Grocery stocks are often overlooked as investment opportunities, due to the competitive environment, low growth rates and historically low profit margins.

However, they are also considered to be counter-cyclical in nature, like other consumer non-durable categories. Regardless of the economic swing, consumers still need to buy food. While this is true, it also should be considered that during economic downturns, consumers shift their buying habits to lower-priced products, clip more coupons and seek the best possible prices. This implies that grocery stocks are both cyclical and counter-cyclical, making them difficult to evaluate for investors. Let's take a look at these types of stocks and how interested investors can sort out the best in the group.(To learn more, read The Ups And Downs Of Investing In Cyclical Stocks.)

What to Look For
Regardless of whether you consider grocery stocks cyclical or not, it is important to evaluate each company separately rather than in aggregate. The industry has seen changes over the last 10 years, and price leaders and product and service differentiations have emerged as direct competition becomes more common. When evaluating grocery stocks, there are a few factors to consider: competition, product mix, target market and supplier price negotiation.

Historically, when margins are low in the grocery business, fierce competition can be taxing on retailers. As low-cost superstores, like Wal-Mart (NYSE:WMT), enter the market, extra pressure is placed on traditional grocers likeKroger (NYSE:KR), which previously only competed with other grocers. Price clubs like Costco (Nasdaq:COST) and BJ's Wholesale Club (NYSE:BJ), which benefit from a diversified selection of discount products including grocery products, have also put significant pressures on retail grocers.

Product Mix
One way for grocers to increase their margins is to target markets with specialty products. Organic, exotic and unique foods have seen increased interest, as consumers demand healthier products. For example, Whole Foods (Nasdaq:WFMI) had some success in reinventing the grocery store model. Its product mix focuses on fresh and organic items that tend to have higher profit margins, although specialty items can also be susceptible to the effects of reduced consumer spending.

Target Market
A grocer's target market can be difficult to evaluate, as it can change over time. A low-price leader like Winn Dixie (Nasdaq:WINN) has historically marketed itself as a cost-saver, but after emerging from bankruptcy (it filed in 2005), in 2008 the company changed some stores to offer higher-end products in order to compete in that market. This flip-flopping can be confusing, not only for shoppers but for investors as well.

Supplier Price Negotiation
The ability to negotiate supplier prices usually comes with the biggest buyers. In a low-margin business, like grocery sales, giants like Wal-Mart clearly have the advantage, and are then able to pass those savings on to customers. This gives the company even more negotiation room when commodities move higher and other retailers are forced to pass the increased costs on to customers.

In both good and bad economic times, there is a group of consumers who will always shop for groceries based on price, which can equate to an added position of strength. Companies like Wal-Mart also benefit from a diversified product mix and can rely on other consumer lines to balance out any blips in grocery trends. They can also include higher-end products like organics, without committing to reinventing themselves in the grocery market space.

How and When to Invest
If you believe that grocery stocks should be categorized as consumer staples, purchasing those stocks during economic slowdowns may be to your advantage. (To learn more, read A Guide To Consumer Staples.)

This theory is based on the belief that the sales and profits from those companies are not as negatively affected by reduced consumer spending. For example, food and beverage companies and consumer products (soap, razors) tend to be lower on the list for consumers to cut when spending is reduced. However, if you believe that the retail end of the grocery business is more cyclical, consider buying those stocks in the same pattern as other retail businesses, like clothing, shoes and hardware. The sales and profits from these companies tend to expand when consumer spending rises and contract when consumer spending falls. (To learn more, read Using Consumer Spending As A Market Indicator.)

As the market has matured, retail grocers are no longer a homogeneous group selling products in the same manner. While you may see the same brands of milk and eggs in multiple chains, the way they are marketed, the services vendors provide and the way they are combined with trends in newer products varies.

The Bottom Line
Investing in grocery stocks is no different than investing in any other industry or sector. Price competition for products can limit a grocer's ability to increase margins, so many retailers have expanded their product and service mix to differentiate themselves. It is probably safe to assume that there will always be retail grocery stores in your town, but the landscape has changed dramatically and competition is fierce, so do your homework and make smart decisions based on research and market analysis.

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