Opportunities in Retail Stocks

Here's hoping that everything you want for Christmas is under your tree this year. But what about retailers? Will this turn out to be a joyous season for them?

We recently sat down with Turner Investment Partners' Bill McVail to find out. McVail is Turner's lead analyst for consumer discretionary stocks, a sector that includes retailers, among others.

McVail also is the portfolio manager for Turner Small Cap Growth fund (symbol TSCEX), which returned 9% this year through December 17 and an annualized 19.2% over the past five years. It is well ahead of its benchmark, the Russell 2000 Growth index, over both periods. The fund is closed to new investors, but we can still benefit from McVail's holiday-shopping-season observations.

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Kiplinger's: It seems as though every Black Friday (the day after Thanksgiving) the media report that stores are packed and things look good for the holiday sales season. How much of that should we believe this year?

McVail: I think when you look back you're going to see a solid holiday season, but it's going to be very targeted in specific categories. Hard goods -- video games, iPods, flat-screen TVs -- will do well. Soft goods -- apparel, outerwear, stuff like that -- is not doing well.

If you have to choose between making sure your kid has an iPod for the holidays or buying another dress or a pair of jeans, you're going to opt for the iPod. That's going be challenge for the broad line retailers.

There seems to be a consensus that any business that depends on consumer spending has a rough road ahead. What will that mean for retailers?

If you have family income of $70,000 to $80,000, but you know that in February your adjustable-rate mortgage payment is going to go from $1,600 a month to $2,100 a month, maybe you won't spend as much money as you have in past. That once-a-month dinner at Cheesecake Factory (CAKE)? You're not going to be doing that anytime soon. Or if maybe last year you bought your wife a nice necklace or diamond earnings, you'll be skipping that this year.

For specific goods I see high demand, but secondary spending will be problematic. I think about the customer who goes into Lowe's (LOW) or Bed Bath & Beyond (BBBY). Four or five years ago, you would go in just needing three or four things and you would walk out with a cart full of stuff. Now if you need three or four things, you buy three or four things.

So where are the opportunities in retail stocks?

Retail corrected in October and November on a combination of concerns about consumer spending concerns and valuations. So you saw everything from Coach (COH) to Under Armour (UA), Guess? (GES) and Crocs (CROX), take hits on the chin.

They were all very high-valuation stocks, and they needed to have a pound of flesh taken out, in the market's view. Coach, a longtime stalwart, really took it on the chin and is trading at a discount to its growth rate.

So I think there are still good brand franchise retailers, both merchandise manufacturers like Under Armour and Crocs, or integrated guys like Coach, trading at reasonable valuations. And all these companies have international growth potential. Their brands are able translate really well to the Far East.

Coach has done that already. In China, Crocs is going from 50 stores to 2,000 in the next 12 to 18 months. It makes sense. Crocs is functional, it's cheap and it is a western brand name. And it's trading at a very cheap multiple after a huge sell-off. I think there are still those kinds of opportunities.

The rap on Crocs is that the company's colorful clogs are a fad that has run its course.

I think people still view Crocs as the Razor Scooter phenomenon of a few years ago, but I do think there's more to it than that.

In the third quarter this year more than 50% of its sales were outside the United States. They have a new line of shoes called You by Crocs, and it was done in collaboration with some Italian footwear designers.

These are shoes that are not at all like shoes you see your nine-year-old wear around the park in summertime. These are pumps with color and style selling for $80 to $150 dollars but still with Crocs material.

The thought process is, here's a shoe with style that still has the materials and the lightness and the comfort that Crocs should have. We'll see. It doesn't have to be 40% of Crocs' sales to be successful. It's an additional footprint to expand the line.

I think the company is very sensitive to the fact it needs to continue to grow its business. It's very much now a kind of show-me stock. When a stock goes from $75 to $40, as that stock did in what felt like an hour and a half, it's put up or shut up time. It's probably trading at 16 to 17 times next year's earnings, but I can't see earnings growth next year of less than 30% to 40%.

You're also a fan of video-game stocks. What does the announced deal between Vivendi (VIV.PA) and Activision (ATVI) tell you about that market?

You're going to see more consolidation in this space because content is important, and you are going to see major media companies want to build out that part of their arsenal. We own Take-Two Interactive (TTWO). It's not without its issues, but that stock popped 15% after the Vivendi-Activision deal was announced (see Time for a Take-Two Take-off?).

Even though this is the second holiday season, technically, of Nintendo's (NTDOY.PK) Wii platform, you're still probably in the third or fourth inning. There's a lot of room to go, and I think everybody wants to make sure they have as broad a suite of products as possible, be they online and console games, sports and action and shooter games.

You're going to see an increasing move into the more casual games. Things like Wii and Guitar Hero radically changed the casual gamers' approach to interfacing with these games. There's a whole new leg of growth here. It's one thing to think about video games being for 16- to 19-year-old guys playing Halo in their dorm room. It's another thing to have guys like me playing Wii Sports tennis with my boys or jamming to Guitar Hero with my son.

I think you're going to see more major media companies devote more resources to this category. It has gone from just a shooter world to more of an all-encompassing world.