Profiting from Economic Cycles

by J. Royden Ward on August 23, 2012
originally from Cabot Wealth Advisory

Profiting from Economic Cycles

The Retail Sector

Dollar General (DG)

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When I first entered the investment world as a neophyte out of college, I was hired as a broker trainee. My job was to take buy and sell orders from an investment advisor located outside of Boston. This wasn’t just any advisor; the company managed 1,500 individual accounts, which grew to 5,000 accounts before I moved to greener pastures four years later.

In those four years, I learned the secret to the company’s success: Follow the business sectors to find timely stocks. Picking stocks in the sectors that are on the move and that offer the most promising prospects worked very well for the advisor and its many clients. 

I try to avoid market timing and charts, because of the whipsaws, head fakes, and myriad confusing chart patterns inherent in market timing. However, there is one chart that I have committed to memory that I consider important: the chart that illustrates the sector rotation during economic cycles. The following chart depicts the 10 sectors of the economy as presented by the iShares division of BlackRock.

Chart 8-23-12


Sector rotation does not occur exactly as illustrated, but knowing where the economy is in the economic cycle can help you allocate your investment portfolio more effectively. Currently, the U.S. economy is in the early stages of expansion. According to the above chart, Early Cyclical stocks will likely outperform other stocks. Included in the Early Cyclical stage are Technology and Consumer Discretionary stocks.

So today, I recommend emphasizing Technology and Consumer Discretionary stocks, because the leading stocks in these sectors will likely outperform other stocks during the early stages of the U.S. economic expansion. If the economy continues to improve, stocks in the Materials, Industrials and Energy sectors will shine.

You might be wondering if I have blinders on because I seem to disregard all of the pitfalls (and cliffs) that we’ve been warned about ad nauseum during the past several months. From where I sit, I see employment slowly improving, home prices and sales increasing and retail getting stronger. Until the picture changes, I will remain cautiously bullish.

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As I mentioned above, Technology and Consumer Discretionary stocks should perform well during the next several months. Retail stocks are included in the Consumer Discretionary sector and seem attractive, even though the sector is undergoing major changes.

Big department stores, such as J.C. Penney’s and Sears, are not faring well because consumers continue to look for bargains either online or in stores. Wal-Mart and TJX, however, are attracting new customers by offering attractive merchandise at low prices. I recommended Wal-Mart and TJX earlier this year, but now their stock prices are too high for you to initiate new purchases.

So-called dollar stores are attracting cost-conscious consumers not only from lower income shoppers, but also from middle income buyers. As a shopper, I tend to shun dollar stores in favor of Wal-Mart or Target, but whenever I go into our local Dollar General or Dollar Tree store, I usually can’t resist the bargains they offer. And there’s a bargain in one of these stocks too!

My favorite stock in the Consumer Discretionary/ Retail/ Dollar Store sector is Dollar General (DG). The company is the largest discount retailer in the U.S. with 10,000 neighborhood stores in 38 states. Dollar General helps shoppers “Save time. Save money. Every day!” 

The company offers quality private and national brand items, such as food, snacks, health and beauty aids, cleaning supplies, basic apparel, housewares and seasonal items at low prices in convenient neighborhood stores. Because of its large size, Dollar General is able to offer a sizable array of products from America's largest manufacturers including Procter & Gamble, Kimberly Clark, Kellogg's, PepsiCo and Coca-Cola.

Dollar General’s sales increased 14%, EPS jumped 39%, and same store sales climbed an impressive 6.0% during the past 12 months. Management’s four-year-old restructuring plan is paying off. Numerous new stores, expansive store restructuring and the installation of additional coolers for fresh produce and frozen foods are attracting new customers.

Dollar General has launched DG Markets, which feature fresh produce. DG Markets are expected to produce four times the sales of core Dollar General stores. Profit margins will be noticeably lower, though.

The slow economic recovery in the U.S. will continue to cause budget-minded consumers to shop at discount retailers such as Dollar General. New customers will likely continue to shop at Dollar General after the economy picks up, too.

Sales will likely increase 10% and EPS will rise 15% during the next 12-month period. The company’s planned 625 new store openings, the on-going restructuring plan, and new DG Markets could produce even faster growth. At 16.8 times my forward EPS estimate of 3.00 for the next 12 months, Dollar General shares are undervalued. DG shares will likely reach my Minimum Sell Price of 77.60 within one to two years.

I will continue to recommend buying Dollar General as well as a few other undervalued, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will include a special feature on Warren Buffett-type companies. I hope you won’t miss it!

Until next time – be kind and friendly to everyone you meet.

Sincerely,  

J.Royden Ward  
Editor of Cabot Benjamin Graham Value Letter

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