3 Stocks With Deep Value In This Beaten-Down Sector

By StreetAuthority | Updated July 30, 2014 AAA

Five years after the economy spiraled into recession, U.S. consumers are in a very different place.#-ad_banner-#

Chastened by the hangover from their borrowing binges of 2006 and 2007, they've spent the subsequent years paying off bills, and building up equity in their homes. The Federal Reserve notes that consumers' debt-to income ratio, which peaked at 122% five years ago, is now back below 100%.

Yet even as consumers are now more capable of spending money, they still don't want to. Wal-Mart (NYSE: WMT) is just the latest retailer to tell investors that sales trends are lousy. Spending by lower-income Americans is really anemic, judging by comments from Wal-Mart and others.

Dozens of other retailers already told us of the tough spending environment, which has triggered an investor exodus from the sector over the past three months.

The Biggest Laggards In A Lagging Sector*

*This table only includes retailers in the S&P 400, 500 and 600.

Beyond these three-month laggards, many other retailers are trading far from their 52-week highs, so this table doesn't fully reflect the sector's woes. For investors looking to enhance exposure to this out-of-favor, group, there are two strategies to pursue: You can either bottom-fish in the cheapest names, or instead look to acquire shares in proven well-run operators that now trade at a discount from their highs. Whole Foods (Nasdaq: WFM) and Rent-A-Center (Nasdaq: RCII) highlight the perils of each of those strategies.

Despite the recent pullback, shares of Whole Foods are still up more than 800% over the past five years, and the forward multiple is still above 25. The innovative grocer is an excellent operator, but it has never before faced such sharp competition. The Fresh Market (Nasdaq: TFM) and Sprouts Farmers Market (Nasdaq: SFM) aim to mimic Whole Foods' approach; if given enough time, they may come to be seen as interchangeable by consumers and investors.

As I noted a few months ago, the Fresh Market is a less expensive alternative to Whole Foods, with a forward multiple of around 20. I suggested a pair trade of these two grocers, as they are likely to be impacted by the same spending trends -- positively or negatively -- and long/short approaches based on relative valuations have been a proven solid strategy across similar retailers.

Rent-A-Center is at the other end of the retail spectrum, renting furniture and appliances to lower-income consumers. As the company recently noted, "We continue to face meaningful headwinds in our domestic U.S. rent-to-own business, including a customer under severe economic pressure." Rent-A-Center just reported quarterly profits of $0.25 a share, far from the $0.75 consensus forecast.

Still, this retailer's impressive Total Yield strategy deserves a mention. Rent-A-Center paid its first-ever dividend in 2010 and has since hiked it sharply. The current yield stands at nearly 4%.

If you're a regular StreetAuthority reader, you know we like companies with rising dividends, diminishing levels of debt and generous stock buyback programs. My colleague Nathan Slaughter's research on Total Yield uses these three metrics to find the absolute best stocks over the long term.

Rent-A-Center is definitely buying back shares aggressively. Back in 2004, shares outstanding stood at 78 million shares. That figure now stands at just 53 million shares, and more than $200 million is available on the current buyback program. Despite stiff challenges, the company still expects to earn $2.30 to $2.50 a share this year.

Perhaps the best approach to the beaten-down retail sector is a hybrid one: Focus on well-run retailers with proven track records, healthy target demographics and reasonable valuations.

Bed, Bath & Beyond (Nasdaq: BBBY), which has quickly fallen out of favor, now trades for just 12 times forward earnings. If you buy into the notion that the housing market will steadily strengthen in coming years, then this retailer is about as well-positioned as any for that trend.

While talking about a customer base with solid demographics, you should also consider Barnes & Noble (NYSE: BKS), which had been staging an impressive rally in recent months, but has once again slipped down to the low teens. I'm still not a fan of the company's e-reader strategy, and think the Nook division should be sold off to the highest bidder. But the core base of bookstores remains nicely profitable, and shares trade for around 4 times earnings before interest, taxes, depreciation, and amortization (EBITDA), on an enterprise value basis.

Lastly, GameStop (NYSE: GME), which my colleague Dave Goodboy profiled last month, has quickly zoomed out of favor after reporting sluggish holiday sales, Shares, which stood above $55 in mid-November, have fallen roughly 36% to $35. Analysts' estimates have come down, but not nearly to the extent that the share price plunge might imply. That makes this a good time to beef up your research on this broken high-flier, as GameStop represents the kind of opportunities that emerge in retail. The company generates robust cash flow, and management has already reinvigorated the company's sales momentum several times before.

Risks to Consider: Consumer spending remains weak, even as consumers say they are feeling better. So if the economy hits a fresh rough patch, then consumer spending will really go into even deeper hibernation.

Action to Take --> Many of these fallen retailers are still underpinned by solid cash flow and valuation metrics. Yet they lack catalysts. A slowly rebounding U.S. economy is the strongest catalyst. As a result, it may take time for these fallen stocks to regain their footing, but patient investors should research the sector while momentum is low.

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