Despite many predictions to the contrary, the demise of the consumer sector did not occur in 2009. We were pleased to see our investment thesis unfold as we had laid out early in 2009. With valuations depressed, we saw great opportunities for the good operators who quickly adjusted their inventories and kept costs under control, thus allowing their margins to expand. While we had high hopes, who would have thought this would have been the best year of the decade for consumer and retail stocks, as measured by the S&P Retail Index and the Morgan Stanley Retail Index?
Retail stocks led the downturn in the economy, beginning their collapse in 2007, long before the broader market and the economy peaked. Therefore it should not have been that surprising to see them outperform the broader market in 2009. So are retail and consumer stocks now vulnerable? We don’t believe so. This sector led the downturn with two big down years in a row – the S&P Retail Index declined 17.9% and followed with another 31.9% drop in 2008. This past year saw that index rebound 47.2%, though many individual retail stock prices still remain far below peak levels established in early 2007. Of course, retail sales have not yet recovered to peak levels but there have been many other favorable adjustments made – operating expenses have been streamlined to meet lower sales levels, capital spending has been reduced, rent expense is no longer rising, sourcing costs have come down, store consolidation has provided incremental share opportunity, and balance sheets have generally been strengthened.
So what does this mean for 2010 performance for the consumer sector? We believe the first half of 2010 will show improving gross margins which should drive earnings growth despite flattish top-line performance (against weak sales results in 2009). Later in 2010, we look for gradual improvement in the unemployment picture, pent-up consumer demand to be unleashed, and consolidation in the number of retail outlets. All this should work to drive overall retail sales gains. We are also encouraged that economists and strategists remain cautious on the consumer, leaving room for upward surprises. Our high-level view is for another year of positive overall stock performance. We believe that stock selection will matter more in 2010 as there will be clear winners and losers.

In our view, the most important theme affecting the consumer sector in 2010 is the widening divergence between the consumer Have’s and Have Not’s’ between the retailer Have’s and Have Not’s, and between the supplier Have’s and Have Not’s.

The Consumers

Unemployment among lower income groups is worrisome and the demographic segment which lives at the poverty level has been increasing. Wal-mart continues to report an increase in the pay-check cycle, which means that more customers are spending money on the first and the fifteenth of the month when salaries and government subsidies are received. These consumers live paycheck to paycheck and are struggling in between pay periods to get by. As we look ahead, higher gas and utility prices look to be incrementally problematic as this expenditure accounts for a significant portion of the group’s disposable income. We remain cautious on consumer stocks exposed to this demographic. At the other end of the spectrum, stock market portfolios and pension funds have recovered somewhat and are providing some optimism among the higher-income demographic, specifically those that are still employed. We are seeing significant improvement in sales of high-ticket items such as home appliances, electronics, mattresses, and even engagement rings. Pent-up demand is driving some of the improvement. Additionally, as the number of layoffs has waned and may even be stabilizing, and as home prices also appear to be stabilizing, the wealthier consumers are feeling psychologically better and more secure and and are resuming their purchases. Discretionary spending among this group is gaining momentum and the beneficiaries will be retailers that offer popular brands, great fashion, and innovative products.

The Retailers

The divergence between the Have’s and the Have Not’s is very apparent at the retail level. Obviously, the economic backdrop will provide an advantage to those retailers that cater to the consumer Have’s, those consumers with greater disposable income. However because we don’t see consumer spending levels soaring, we continue to believe that the strongest operators will have a significant advantage in the coming year. In addition, within the retail sector we identify the Have’s as companies with strong balance sheets, solid management teams, and superior track records. Conversely, the Have Not’s lack these enviable qualities. Companies with the strongest balance sheets and good operating momentum are in the best position to negotiate at all levels of their business – sourcing, occupancy costs and location in retail centers, media purchases, and the quality of personnel that they attract. These advantages will allow the strongest retailers to widen their lead against their peers and should contribute to continued solid results going forward. Of course product misses can temporarily derail even the strongest companies so monitoring fashion is also important. We diligently watch trends through our regular field checks in stores and malls throughout the country. We believe it is key to invest in companies that have strong balance sheets, solid management teams, and desirable brands and products.

The Suppliers

At the supplier level, we also identify Have’s and Have Not’s. The supplier Have’s boast superior brands and products and strong balance sheets, while the supplier Have Not’s are narrowly focused and have less desirable products and/or brands. In difficult times, retailers are less willing to take risks with unknown and unproven products and brands. While this may contribute to a stale shopping experience for the consumer, it does contribute to a widening divergence between the larger suppliers with established successful brands and those that are trying to emerge in the marketplace. Furthermore, a strong balance sheet has gained importance as retailers have become more discerning in who they are willing to take on as their partners. Tighter credit conditions have made the business of financing receivables more challenging and smaller suppliers are finding it difficult to compete. Given this scenario, we expect more consolidation at the supplier level as the strongest suppliers continue to build their brand portfolios by acquiring smaller brands that have achieved success but are limited in their ability to grow. As far as investing in these companies, some of these smaller companies with good products will be attractive takeover targets.

So don’t count the consumer out in 2010. We are not looking for spending to soar and for consumers to replenish their levels of debt. Yes, the world has changed and we are in a new normal but we are impressed with how well and how quickly the good retailers have adjusted their inventories and their costs. With at least two thirds of our GDP coming from the consumer we believe their will be opportunities for investors to make money in this sector as the economy stabilizes and then improves modestly.