Keep an Eye on Discount Retailers

That's the advice from S&P's Thomas Graves, who expects consumers to keep on spending, particularly at chains like Costco and Wal-Mart

The consumer has been powering the economy -- and will continue to do so, although perhaps not at the pace witnessed in previous recoveries. That's the prediction of Thomas Graves, group head of the Standard & Poor's analysts covering stocks in the consumer discretionary sector.

In Graves's view, the best consumer stocks now are those of companies that benefit from lower interest rates or consumers' interest in lower prices. In the first category he puts homebuilders such as Hovnanian Enterprises and D.R. Horton, and in the second retailers such as Wal-Mart and Costco.

He sees digital video disks (DVDs) as a promising innovation but not one that yet has the power to move stocks, since most of the companies involved are such giants. Among entertainment names generally, he considers stocks "adequately priced," though he says S&P likes News Corp., Fox Entertainment, and Liberty Media -- and recommends avoiding AOL Time Warner.

Graves made these and many other points on consumer stocks in a chat presented Oct. 1 by BusinessWeek Online and Standard & Poor's on America Online. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Tom, how about that market [up 32 on the S&P 500 and more than 346 on the Dow today]? I've asked this same question before, only to have the market reverse itself again, but have we turned a corner at last?


I would not look for today's action to be a sign that the market is going to move higher on a sustained basis. We're likely to continue seeing crosscurrents as investors worry about troubles in the Mideast, but we also look for signs that economic growth is picking up and is creating good investment opportunities.

Q: Do you expect consumers to keep spending, as they have so valiantly been doing? And will consumer stocks benefit accordingly?


We do look for consumers to continue to provide some leadership in fueling economic growth. However, because they've done such a good job over the last two years, we would not look for consumer spending to provide the kind of strong leadership that it has coming out of periods of previous economic weakness.

In general, we do look for both the broad market and for consumer discretionary stocks to move higher in the year ahead. Some of our favorite investment themes among consumer discretionary stocks include looking for beneficiaries of low interest rates and investing in companies that should benefit from consumers' emphasis on lower-priced goods.

Q: What is the outlook for the food sector? Though I doubt you can call food "discretionary."


S&P is recommending an overweight position among consumer staples stocks, which includes foodmakers. Among our favorites in this area are Dean Foods (DF ), Kraft Foods (KFT ), and PepsiCo (PEP ).

Q: What consumer discretionary names look good?


We're particularly bullish on the homebuilding group, because we expect relatively low interest rates will continue to fuel sales. Among the homebuilding stocks that we especially favor are Hovnanian Enterprises (HOV ), KB Home (KBH ), Lennar (LEN ), and D.R. Horton (DHI ).

Q: And what about stocks that benefit from consumers' interest in lower prices?


In our view, we're going to continue to see a relatively high level of price sensitivity among consumers, which should cause discounters and some mass merchandisers to gain market share from some other retailers. Among our favorite stocks in this theme are Wal-Mart Stores (WMT ) and Costco Wholesale (COST ).

Q: Opinion on the entertainment area -- Disney (DIS ), Six Flags (PKS ), Carnival (CCL )?


We're not especially bullish on entertainment stocks. In our view, soft levels of consumer travel are going to limit the gains in areas such as theme parks, hotels, and cruise ships. And for the major providers of filmed entertainment and music, we generally see the stocks as being adequately priced. Among entertainment-related stocks, our favorites include News Corp. (NWS ), Fox Entertainment Group (FOX ), and Liberty Media (L ). However, we do advise steering clear of AOL Time Warner (AOL ).

Q: I had Home Depot (HD ) for three years -- split twice. Hold or sell? And what about Lowe's (LOW )?


We like shares of both Home Depot and Lowe's. Shares of Lowe's have been doing considerably better than Home Depot. However, we believe that both stocks should benefit from consumers continuing to invest in their homes, and we view both stocks as attractive.

Q: What do you think of Clorox (CLX ), a product for consumer kitchens and baths?


We have a favorable opinion on Clorox. The company said in mid-September that it expected its September quarter results to be better than expected. We look for the stock to outperform the broader market over the next 6 months to 12 months.

Q: Speaking of bathrooms, do you think Bed Bath & Beyond (BBBY ) is a good stock to hold now?


