For Value Investors, Deep Bargains In This Ignored Sector

On Aug. 27, the market did something it hasn’t done in more than a year. On both the New York Stock Exchange and the Nasdaq composite index, the number of stocks making new 52-week lows exceeded the number of stocks making new 52-week highs.

Although this reversal is leading to a lot of hand-wringing among technical analysts, fundamental analysts have a different take. Fresh lows can point the way to deep value opportunities — if you heed a few key caveats.#-ad_banner-#

First, you need to be sure that the stocks making fresh lows already fully reflect a period of weakness to come. If the estimates for the next quarter still look too high, then you may as well be patient until those decks have been cleared. Second, you want to be sure that they sport value metrics that represent real value.

There is a wide variety of stocks that have fallen sharply in the past few weeks and months, though most have not yet touched 52-week lows. With a bit more market weakness in the days ahead, the list of stocks making fresh 52-week lows may swell sharply, so it pays to monitor the list on a daily basis to spot emerging trends.

For now, there are two distinct groups making fresh lows: teen apparel retailers and emerging markets. I’ve written a great deal recently about emerging markets, so I will instead give a deep look in search of value among the beaten-down retailers. Here’s a quick snapshot of the struggling group. (I’ve included Vera Bradley (NYSE: VRA), which appeals to a slightly older demographic.)

Why are these stocks touching fresh lows? Teen unemployment remained quite high this summer, and a lack of spending money means that clothes bought last year will have to suffice.

Yet it’s important to remember that teen spending is historically very erratic, which is why stocks like Aeropostale (NYSE: ARO) and American Eagle Outfitters (NYSE: AEO) have posted wild stock price swings over the past five years. They plunged and then rebounded in 2008 and 2009, again in 2011, and are doing it again now.

To be sure, Aeropostale has been one of the segment’s weakest performers, as its shares are trading right back at levels seen in the depth of the 2008-’09 financial crisis. But this is no time to bottom-fish this stock. Margins are plunging, same-store sales are sharply negative (15% in the most recent quarter), and though the retailer still has $100 million in cash, future projected losses could lead to an eventual cash crisis.

  Flickr/Random Retail  
  Even as American Eagle’s recent performance has been poor relative to its own track record, the company still is posting gross margins higher than rivals such as Aeropostale.


Meanwhile, a much better scenario is emerging for beaten-down rival American Eagle Outfitters. Though current business conditions are lousy, this retailer has a very strong balance sheet with $400 in million in net cash. That figure is expected to approach $600 million after the upcoming holiday selling season, according to management, which would represent more than 20% of the company’s market value.

American Eagle — which pays a 3.4% dividend — has already cut its share count from 233 million in fiscal 2006 to a recent 196 million, and current share buybacks should push that figure yet lower.

Moreover, even as American Eagle’s recent performance has been poor relative to its own track record, the company still is posting gross margins nicely higher than rivals such as Aeropostale. Goldman Sachs anticipates 35% gross margins this year, compared with 20% for Aeropostale.

Simply put, AEO can handle price wars and Aeropostale cannot, which means that AEO can make life really miserable for its rival during this upcoming holiday season, forcing Aeropostale to deeply retrench.

Risks to Consider: Keep an eye on back-to-school sales trends for these retailers. They are likely to be tepid at best and could pressure even top-performing retailers such as Gap (NYSE: GPS).

Action to Take –> Looking ahead, the clouds hanging over teen retail spending as the economy strengthens, and American Eagle Outfitters would likely be a key beneficiary of such a rebound.

Investors should also brush up on another lagging retail stock: Vera Bradley, which has fallen from $50 in early 2011 to a recent $20 on the heels of mediocre sales growth and concerns about rising inventory. Notably, profits forecasts for both this year and next have only come down by a modest amount over the past 90 days. Also, the retailer is financially healthy, reasonably valued (trading at 10 times projected fiscal 2015 profits) and likely to see a sales boost from a resurgent U.S. economy.

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