Retail Stock-Picking: Keep Your List Short - TheStreet

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

Fellow

RealMoney

contributor Alan Farley recently offered his technical take about why

lower oil prices should offer a boon to retailers

. Being a value guy myself, I thought I'd explore Alan's argument from a different angle.

The Oil Effect

Whether you look at charts or not, the argument that lower oil prices benefit retailers is logical. If there's a decline in a consumer's energy costs -- gas, heating and cooling your home -- there's more money left over for other pleasures. And given that many U.S. consumers have a propensity to spend as opposed to save, odds are that retailers could benefit.

Nonetheless, as a value investor, my interest in examining the retail sector hinges on the fact that the industry has been crushed over the past year and a half, and bargains are usually found in the most unloved sectors.

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Short vs. Long Term

Not all retailers are created equal. While technical analysis will tell you that

Wal-Mart

(WMT) - Get Report

has broken "resistance levels," Wal-Mart is kind of like the "heads I win, tails I still win" retail play. A poor economy makes Wal-Mart more dominant than it already is. When food and energy costs are rising, Wal-Mart can still exert its influence on suppliers to get the best possible deals. For most suppliers, not selling to Wal-Mart is simply out of the question. Conversely, though, even when the economy is strong, folks still want to save money so they can spend it on other pleasures.

In the short run, retailers could benefit from a stroke of perfect timing: lower oil prices just in time for the holiday shopping season to kick in. Some analysts suggest that oil would need to be around $90 or $95 a barrel before the threat of inflation subsides. That price point now looks like a very realistic possibility. And because markets are forward-looking mechanisms, retailers' shares could rise in anticipation of positive consumer sentiment coupled with holiday shopping.

In fact, this has already started happening. Since mid-July,

Dillard's

(DDS) - Get Report

has rebounded from around $9 to $14.50, or more than 60%. Similarly,

Nordstrom

shares

(JWN) - Get Report

have rebounded from $26 to $34, or 30%, over the same stretch. In fact, July 14 seems to be the near-term bottom for retailers -- coincidently, about the same time oil prices began their quick descent.

TheStreet.com TV: Cramer: Stick With These Two Retail Winners (Sept. 12)

To watch the video, click the player below:

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Over the long run, however, investors would be wise to exercise caution. The retail industry is very finicky, with no competitive advantages (except low prices at Wal-Mart and luxury goods). Retail might be the most competitive industry in the markets today. Even worse, inventory values are very volatile; one season's fashions are next quarter's writedowns.

Besides, while oil prices have declined nearly 40%, gas prices are only down 10% to 15%, depending on where you live. And the decline in agriculture commodities has yet to meaningfully affect food prices. And ultimately, the 800-pound gorilla is housing. During previous situations characterized by high energy costs, consumers were confident that their home equity was rising. Today, home equity values are rapidly declining, wiping out the bulk of "savings" for many households. This situation places further strain on the long-term economics of retailers for the foreseeable future.

Quality Counts

Interestingly, higher prices can actually be a very good thing in retail. As Charlie Munger likes to proclaim, "Invert, always invert." A retailer that sells luxury or high-end ticket items actually has a stronger economic position than a discount retailer. When is the last time you saw a Louis Vuitton handbag on sale or at a discount store? You never see that. Luxury goods carry a different perception in the eyes of consumers, who are willing to pay top dollar to have them.

While people aren't buying designer handbags every month, luxury retailers operate on low-volume, high-price business models. Besides, luxury retailers have immense brand value and strong customer loyalty. While higher-end department stores such as Nordstrom have seen shares rise of late, deep discounters like

Stein Mart

(SMRT) - Get Report

continue to trade at all-time lows. Even money-saving consumers aren't having the effect on discounters that one would expect.

If you want the best economic advantages with retailers, your best bet is to go high-end. Premium prices command premium margins, and the risk of fashion obsolescence is much lower.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Stein Mart to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

This was originally published on

RealMoney

on September 11, 2008. For more information about subscribing to

RealMoney,

please click here.

At the time of publication, Gad had no positions in the stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the

Gad Partners Fund

, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a

value investing blog

inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at

sham@gadcapital.com

.