We like BBBY. It recently reported earnings that exceeded analysts' expectations. The company has a sturdy balance sheet and minimal earnings quality concerns, and we see the stock's premium valuation as being modestly warranted.

Q: Are any old-line department stores worth a look, or is the Wal-Mart model today's place for your money?


We're not especially bullish on department-store stocks. We do like shares of Sears Roebuck (S ), and we advise that investors hold shares of some other department-store stocks such as Federated Department Stores (FD ) and May Department Stores (MAY ). However, department stores are not an area we advise investors to overweight.

Q: Opinion on the beverage industry -- BUD (Anheuser-Busch), RKY (Coors), SAM (Boston Beer)?


We like shares of both BUD and RKY. Those stocks fit our general theme that consumer staples stocks should do well in an environment that still looks volatile and one in which investors are likely to seek what seem like safe havens among stocks of companies that provide basic products to consumers.

Q: Who is the best value (price vs. growth of sales and earnings) for consumer noncyclicals, in your opinion?


I'm assuming you're talking about consumer staples. Rather than single out one stock among our favorites, let me mention some of the ones we particularly like in that group. These include Procter & Gamble (PG ), Alberto-Culver (ACV ), and Constellation Brands (STZ ). In addition, we earlier mentioned some of our other consumer staples favorites such as PepsiCo and Kraft Foods.

Q: What is S&P's definition of the difference between consumer discretionary and consumer staples?


Consumer staples tends to represent industries and stocks that provide basic goods to consumers, ones for which demand is not likely to vary dramatically during different points in the economic cycle. On the other hand, consumer discretionary stocks tend to be in industries that are likely to be affected more by macroeconomic conditions such as interest rates and energy costs.

Q: Do you see any prospects for innovation that could ignite more consumer buying? I suspect the corporate hold-down on spending and on R&D may be limiting any flow of new products.


We see innovation already favorably affecting consumer demand in a number of areas. This includes home entertainment, where the success of DVDs has bolstered consumer spending. Entertainment is an area where technological innovations continually help to add value to entertainment companies' libraries of movies and music.

Our assumption is that this trend should continue, and although the music industry currently is being hurt by free downloading of songs off the Internet, we expect that, in the longer term, the Internet will increasingly become a tool for entertainment companies to realize sales and profits.

Q: What stocks will ride up on this wave?


We've already touched upon our rather lackluster prospects for stocks of major entertainment companies. The companies that we follow tend to be so large and diverse that we don't expect technological innovation alone to be a compelling factor for purchasing them now.

Q: You haven't pinned any stars on the stocks you've mentioned so far -- what are a few of the 5-STAR (strong buy) names in S&P's Stock Appreciation Ranking System (STARS)?


Let me take this opportunity to mention some of our other favorites [buys] among consumer discretionary stocks. These include Mohawk Industries (MHK ), Applebee's International (APPB ), Wendy's International (WEN ), and Chico's FAS (CHS ).

Q: Any hope for Kmart (KM )?


We're advising investors to steer clear of Kmart stock. The company has filed for bankruptcy, and there's not enough visibility on what lies ahead to advise people to own the stock.

Q: What do you think of Limited Brands (LTD )?


We do like shares of Limited. It's not our favorite apparel retailer, but at its current level, we do view the stock as attractive.

Q: Buy, sell, or hold Pier 1 (PIR )?


Pier 1 is a stock that we like. We expect that the company should benefit from consumers continuing to invest in their homes, and that the stock will outperform the market over the next 6 to 12 months.

Q: What about auto stocks -- GM (General Motors), F (Ford), and DCX (DaimlerChrysler)?


We're modestly negative on the stocks of the automakers that we cover. We recommend that investors avoid shares of DaimlerChrysler. And we have hold recommendations on GM and Ford.

Q: As our hour winds down, what advice would you like to leave us with about consumer stocks, Tom? A: We believe that consumers will continue to do their part in bolstering the U.S. economy and that there are a variety of good investment opportunities in this sector. Today, we have mentioned many of our favorite stocks, including some on which we have buy recommendations and others that we are advising investors to accumulate.

Earlier, when asked about today's stock market action, I commented that I don't look for it to be sustained. What I meant by that was I would expect the market to continue to show volatility in the weeks ahead, and that it's unlikely to go up in a straight line. However, we do expect the market to be higher a year from now than it currently is and believe that there are many individual stocks that investors can benefit from.

Edited by Jack Dierdorff

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