Starbucks recently announced that it would pay its first-ever dividend.Lisa Poole/The Associated Press
Even though U.S. consumer stocks have been showing signs of life, following upbeat earnings from the likes of McDonald's Corp. and eBay Inc. , Alexandra Mahoney, an analyst at UBS, remains cautious about the sector.
There's no real mystery why: U.S. unemployment remains high, and is expected to stay high through 2011, which has a negative impact on consumer sentiment. While earnings reports have been stronger than expected during the economic rebound - and consumer discretionary stocks are up an impressive 118 per cent since bottoming out in March, 2009 - it has been due mostly to cost-cutting and innovative product offerings, according to Ms. Mahoney.
UBS recently cut its recommendation on consumer discretionary stocks to "underweight" from "moderate underweight," based on these concerns, as well as the fact that discretionary stocks are trading at a valuation premium relative to the rest of the market.
Based on consensus 2011 estimates, the S&P 500 consumer discretionary subindex has a price-to-earnings ratio that is 1.15 times that of the broader index. "This premium is in line with the index's five-year average" she said in a note. "However, we view this premium as too expensive considering the macroeconomic pressures we identified."
Nonetheless, Ms. Mahoney hasn't written off the entire sector. Indeed, she has an interesting approach to specific areas within this broad group of stocks, based largely on her view that moderate- and low-income earners suffer a disproportionately higher unemployment rate than higher-income earners.
As a result, she recommends investing in the two ends of the discretionary spectrum - the low end, such as Dollar General Corp. , which benefits from cost-conscious consumers; and the high end, such as Starbucks Corp. , where consumers have been relatively sheltered from surging unemployment. She has "outperform" recommendations on both stocks.
On Dollar General: "Dollar General's valuation is compelling, in our opinion, given our favourable outlook for its secular and company-specific drivers. The improved customer experience may mitigate customers 'trading up' when the economy recovers. In addition, the company's multiple product and operational initiatives will help build sales layers that will keep fuelling to same-store sales growth. These fundamentals create a platform for DG to grow sales and profits detached from the macroeconomic cycle."