Five Retail Stocks to Watch in 2010

NEW YORK (TheStreet) -- Individual stock selection will become increasingly important in the retail sector in 2010.

Consumer spending is only expected to improve marginally next year, with Citigroup forecasting a meager 2% increase on the whole. "Without a robust consumer-spending recovery to boost sales universally across all retailers, individual stock selection will become more critical," Citi analyst Kimberly Greenberger wrote in a note.

In truth, retail stocks had an incredible run in 2009 despite lackluster fundamentals, Needham analyst Christine Chen said. The S&P Retail Index is up 40% for the year-to-date period to close on Friday at 407.05. In comparison, The Dow is up just 12.5%, while The S&P 500 has grown 18.3% during the same period.

So what can we expect for retail stocks in 2010 after this arguably unjustified rally?

"We believe valuations heading into 2010 are still reasonable, given that earnings estimates have likely bottomed and will continue to trickle upwards in the next few quarters as the economy continues to stabilize," Chen wrote in a note. "We believe there is room for upward-estimate revisions in 2010, resulting in both further multiples and stock price appreciation for those retailers with the right product to drive top-line growth."

Thus, according to Greenberger, investors should focus on retailers with: strong management teams and brands; sustainable sales growth via new stores or comparable sales expansion; high-income core customers; structural changes that will generate higher margins; and earnings growth driving incremental margin leverage given 2009 cost cuts.

And while luxury retailers were the last to go into the recession, analysts agree that stores that cater to the upper middle-income consumer are best positioned for 2010.

"These shoppers have both the ability and willingness to spend," UBS analyst Roxanne Meyer said. "Last year they still had the funds to spend, but turned off the willingness due to fear. Now there is a pent-up demand for self purchases."

Retailers that have a substantial international presence are also smarter bets for investors who are weary of a U.S. economic recovery. In addition, investors should avoid companies that are overexposed to traditional malls.

Ultimately, while in 2009 the predominant focus was on profits, 2010 will be a top-line story for retail. "[Next year] will be less about margin recovery," said Matt Arnolds, analyst at Edward Jones. "Retailers will be more reliant on consumer spending, as they have already pulled out all the tricks when it comes to cost cutting and inventory control."