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