Buying with Discretion

While S&P's Thomas Graves urges investors to go easy on consumer-staples stocks, he finds a lot to like in Pacific Sun and Guitar Center

In this holiday shopping season, investors should look at consumer stocks with a discerning eye. That's the recommendation of Thomas Graves, group head of the Standard & Poor's analysts covering consumer-discretionary stocks. He adds that S&P suggests a market weighting for stocks in that sector -- and an underweighting for the consumer-staples group.

Among the stocks covered by Graves' group at S&P, he reports strong buy ratings on, among others, Pacific Sunwear of California (PSUN ), Best Buy (BBY ), and Guitar Center (GTRC ). Others with that top rating include News Corp. Class B (NWS ) and Weight Watchers International (WTW ).

Graves reckons that consumer spending will increase in 2005, but at a slower rate than in 2004, partly because of likely increases in interest rates. These were among the highlights of Graves' remarks from an investing chat presented Nov. 30 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

(Thomas Graves is a Standard & Poor's Equity Research Services analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Tom, the holiday shopping season has begun -- how's the season for the stocks you cover at S&P?


We cover a wide range of retail stocks at S&P. What we're seeing thus far is that the holiday shopping season got off to a strong start on the Friday after Thanksgiving. However, sales momentum weakened considerably on Saturday and Sunday. Thus, we see a mixed picture for the companies and stocks that we cover. We do expect consumer spending levels to show respectable growth during the holiday season, but we believe that investors need to be selective in their choice of retail stocks.

Q: What is your opinion on Urban Outfitters (URBN )?


We have a hold opinion on shares of Urban Outfitters. The company recently reported sharp growth in third-quarter earnings, and we raised our earnings estimate for the year ending January, 2005, to $1.09 [per share], up from $1.06. We have a 12-month target price of $45.

Q: What is your prediction for the Kmart (KMRT ) and Sears (S ) merger? Will it make an impact on Wal-Mart (WMT )?


The combination of Kmart and Sears should create a company that would have greater buying power with suppliers than either Sears or Kmart would have separately. We have a hold opinion on shares of Sears, and we think that Sears has an opportunity to strengthen its competitive positioning through real estate, product, and cost synergies with Kmart. However, we think it will likely take time for results to be measured, and we see significant integration and execution risks. We do not have a stock opinion on Kmart.

Q: How about Wal-Mart, with or without a Kmart/Sears merger?


Although Wal-Mart's recent sales were disappointing, we have a buy opinion on the stock. We look for the company to show improved inventory control, fewer markdowns, and improved shrinkage in the important January quarter.

Q: What's your long-term view of Target (TGT )?


We have a hold opinion on shares of Target. The company's third-quarter earnings exceeded our estimate by 1 cent. We do not have a long-term opinion on shares of Target.

Q: Given your advice on being selective with retail stocks, do you have any buys besides Wal-Mart?


First of all, I have to differentiate between a buy opinion and a strong buy opinion. Retail stocks on which we have a strong buy opinion include Pacific Sunwear of California, Best Buy, and Guitar Center.

Q: What's your top stock pick for 2005?


We're not highlighting any one stock as our favorite one for 2005. However, within the consumer-discretionary sector we do have 12 stocks on which we have a strong buy opinion. These stocks include News Corp Class B and Weight Watchers International. In other sectors we also have about 100 other stocks on which we have a strong buy opinion.

Q: What's doing in the world of entertainment and gaming stocks, Tom?


The U.S. gaming industry has been showing good growth in 2004, and there has also been a considerable amount of merger-related activity. At least three large acquisitions within the industry are now pending. We're clearly in an industry consolidation phase. Gaming stocks have done relatively well this year, and we're not especially bullish on the group currently. Within the entertainment area, we do have a buy opinion on shares of Time Warner (TWX ), and we have hold opinions on shares of Walt Disney (DIS ) and Viacom class B (VIA.B ). Our favorite stock within the entertainment area is News Corp. class B shares.

Q: How about the hospitality industry? Hotels and restaurants?


