Small-Cap Discretionary Jewels

Despite the worries about potential collapse of the euro and looming energy price increases, consumers in the United States have begun to open up their wallets and return to spending. Optimism is returning, albeit slowly, and consumers have picked up their expenditure habits. Recent data from the International Council of Shopping Centers reported that chain store sales were up 2.5% for the week ending June 19 from a year ago. Sales expectations for the month of June are forecast to rise between 3-4%.

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Shift from Staples to Discretionary
Factory activity appears to be on the mend and increasing, signs of job creation are promising, and weak inflation numbers have helped keep key Federal Reserve interest rates down. These factors have helped consumer sentiment rise to more than previously estimated numbers and the highest point in nearly three years. While the recovery is slow going, more consumers are feeling better about their prospects and there has been a shift from more staple purchases, such as groceries and toilet paper to discretionary items, like those delicious Starbucks (Nasdaq:SBUX) lattes.

Stocks in the consumer sector are also feeling this as well. The more boring Consumer Staples Select Sector SPDR (NYSE:XLP) is relatively flat in performance this year, while the Consumer Discretionary Select Sector SPDR (NYSE:XLY) is up about 5% YTD, or 40% over the past 52 weeks.

Smaller is Key
Wall Street's largest stocks have lost ground since the beginning of the decade starting in January of 2000, however, small-capitalization stocks have flourished by almost 100% in that period. Because of their nature, small-cap stocks tend to benefit more rapidly from economic rebounds. Low periods of inflation and low interest rates also help decrease borrowing costs for the tinier firms. If the consumer is truly starting to turn in favor of spending, then these minuscule companies might be a more compelling play on the discretionary market place.

Finding Some Crown Jewels
Exchange-traded fund manager PowerShares recently launched the PowerShares S&P SmallCap Consumer Discretionary(Nasdaq:XLYS) which looks at consumer plays within the S&P 600 index. This ETF is good place to start looking for interesting shopper "wants" small-caps. (To learn more, see Analyzing Retail Stocks.)

It's amazing what a little celebrity can do for your product. While a few years back, high-end premium jeans such as True Religion Apparel (Nasdaq:TRLG) were all the rage, these days, affordable luxury is king. Joe's Jeans (Nasdaq:JOEZ) could be seen as a great play on the uneasy consumer. Its products are quickly becoming hip with the Hollywood crowd, but sell for less than some of its rivals. Add this to a debt-free balance sheet and PEG ratio of 0.46, and the company looks like a great buy.

Even with consumers cutting back on eating out, Texas Roadhouse (Nasdaq:TXRH) has managed to grow its earnings, beat estimates and raise its guidance repeatedly throughout the recession. The company has been smart with its expansion, only opening three new establishments during the recent quarter and currently runs a total of 325 restaurants. Shares of the company seem fairly priced at a forward P/E of 18 and a PEG of 1. However, if the company continues to beat estimates, its current valuation may seem like a bargain.

Toy maker, JAKKS Pacific (Nasdaq:JAKK) has spent the recession beefing up its licensing deals with such companies as Disney (NYSE:DIS) and the mix-marital arts federation UFC. The company beat earnings estimates by nearly 18% in the first quarter and trades at 12 times forward earnings, below the industry average. As the economy improves, consumers will be more inclined to purchase some of JAKKS higher margined toys for their children.

The Bottom Line
With the economic recovery is beginning to take shape, consumer spending is beginning to rise, albeit slightly. As this trend continues, discretionary firms should prosper as the market shifts from more needs to wants. Small caps within the space should see even greater growth and could be leveraged way to play the trend. The previously mentioned ETF or stocks are a good starting point for investment.

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