Buy Dollar General … AFTER the S&P 500 Hype Dies Down

by Dan Burrows | November 27, 2012 12:29 pm

Buy Dollar General … AFTER the S&P 500 Hype Dies Down

Dollar stores have been a heck of an investment over the past few years as cash-strapped consumers clamor for bargains amid a crummy economy and high unemployment.

Now they’re starting to get some respect from the keepers of the most important benchmark of U.S. equity market performance, too.

Dollar General (NYSE:DG[1]), the largest dollar-store chain with more than 10,000 locations in 40 states — and an InvestorPlace Real America Index[2] component — will be included in the S&P 500 at the close of trading Friday. The retailer will replace Cooper Industries (NYSE:CBE[3]), which is being acquired by Eaton Corp. (NYSE:ETN[4]), S&P Dow Jones Indices said late Monday.

What It Means

Dollar General’s stock got a lift on the news in an otherwise down day for stocks — but then, newly minted members of the S&P 500 usually do[5]. Inclusion in the S&P 500 means legions of index funds tracking the S&P 500 will have to buy shares. Plenty of active managers will likewise buy shares in DG (if only because some of them are secret benchmark-huggers).

It all adds up to increased demand for Dollar General, at least in the short term.

What It Doesn’t Mean

Nothing about the fundamentals has changed. This is really a trade for fast-moving professionals, so if you try to front-run this move, you do so at your own peril.

Just look at the action in DG early Tuesday in wake of the news. The stock jumped as much as 2.5% right after the open. Two hours later it was up just a half-percent. If you bought at the morning high, well, you were sitting in a 2% paper loss before lunch.

Apart from forcing S&P 500 index funds into buying Dollar General, inclusion in the index doesn’t really signify all that much.

One big misconception is that the S&P 500 is an index of the 500 largest companies in the U.S. stock market.

It’s not.

The index is made up of 500 companies the folks at S&P Dow Jones Indices figure best reflect the totality of the U.S. stock market and, by extension, the economy. Yes, stocks need to meet some eligibility requirements — such as a minimum market capitalization of $4 billion, a history of profitability and adequate liquidity at a reasonable price, among other considerations.

But size alone doesn’t get you in. Recall that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A[6], BRK.B[7]) didn’t make the cut until 2010, after a 50-for-1 split of the Class B shares made inclusion possible.

The Bottom Line

Although trading the stock based on the S&P 500 news might be folly, the fundamentals augur well enough for long-term gains.

The price certainly seems right, as DG shares appear to be on sale — they’re trading at slight discounts to their own five-year averages on both a forward and trailing earnings basis, according to data from Thomson Reuters Stock Reports. Indeed, the forward price-to-earnings ratio of 15 looks especially attractive considering the forecast long-term growth rate of more than 17%.

At the same time, for what it’s worth, Wall Street’s median price target stands at $61, good for an implied upside of 23% in the next 12 months or so.

So don’t get caught up in the S&P 500 hype, but do consider Dollar General for the long run. S&P Dow Jones Indices’ imprimatur helps confirm InvestorPlace’s take on this name, which has been bullish for a while[8].

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DG: http://studio-5.financialcontent.com/investplace/quote?Symbol=DG
  2. Real America Index: http://investorplace.com/real-america-index/tennessee-dollar-general-dg-a-booming-bargain-store/
  3. CBE: http://studio-5.financialcontent.com/investplace/quote?Symbol=CBE
  4. ETN: http://studio-5.financialcontent.com/investplace/quote?Symbol=ETN
  5. newly minted members of the S&P 500 usually do: http://investorplace.com/2012/09/see-ya-sears-hello-lyondellbasell-shld-lyb/
  6. BRK.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.A
  7. BRK.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.B
  8. bullish for a while: http://investorplace.com/2012/09/dollar-general-we-salute-you-dg-earnings-dltr-fdo/

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