5.96 Ross Stores 17.9 N/A
1.34 0.85 7.74 5.18 Among the stocks listed in this table, all six are trading
at or near their 10-year peak price-to-sales ratios, and all but Family Dollar
(NYSE: FDO ) and Big Lots are at or near the 10-year peak in their price-to-book
ratios. Bulls might argue that such multiple expansion is warranted, but it also
raises the risks for investors who are late to the party. This now is a
well-known story and a potentially crowded trade with all of these names
having hit all-time highs in the past week. It's true that the off-price
retailers still have a lot going for them not least of which is their ability
to provide a positive earnings story in a tough environment but investors need
to be extremely mindful of their entry points with these stocks' risk/reward
profiles becoming distinctly less favorable in the past 12 months. Click to
Enlarge As of this writing, Daniel Putnam did not hold a position in any of the
aforementioned securities.