How to Pick Winning Retail Stocks, Pt. 2

This column was originally published on RealMoney on June 7, 2007 at 1:17 a.m. ET. It's being republished as a bonus for TheStreet.com University readers. For more information about subscribing to RealMoney, please click here.

I really enjoy the process of picking retail stocks, and I wanted to give you a behind-the-scenes look at how I look for winners in the sector. In part 1, I led you through the first steps of retail-stock selection:

• Select retailers you know something about.
• Make sure the retailer's stock is public.
• Check for sufficient market capitalization, share size and liquidity.
• Look for an attractive technical uptrend.
• Focus on stocks with attractive valuations.

Now I'll drill even deeper into the key fundamentals that I consider before I take the plunge on a promising retail stock.

Peer Standing

At the end of the first part of this stock-picking journey, the universe of retail stocks had come down to a handful that looked attractive. But there's more work to do.

The next thing to figure out is where each retailer stands in its marketplace. Is it a gorilla, a medium player or an up-and-comer? Figuring that out requires key financial data on each of the prospective winners and its competitors.

Not so long ago, this would have been a monumental task that would have required scouring each company's filings with the Securities and Exchange Commission, such as 10-Ks and 10-Qs, and crunching a bunch of numbers.

Now sites such as Yahoo! Finance Industry Center or Reuters make this information easy to get. Typing in a ticker symbol yields a table of key data points on the retailer in question and its competitors. I sort this table by market cap from the biggest company to the smallest. Where does my retailer fit into the mix? Is it a smaller player or does it dominate its peers? Note the result on the list of potential stock picks and move on to the next one.

Two Key Points

Then compare the retailer with industry averages on two data points:

1. net profit margin (net profits divided by sales)
2. long-term debt-to-equity ratio (long-term debt divided by equity)

In both cases, the target stock needs to be in line with industry averages or better. For profit margin, that means my retailer must meet or exceed the industry average. For the long-term debt-to-equity ratio, my retailer must meet or be less than the industry average.