Hotel stocks have also performed well this year, and we do have strong buy opinions on two stocks in the hotel area. One of these is Fairmont Hotels & Resorts (FHR ), and the other is La Quinta (LQI ). Within the restaurant area, our favorite stock is P.F. Chang's China Bistro (PFCB ).

Q: What makes those stocks stand out in the crowd?


P.F. Chang's is a fast-growing company whose stock, we believe, should have considerable upside potential. We have a 12-month target price for the stock of $63. We expect that La Quinta should benefit from a continued upturn in the U.S. hotel industry, and we have a 12-month target price for the shares of $10. With Fairmont, we see the stock attractively priced, and we have a 12-month target price of $33. Q: Would you scale back on Starbucks (SBUX )?A: We have a hold opinion on Starbucks. We do see the stock as being valued at a lofty premium to the S&P 500, but we believe this is justified, given Starbucks' strong growth prospects and a history of successful product innovation.

Q: Are you seeing any repercussions from the high cost of energy?


We believe that higher gasoline prices have caused lower-income consumers to travel less than they would have if gas prices were lower. Going forward, we expect that higher home-heating costs, especially in cold weather locations, will have a negative impact on consumer spending this winter. Longer term, though, we expect that energy costs will be coming down from recent levels.

Q: Any consumer stocks investors should sell, in S&P's view?


Yes. S&P has a strong sell opinion on approximately 32 stocks. Among those are about nine stocks in the consumer-discretionary sector. These stocks include shares of Delphi (DPH ) and Superior Industries International (SUP ).

Q: The word is that luxury goods are moving well -- does that translate into good news for some stocks?


We do believe that the outlook for luxury goods is somewhat stronger than it is for some other parts of the retail spectrum. We believe that the recent reelection of President Bush is likely to bolster confidence among a number of higher-end consumers, since continuation of a Bush Presidency would seem to bode well for tax rates that consumers are likely to face. Two stocks that we expect to benefit from favorable high-end spending are Coach (COH ) and Brunswick (BC ). Brunswick is a manufacturer of boats and engines

Q: Do you have any forecast of consumer spending next year, and thus for consumer stocks? Many analysts expect a bit of an economic slowdown.


We expect decent growth in consumer spending next year, but at a pace of growth that is less than we expect for 2004. Several factors that we expect will limit consumer spending and the performance of consumer-discretionary stocks include the likelihood of higher interest rates and less of a benefit to consumers from the refinancing of home mortgages.

Q: With electronics products selling fast, what about retailers specializing in that area?


Best Buy is one of our favorite stocks. And we also have a buy opinion on shares of Circuit City Stores (CC ).

Q: What effects from online shopping do you see in retailing, especially any impact on stock values?


We do believe that online retailing is picking up market share from traditional retail activity. Among some of the more visible Internet retailers, we have a hold opinion on shares of Amazon (AMZN ) and eBay (EBAY ).

Q: Is J.C. Penney (JCP ) a buy for the long haul -- say, two years?A: We do not provide two-year stock opinions -- our emphasis is on 12-month performance. We have a hold opinion on shares of J.C. Penney. We also have a 12-month target price of $42.

Q: Will Wal-Mart's expansion into the high-end electronic market have an impact on the old guard, such as Circuit City and Best Buy?


We do expect that Wal-Mart's presence in any category is likely to increase the level of competition. Within consumer electronics, we see strong consumer interest in a number of products, including DVD players. At least for the time being, we believe that the market for consumer electronics is large enough to enable companies such as Best Buy and Circuit City to grow, even with competition from Wal-Mart.

Q: Overall, it indeed sounds like a mixed picture for consumer stocks, Tom.


I agree with that. We're currently recommending that investors market-weight this sector within their stock portfolio. We do see some attractive stocks within the sector, but we advise investors to be selective.

Q: On balance, is consumer staples any stronger as a sector than consumer discretionary?


Actually, we have an underweight opinion on the consumer-staples sector. In comparison, we recommend that investors overweight the telecommunications-services sector.

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