Newly Released Data Makes This Sector Even More of a Long-Term Buy

If you are a close watcher of retail stocks, you have every right to throw up your hands in exasperation. With all of the distress taking place among consumers, who would have guessed that the back-to-school season would be so good?

Some retailers, such as Abercrombie & Fitch (NYSE: ANF) and Limited Brands (NYSE: LTD), posted surprise double-digit gains in same store sales, while many others posted comps in the mid single-digits. Almost all of them were ahead of analysts’ forecasts.

Does this mean that we should take all of the gloom and doom about consumers with a grain of salt? Yes. Does this mean that retail stocks have become a compelling buy? Yes. But not for the reasons you think, and only in the long-term context. 

It may look as if we’re off to a strong rebound in retail spending. But one month’s data does not a trend make. October sales could just as easily be lackluster. Instead, the real reason to like retail stocks is the tremendous amount of earnings leverage they can garner from only modest sales growth. I covered this topic in early July when the Merrill Lynch Retail HOLDRs ETF (AMEX: RTH) moved to lows for the year. [Read: “A Little goes a Long Way for this Sector”]

Since then, that ETF has risen nearly +15% to almost $100 and is now close to the all-time high of $107 hit back in 2007. Trouble is, retail sales remain well below levels seen back then.

Why the recent rally? Investors increasingly understand that retailers are now so lean and efficient that only a modest improvement in sales yields far more robust profit gains. Curiously, retail stocks, after a recent strong run, are flat this week even as sales numbers are surprisingly robust. Only Abercrombie & Fitch, Zumiez (Nasdaq: ZUMZ), American Eagle Outfitters (NYSE: AEO) and The Buckle (NYSE: BKE) are big gainers in Thursday trading. (The Buckle’s surge comes as negative sales comparisons were not as bad as had been feared).

At this point, investors have more questions than answers. Was this sales spike due to back-to-school demand or a harbinger of more robust spending to come in the seasonally quieter next two months before December?  Should we now assume that holiday spending will be very strong? Should investors jump in now, even after the sector has had a solid rebound? Truth is, we really don’t know. Retail sales have been surprising to the upside and downside for a number of months. And through that time, no clear trend has been established.

Action to Take –>
As noted earlier, retail profits could hit record levels in the next few years as the industry’s leading players now operate in an ultra-lean fashion. That makes them a long-term buy. But near-term results are likely to keep wobbling up and down. With myriad state layoffs expected to keep coming [See: “12 States in Financial Distress”], any private-sector job creation is likely to be blunted. And as long as unemployment remains quite high, any retail euphoria needs to be kept in check.

Keep an eye on that Retail HOLDRs ETF. It’s proven wiser to buy it after steady pullbacks, and persistent concerns on the economy just might create the pullback that value investors crave.