21st June 2024

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Business Industry and Financial

Best Retail Stocks of 2023: Retail Investing 101

Blue Wal-Mart shopping carts stacked together

Image source: Getty Images

Many investors buy retail stocks because it gives them opportunities to own parts of the businesses where they shop. But just because you like shopping at a particular store doesn’t mean it’s a good portfolio investment.

The COVID-19 pandemic benefited some retailers and hurt others. E-commerce sales boomed as consumers avoided stores, and sales of certain products soared. Spending that would otherwise have gone to travel or entertainment funded home improvement projects and electronic gadgets instead.

Retailers battled shortages and supply chain constraints for much of the pandemic as they scrambled to meet consumer demand. That problem has now flipped: Sky-high inflation and recession fears are beginning to change consumer behavior and lead to excess inventory. Retailers that are able to nimbly adapt will thrive in the late-pandemic era.

Let’s delve into some of the top retail stocks and what you need to know about investing in retail companies.

There are hundreds of publicly traded retailers, but these five have risen to the tops of their industries:

1. Amazon

As the preeminent e-commerce retailer, Amazon.com (AMZN 0.03%) got started by selling books and now operates a marketplace enabling the online buying and selling of almost everything. Amazon’s 2017 purchase of Whole Foods Market also gives it a ready-made network of brick-and-mortar retail stores to further engage customers.

Amazon enjoyed soaring demand in 2020 and 2021 as shoppers shifted their spending online, prompting the company to aggressively expand capacity. Now that demand is cooling, Amazon is focused on boosting productivity and trimming expenses as it runs up against rising supply chain costs.

Amazon’s profits have plunged so far in 2022, but the online retail giant is well-positioned to lead the e-commerce market in the long run. Smaller players without the scale and logistical muscle of Amazon will struggle mightily to cope with surging supply chain costs, and the company also has a highly profitable cloud computing business to help shore up the bottom line.

While Amazon is facing some short-term issues, it’s never a good idea to bet against the e-commerce pioneer.

2. Home Depot

The home-improvement retailer is best known for its big box warehouse stores and extensive inventory. Serving both do-it-yourself homeowners and professional contractors, Home Depot (HD 0.43%) is consistently expanding both sales and earnings. The company has built a substantial e-commerce presence while largely holding would-be competitors at bay.

Home Depot’s sales soared during the pandemic with the sharp rise in consumers taking on home improvement projects. Strong demand for housing is maintaining high sales volumes even as the pandemic subsides in the U.S.

Home Depot certainly faces some headwinds as rising mortgage rates knock down home sales, and inflation may eventually put a damper on demand for home improvement projects. But the company still managed comparable sales growth of 2.2% in the first quarter of 2022. The sales gains Home Depot made during the pandemic haven’t gone away, and the company expects solid comparable sales growth of 3% for the full year.

3. Lululemon Athletica

As a pioneer in athletic clothing, Lululemon Athletica (LULU 0.29%) initially focused on making yoga apparel. The company has gradually courted a wider set of customers who want to stay fit and dress comfortably.

Store closures due to the pandemic hurt Lululemon’s results early in 2020, but the retailer has strongly recovered and maintained that momentum into 2022. Comparable sales jumped 28% in the first quarter, with direct-to-consumer sales soaring 32%. Total revenue has more than doubled over the past three years, with the early pandemic proving to be nothing more than a blip in Lululemon’s growth story.

Office workers won’t be going back to uncomfortable clothing after two years of working from home. Lululemon’s apparel has never been more popular, and that popularity looks like it’s here to stay.

4. Ulta Beauty

Tapping into the trend of providing experiences that lure shoppers into stores, Ulta Beauty (ULTA -0.48%) offers in-store salon treatments to its customers. The concept has taken off, and its stores were attracting plenty of customers before the pandemic struck.

Ulta’s sales were severely affected by stay-at-home orders in 2020, but the retailer was able to muddle through a difficult year. Sales have strongly bounced back, and Ulta has been enjoying robust growth in 2022. Comparable sales shot up 18% in the first quarter, and transactions jumped 10%.

Total revenue should come close to $9.5 billion this year, based on the company’s guidance, and an operating margin in the mid-teens is a testament to how well the Ulta model works. A recession would likely hurt sales and profits in the short term, but Ulta’s long-term growth prospects are very much intact.

How to identify the best retail stocks

Finding high-quality retail companies requires looking at some key aspects of the company’s retail business. The strongest retailers perform well based on these key metrics:

Sales growth

The best retail companies consistently expand the revenue they generate from the products they sell. Retailers can increase sales both by building more stores in new locations and boosting sales at their existing stores.

Same-store sales, or comparable-store sales, is a retail-specific revenue metric that evaluates revenue growth for stores that have been in business for at least a year. The best retailers produce strong same-store sales numbers and robust overall sales growth.

Earnings growth

A retailer can generate revenue but still not be profitable. Most retailers can lower prices or offer promotions that persuade more people to buy more things, but if their prices are too low, they lose money on each sale.

The top retail companies have loyal customers who are willing to pay premium prices, and these companies are also able to minimize costs to maximize profits. Investors should be cautious about buying shares in retailers that struggle to increase their earnings as measured both by absolute values and earnings per share.

Performance during key times of the year

Much retail business is seasonal, and many retailers do a large part of their annual business during the holiday season in November and December. Strong holiday sales can make up for weaker business conditions at other times of the year. Many retailers also offer lucrative promotions to shoppers during the holidays to further boost their seasonal sales.

Although the end of the calendar year is most commonly the high season for retailers, it’s not the only one. For instance, retailers that focus on younger shoppers typically see big spikes in sales during the back-to-school season.

Examining sales trends can help you understand the degree to which a retail business is seasonal. Strong performance by a retailer during a key season can indicate that the company is outcompeting its rivals.

Size of store network and real estate holdings

In addition to knowing a retailer’s number of stores and its locations, investors can pay attention to retailers’ real estate holdings. Retailers that maintain networks of physical stores may have extensive real estate assets.

While maintaining and improving stores can be costly, the retail floor, backrooms, and other spaces that retailers own or lease have value. Even when a company’s retail operations aren’t particularly profitable, the value of its underlying real estate can comprise a huge portion of the company’s overall worth.

Investors can also evaluate how efficiently a retail company uses its real estate. Computing metrics such as sales per square foot can indicate how profitably a retailer leverages the space it owns to sell its products.

Strength of e-commerce sales

Retail companies previously had either physical stores or sold their goods online but rarely both. Today, many companies have both e-commerce portals and brick-and-mortar locations.

As e-commerce has increasingly gained popularity, many retailers’ online sales are growing much faster than their overall sales. The best retailers use their network of stores to their advantage by offering services such as in-store pickup and local delivery. Retail businesses without a strong online presence are likely to have increasing difficulty competing with their peers.

Balance sheet strength

When considering investing in a retailer, look for plenty of cash and manageable debt on its balance sheet. The pandemic caused steep sales declines and big losses for portions of the retail sector, and retail businesses that were financially fragile before the crisis have not fared well. Major retailers such as JCPenney and Neiman Marcus were forced to declare bankruptcy, unable to cope with the sudden drop in demand for in-person shopping.

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Are retail stocks right for you?

It’s always fun to invest in companies you know and love, and retail stocks often fit the bill. Focus on the retailers with the strongest business fundamentals — low debt levels, healthy cash flows, and strong competitive positions — to give yourself the best chance to make money for your investment portfolio.

John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon.com, Home Depot, Lululemon Athletica, and Ulta Beauty. The Motley Fool has a disclosure policy.