Leave When the Street Loves Retail

• ByTim Melvin, RealMoney.com Contributor
• On 1:15 pm EDT, Friday September 4, 2009

Once again, all the talking heads are telling me that retail is getting better and I should be buying these stocks. As much as I hate to disagree with the collective wisdom of Wall Street, they have lost their minds.

The fact that some retailers beat your expectations doesn't mean that things are better; it means that you are a poor forecaster. When things are getting better, analysts always underestimate profits and revenue, and when things are getting bad, the herd instinct leads to forecasts that are too pessimistic.

There is a way to play retail stocks, and it has made me money over the years. Find low-leverage retailers that trade below book value and preferably pay a dividend, and buy them. Then, sell them when the whole Street loves them and thinks that things are better.

As an example of this approach, take a look at the stock of Oxford Industries. I suggested this stock back in early January when it traded right around book value and was offering a decent yield. As a bonus, insiders were buying. There was a little bit of Peter Lynch's strategy in this pick because I am a huge fan of Tommy Bahama clothing.

Wednesday night, the company reported revenue and earnings that were down substantially. The numbers did exceed Wall Street's expectations, however, and the company raised its second-half guidance. Analysts scrambled to raise their ratings on the stock, and it traded more than 20% higher during the day Thursday. That was the time to sell the stock, locking in a profit of more than 100% in less than a year.

The same trade would have worked with bookseller Barnes & Noble). It clearly has won the battle with Borders in the war of mall-based book stores. Despite Amazon's gigantic presence in the market, there will always be room for one national bookstore chain, and it looks like Barnes & Noble is going to be it. Last November, the shares traded down to book value and offered a good yield. Since then, the shares have doubled despite ongoing consumer weakness.

It is the only way I buy retail-oriented stocks. Earnings forecasts, especially for the specialty retailers, are often worthless. Tastes change in the specialty group with alarming speed. I have no way of predicting what women or teens, the primary buyers in this group, will favor from week to week.

I can walk into the Tommy Bahama outlet nearby and have a new wardrobe in less than 15 minutes, but I am not exactly on the cutting edge of fashion. However, I can add up balance sheets and come up with a rough estimate of liquidation value for a company and buy the stock for less than that.

To give you some idea of how overdone the retail stocks are right now, when I screened for stocks that fit the requirements, I got one stock. It is a name I have owned for some time now: Foot Locker. (Currently, I only have a very small stake in the shares.) Given my present view of retail and the stock market in general, I fully expect to buy more at lower prices in the second half of the year.

Foot Locker is one of the largest athletic shoe and apparel companies in North America and my expectation is that it will survive and eventually thrive. The company has very little debt and more than $400 million in cash on hand.

After reporting declining sales and flat earnings for the second quarter, the stock sold off a bit last month. This caught the eye of the company's new CEO as he stepped in and bought $427,000 worth of stock right around current prices. Apparently, he believes that the combination of cost-cutting and eventual economic recovery give the company excellent upside potential over the next few years.

I agree and own the stock. I also hope to buy more in a market pullback. I do not know if the stock can nearly triple to reach the 2007 highs, but I expect it to perform very well over the next five years.

Retail is one of the more difficult sectors in which to invest. If I had to depend on my knowledge of fashion and shopping trends, I would never make a dime in the stocks. Counting on the optimism/pessimism cycle of Wall Street also would have condemned me to piling up a losing record in the sector. They tend to love stocks near the highs and hate them at the bottom.

That is pretty much the exact opposite of what I am trying to accomplish as a value investor, so I never read the reports or pay attention to the rankings. Instead, I focus on tangible book value, dividends and patience.

At the time of publication, Melvin was long Foot Locker, although positions may change at any time.

Buzz up!