5 Great Recession Resistant Stocks

The discount stores present a rather tricky investment proposition right now. The stocks are not cheap but revenue and earnings trends are in their favor. They have been benefiting from a weaker economy, however if the economy improves will they lose traction? Moreover, with aggressive new store roll outs are they setting themselves up for over capacity?

The answers to these questions aren’t easy and investors have a right to want a margin of safety built into these stocks in order to deal with the uncertainty. With that said I must confess I am coming round to the view that, actually, something rather fundamental is happening within US retail which means that the discount stores do have strong long term prospects.

Germany Leads America Follows

Following the reunification of Germany the country fell into a period of low growth and austerity as higher ‘reunification’ taxes kicked in and the country dealt with integrating a far less prosperous economy.  During this period two discount stores (Aldi and Lidl) came to prominence as German consumers acquired the habit of trading down and buying through discounters.  The stores are about as Spartan as they come. Shoppers don’t go there for the retail experience, they go because it’s cheap.

And they kept on going even when the economy picked up. Indeed, Aldi & Lidl have done so well that they expanded their operations to international markets. I think this portends well for the discount retailers in the US.

Furthermore, I am a great believer in behavioral finance and many of its underlying assumptions. One of which is the idea that consumers are far more responsive to price hikes than they are to price reductions.  In other words once they get used to low prices they are a lot more reluctant to pay higher again. Traditional grocers will have a hard time grabbing back footfall from discounters if they are selling the same items but at higher prices.

Are Discount Retailers Properly Priced?

While they may get their product pricing right is the market getting these stock’s pricing right?  I’m going to take a look at some metrics. By discounters I mean the usual suspects (dollar stores) but I will also include off-price clothing retailers like TJX Companies (NYSE: TJX) and Ross Stores (NASDAQ: ROST).  All figures are quoted or derived from Yahoo! Finance.

I need to explain something about this table. All these companies are aggressively expanding their number of outlets and are in an expansionary capital expenditure phase. Therefore it doesn’t make sense to assume that current free cash flow is representative of the underlying cash flow generation. With that in mind I have assumed that capex equates to current depreciation in order to calculate adjusted free cash flow.

Of course this assumption makes sense as long as you believe that the current expansionary capex will lead to future incomes in line with what they are generating now.



The Dollar Stores

In order to demonstrate how this applies to the dollar stores namely, Family Dollar (NYSE: FDO), Dollar General (NYSE: DG) and Dollar Tree (NASDAQ: DLTR) here is how they have been expanding their stores over the years.

And it shows no sign of slowing. Of course it is one thing to expand stores but is this having a negative effect on same store sales growth? According to the following chart the answer is no!

In conclusion, I like the outlook for the dollar stores. I like the expansion plans and of the three I think Dollar Tree looks like the best value. This is just my personal preference but I like an underlying free cash flow yield of 5% plus teens growth in my stocks and Dollar Tree offers that.

The Off-Price Retailers

The big two here are TJX Companies and Ross Stores. As you can see on the first table they are the cheapest according to my free cash flow metric. I think the market is right to do this. These companies have more variability in their supply chain because they retail ‘off-price’ products and essentially rely on other retailers for their supply chain. That said every time I have listened to a TJX conference call its management has made the point that it has no problems obtaining product.

Moreover with footfall up at both TJX and Ross, they are making efforts to retail new product lines and/or geographic areas. In particular Ross is expanding its home goods lines and TJX claims to be the leading off-price retailer in Europe. Sales growth has been very strong in recent years.

My preference would be for TJX over Ross. I happen to like the European exposure because as the economy stays weak more consumers will be inclined towards TJX’s offering and as the leading player it will have good stock purchasing opportunity with the retailers.