Grading Back-to-School Stocks

Some outfits that gain from families' spending may make dicey buys. But equity pros reveal those investments with strong potential

By Amey Stone

Just because you spent the past weekend at the mall making sure your kids have the right jeans, sneakers, notebooks, and electronic equipment for the start of school or return to college doesn't mean all the companies that offer such goods are great stock buys. Portfolio managers warn that the retail segment -- especially companies that cater to fickle teens -- can be treacherous for investors.

Nonetheless, stock pros have their favorite picks among these back-to-school stocks. The National Retail Federation projects $48 billion in sales this year, two-thirds of that by college students. So while you're helping your kids stock up for school, you may want to add some stocks to your portfolio as well (if you have any money left over, that is.) Here are some of the pros' current favorites:

Apple Computer (AAPL )

Thanks to the success of the iPod, a must-have for college students, the computer maker has stunned Wall Street with a leap to $46 a share, from $15 a year ago. Now, its challenge is to make a similar mint out of other products, such as its iTunes music store, a new souped-up mouse, the latest G4 notebooks, and a $499 Mac mini.

The company now has a steep price-earnings ratio of 39 (based on the last four quarters of earnings). But Shawn Price, portfolio manager of the Touchstone Large-Cap Growth Fund, thinks there is more bite on the upside left in Apple.

J.C. Penney (JCP )

Your teenager may not be rushing out to Penney for the hottest fashions, but families looking to outfit younger children in affordable duds will be there in droves, says John Carey, portfolio manager of the Pioneer Fund. The retailer was long a dud with investors but has reestablished itself as a value play in the past year. It is now up to $50 a share, from $34 last November (and just $15 in 2003). Yet, its p-e is only 18, and you get a 1% dividend yield. Price has Penney in his portfolio as well.

Sears Holdings (SHLD )

Like Penney, Sears is an affordable place for families to stock up on all kinds of back-to-school items. The stock, the product of a merger of Kmart Holdings and Sears orchestrated by billionaire investor Eddie Lampert, is mainly a real estate play, says Price. It trades at $135, up from a low of $67 a year ago. Yet, it is even cheaper than Penney, with a p-e of just 14

Office Depot (ODP )

While Staples (SPLS ) is the leading office superstore and an obvious destination for school supplies, Office Depot is the stock in that category drawing investors' interest. Jeanne Mockard, portfolio manager of the George Putnam Fund of Boston, says it is one of her favorite companies. At $29 a share, it recently hit its 52-week high (up from $14 last November). The p-e is 26 -- a bit steep -- but as management continues to improve operations, Mockard believes earnings can drive the stock higher.

Walgreen (WAG )

The drugstore chain is up to nearly 5,000 stores -- not by buying other chains, but by using its free cash flow to grow organically. Carey has owned the stock for nearly 20 years (see BW Online, 8/10/05, "A Buy-and-Hold Vet's Winning Bets"). Walgreen now trades at $47, up from a 52-week low of $35. Its p-e of 31 is pretty rich, but Carey, who doesn't like to trade his winners, is still holding onto his shares.

Nordstrom (JWN )

As a luxury retailer, Nordstrom has prospered this year by catering to the high-end consumer -- those folks that don't let the spike in gasoline prices interfere with their spending, says Carey. It is one of the few retailers to raise its earnings guidance when reporting second-quarter results. With a ritzy children's clothes department, Nordstrom should do well in back-to-school sales. The stock is at $34, up from $18 a year ago. The p-e is 20, and it has a 1% dividend yield.

Gap (GPS )

With more than 3,000 Gap, Old Navy, and Banana Republic stores, this company will be the first stop for many families when outfitting their kids for school. It offers popular clothes without the high price and boasts strong free cash flow. Some investors snub the stock, but Carey thinks it could have a strong back-to-school season. At $20 a share and with a p-e of just 15, it is certainly reasonably priced. And the stock has barely budged in the past year, leaving room for gains if it surprises Wall Street to the upside.

Linear Technology (LLTC )

This chip stock isn't on parents' back-to-school shopping list, but Paul McEntire, chairman of Skye Investment Advisors, in Redwood City, Calif., says it is a great way for investors to play kids' craze for electronic gadgets. The company makes special-purpose chips that go into cell phones, handheld computers, and the like.

"It will have significant growth," McEntire believes, while the PC business may be in for a slowdown as people replace their computers less often. At $37 a share, Linear has a p-e of 27 and a dividend yield of 1.1%.


  Keep in mind that expectations for a strong selling season were dampened this year when July retail-sales figures were a bit weaker than expected. Wal-Mart (WMT ), a leader in this sector, further scared investors on Aug. 16 when management expressed worries about the impact of higher gas prices on future sales.

What's more, falling prices in some categories -- electronics most notably, but even jeans -- means retailers have to sell more to generate the same revenues, points out Jay MacIntosh, director of Ernst & Young's retail-sales practice. The firm analyzes the price of a basket of back-to-school items and found a 1% drop overall for the past three years, including a 9% drop in jeans.

In fact, the denim craze that has fueled teens' apparel spending is topping out, believes Richard Hastings, senior retail-sector analyst at Bernard Sands. With a single pair of jeans now including holes, worn fabric, and embroidery, "they've clearly run out of things they can do with denim," he says. If he's right, that could spell trouble for clothing retailers like Abercrombie & Fitch (ANF ) and American Eagle Outfitters (AEOS ).


  Peter Cohan, an author and investment strategist in Marlborough, Mass., says his shopping list for his high-school-bound daughter includes a laptop from Dell (DELL ), school supplies from Staples, new clothes from places like Target (TGT ), Marshall's (TJX ), The Gap, and Abercrombie & Fitch, and new shoes from DSW (DSW ).

Yet, "as stocks, I'm not really excited about any of them," Cohan says. "They also seem to be stuck in a trading range at best."

A strong back-to-school season isn't a reason to rush out and buy most stocks, says Price. He drilled down through the quarter-by-quarter financial results of 3,000 stocks looking for third-quarter trends. Overall, he notes, "there wasn't a back-to-school phenomenon that we could find."

Still, portfolio managers expect plenty of individual companies to prosper this fall as students and parents prepare for school and college. A few of their favorite names may be worth considering as additions to your back-to-school shopping basket this year.

Stone is a senior writer for BusinessWeek Online