A Strategy for Retail

Investors looking to balance growth and value might consider Kohl's and Gap.
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Investors have set aside concerns about consumer spending and piled into the retail sector on newfound optimism that the recovery is producing real wage growth for U.S. shoppers.

With the market in rally mode, the S&P Retail Index is leading the way, up 19% since the beginning of May. Meanwhile, oil prices are in retreat, inflation has been held at bay, and the jobs numbers, though still somewhat lacking in nonfarm payroll gains, have been encouraging.

While there is no guarantee that this rally is sustainable, investors should be ready if this economy starts producing the sort of corporate profits and wage growth that will help consumers pay down debt. In the retail sector, a diversified wager divided between a quality growth stock and a time-tested value stock could do the trick.

For half a decade now, shares in companies with low valuations and dependable results -- value stocks -- have outperformed those of companies that are priced higher on hopes that their business will take off -- growth stocks. Since 2000, the Russell 1000 Value Index has gained 6.4%, while the Russell 1000 Growth Index has dropped 10.4%.

Of course, if we go back in time to 2000, at the height of the tech bubble, a five-year comparison between these two indices would show the opposite results. Growth stocks were soaring while their value counterparts had fallen out of favor with investors.

This comparison (somewhat imperfectly) illustrates the cyclical nature of the two investment categories. Since the stock market began rallying on the current economic recovery at the start of 2003, value stocks have carried the broader markets because investors were defensive -- still uncertain that the kind of jobs and profit growth that characterizes a robust economic expansion would ever materialize.

In fact, it's uncertain whether this has really changed.

"Growth stocks still haven't shown a sustained ability to outperform value in this market," says Morningstar analyst Dan Culloton. "At some point, there should be a rotation and growth stocks will begin to benefit, but no one knows when or if that will really happen in the near term."

Some bullish traders think that time is at hand, as the

S&P 500

(SPX)

has finally made a new four-year high. Meanwhile, the Russell 1000 Growth Index has outperformed the value index for the last three months, climbing 8.8% while its counterpart was up a still-respectable 7.4%.

If this trend survives an earnings season that has already shown some disappointments, it could mean that consumer spending is off and running. In that scenario, retail stocks could continue to yield rich rewards. If it turns out to be a temporary blip, not all would be lost if an investor has at least partially held on to his or her defensive position.

Shares of

Kohl's

(KSS) - Get Report

and

Gap

(GPS) - Get Report

are both included in the Russell 1000 Growth Index, but a closer look reveals that they draw a nice contrast between growth and value traits.

With roughly $12.1 billion in annual revenue and about 650 stores nationwide, Kohl's is smaller than Gap, which boasts over $16.2 billion in revenue and about 3,000 stores divided between several different concepts. However, Kohl's has a larger market cap of $19.7 billion compared with Gap's $18.8 billion, indicating that investors have high hopes for Kohl's to grow aggressively in the years ahead.

Merrill Lynch analyst Kevin Boler noted in a recent research report that Kohl's has grown its store count 21% annually for the last five years, and he expects it to grow at 15% for the next five years. For Boler, square footage growth is the "ultimate measure of sustainable growth for a retailer," and only a select few can expand it over many years.

"On this measure, Kohl's ranks very high relative to its big-cap peers and deserves a higher multiple when comp sales improve," Boler says. (His firm is a market maker in shares of Kohl's, and it has an investment banking relationship with the company.)

For June, Kohl's surprised Wall Street with a stronger-than-expected gain in comp sales, sales at stores open for at least a year, of 14.4%. Year to date, the retailer has maintained an impressive 5.4% increase in same-store sales, indicating that its business is healthy, even under the strain of aggressive growth.

To be sure, Kohl's is a riskier investment. Because of inventory management missteps, its sales suffered in 2003, along with its stock, but that trend has since been reversed. So far this year, shares of Kohl's have gained roughly 19%. Last year, they added 9%. (

Kohl's stock was the subject of a bullish profile on this Web site at the start of 2005.)

The Gap, meanwhile, lacks Kohl's momentum, but it's a cash cow that does not appear to have much downside in its valuation. For every month so far this year, the retailer has posted negative comps, except June when it broke even. In 2004 it broke even for the year, signaling that it's not exactly hurting any of its competitors.

Its stock shed nearly 9% last year, but it paid out a dividend yielding almost 8%. So far this year, the stock has held its ground in the face of its lackluster sales results, while the dividend payments have continued. On Tuesday, the company signaled it would step up its already extensive share-repurchasing program with an announcement that its board approved an additional $500 million in buybacks.

Gap has yet to fully recover from some fashion faux pas earlier in the decade when it lost favor with its core customers, and its longtime chief executive, Mickey Drexler, stepped down in defeat. Successor Paul Pressler shored up Gap's financial position, restored its credit ratings, cut costs and focused on returning value to investors.

Plus, with all of its store concepts -- which include Gap Stores, Banana Republic, Old Navy and Gap Kids -- it's a well-diversified company in terms of fashion risks and economic conditions.

Using a discounted cash flow valuation method, Morningstar analyst Joseph Beaulieu pins the fair value of Gap's shares at $26. Currently, they are trading around $21. Even while its monthly sales numbers continue to lag, the retailer is becoming more profitable by increasing its gross margins. Currently, Gap runs about a 7% gross margin, and Beaulieu estimates that figure could jump into the low teens.

If some traumatic economic event occurs that stunts consumer spending -- such as the bursting of a housing bubble, a terrorist attack or a pickup in inflation -- then retailing is not the place to be. Otherwise, investors could see healthy returns between these two high-quality companies.