It might be the tactile immediacy to most of our lives, but after technology, retailers may hold the most fascination for investors. And with the economy looking ever more likely to deliver on the promised second-half recovery, retail stocks have been on a tear. The S&P 500 Retail Index (RLX) is up some 35% so far this year.
But aside from my natural reluctance to buy at new 52-week highs, the obvious question is, has all the good news been priced into many of these stocks? Moreover, how can we use options to take advantage of opportunities in this hot sector?
A Man's Got to Know His Limitations
One of my first assignments helping an analyst in his research involved the then-up-and-coming
. As part of my due diligence, I walked over to the legendary Sam Ash stores that dominate Manhattan's Music Row on 48th Street. My innocent attempt at a Peter Lynch approach to get the industry pulse revealed several things, none of which provided any insight into the company's prospects.
Not knowing anything about the music business prevented me from asking relevant questions, and even if I did, managers are less than forthcoming with information about themselves, leading me to the important conclusion that value-added fundamental industry research is rarely provided by a dilettante.
For a current look at the sector, I turn to specialists who focus on the mercurial world of retailing and ride their investment-research coattails into the all-important fall season. John Pinto and Evan Jones co-manage Brightleaf Partners, a North Carolina-based hedge fund focused on companies in the consumer universe that is up 30% through the end of August.
Brightleaf focuses on small-cap companies for two main reasons. "That's where our research and insight can provide an edge through identifying value discrepancies and price inefficiencies," said Pinto, "and historically, small-caps offer more growth opportunities."
But just because they don't take positions in the popular big-cap names such as
doesn't mean they don't follow them. "They are very useful for gauging macro-trends and assessing what products are selling well or poorly, but we can really add value by drilling into under-covered companies," explained Pinto.
Where Are We At? Where Are We Going?
The Brightleaf portfolio was 90% long in March and April, but has been slowly pared back and now stands at 60% long, 20% short and 20% in cash. Strong back-to-school sales make Pinto more optimistic about leaning toward adding longs, but his enthusiasm is tempered by what he calls a "normalization of the value." "I don't expect any headfakes or blow-ups coming out of the back-to-school season. The overall trend is up so I'd rather keep cash on hand than stubbornly short names with momentum," added Jones.
This points to an important difference between hedge funds or individuals that can go both long and short vs. long-only mutual funds that basically need to stay fully invested. Sometimes the possibility of underperformance through missed opportunity is the lower, more acceptable risk compared with forging ahead in some misguided attempt to keep up with benchmarks.
What Are We Doing?
That's not to say the Brightleaf boys are without ideas. But remember, any mentioned stocks represent just a few of their holdings, and I wanted to focus on some less-than-obvious names. Also, much to my chagrin, Brightleaf rarely uses options, so the suggested options strategies are entirely my doing.
One of their most interesting suggestions for gaining exposure to an improving consumer sector is
. While the Street did not greet its recent acquisition of
with much enthusiasm, the stock has recovered from its swoon now that the needed issuance of stock and convertibles is complete. The combined companies are now the largest
ground shipper in North America.
This is important in two respects. "Ground shipments are becoming increasingly more important and provide much better margins than air delivery and the growth of specialty stores and online sales makes the less-than-truck or -freightload a growing niche," according to Scott Flower, an analyst with Smith Barney.
Because the trucking industry is relatively low beta (meaning I doubt the stock is going to vault geometrically higher in the near term), one way to play this might be to sell puts. This will give you a moderately bullish position in which you profit if the stock remains flat or rises, and gives you an opportunity to buy the shares at a lower level should the price dip.
Currently trading at $29, you can sell the October $30 put for $2.50. This gives you $150 per contract, or a 5% time premium income over the next six weeks. The maximum profit is $2.50 a contract for a 8.6% gain in just over six weeks. Once October expires, if you still like the stock, repeat and sell the November series. This is a pretty exciting return for a "boring" business.
The video game industry, both on the publishing (software) and retail side, is one of Brightleaf's favorite sectors because it's a growth industry and presents the possibility for big gains. For example, among their holdings is
, but given that it just jumped some 20% on Wednesday, we'll move along to another favorite play.
And that's retailer
along with its majority-owner
Barnes & Noble
. "GameStop has a great business model of small, low-cost stores and the concept of being both a seller of new and used games, and also a place to play gives it a great dynamic that matches the nature of the teenage user base," said Pinto.
But Pinto also points out the volatile nature of this group and therefore suggests being nimble with the position. In fact, this is one stock in which he chose to purchase calls to build the long position.
Another interesting pick is
California Pizza Kitchen
. Once a Wall Street darling, it, like many food chains, fell out of favor when overly ambitious expansion plans went awry. "This is a turnaround play," said Brightleaf's Jones. "We like it for the brand name, which is still recognizable; the concept is still viable and most importantly it has some real assets in terms of its real estate, which it is making huge strides to consolidate."
I notice some similarities to both
(owner of seafood and Crab Shacks among others) and
(Red Lobster, Smokey Bones and more), which managed to turn around struggling food chains mainly through control of prime real estate locations. By paring down their locations, California Pizza Kitchen should see improved margins and an increase in sales per location.
You might want to look at some LEAP calls in California Pizza. With the stock currently trading at $17.50, you can buy the April 2004 17.50 call for $2. That's a pretty conservative outlay for a food retailer that could start posting some very positive comparable sales figures.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to