Buy Walmart on cash flow, Sell Target on inventory: Portfolio manager's stock trades

Big box retailers are on deck to report earnings next week, including Home Depot (HD), Walmart (WMT), and Target (TGT). Zacks Investment Management Client Portfolio Manager Brian Mulberry and Main Street Research CIO James Demmert join Yahoo Finance Live to discuss their latest stock trades regarding retailers and luxury brands, including LVMH (MC.PA) and Tractor Supply Company (TSCO).

Stocks to Buy

"These companies, like Walmart, that continue to generate an enormous amount of cash flow have that capital to reinvest in themselves organically and grow," Mulberry says on the interest rate environment for large retail chains. In the fashion world, luxury brand consumers that are attracted to LVMH tend "to be pretty consistent through all kinds of economic climates," Demmert discloses. Tractor Supply Company is driven by this "incredible move by millennials to the outer, more rural parts of the country," Demmert comments. Home Depot is being driven by post-pandemic trends where consumers, similarly to the beginning of the pandemic, homeowners are investing back into their space with renovation projects, encourage by housing market trends.

Stocks to Avoid, Sell

Compared to Walmart, Target has had "a difficult time managing their inventory, and they now have a new problem where they just acknowledged that they have over $500 million worth of shrink or theft coming out of the stores, Mulberry says.

Video Transcript

SEANA SMITH: All right. Well, big name retailers, including Walmart and Target, gearing up to report their quarterly results next week, and it certainly is a tricky year for retailers as they navigate what is becoming a more cautious consumer. So what names should you buy, and what should you sell? We want to bring in James Demmert. He's Main Street Research Chief Investment Officer, along with Brian Mulberry, Zacks Investment Management Client Portfolio Manager. Great to have both of you.

Brian, let me start with you. We talk about the fact that it's a tough environment here for retailers. More and more consumers-- we've seen this trend over the last couple of quarters. More consumers starting to trade down. Walmart is one of your picks. What gives Walmart the edge in this environment?

BRIAN MULBERRY: As you guys have been talking about, inflation has been a big impact on bottom lines across the board. Just simply the cost of doing business, labor and supply chain issues have made things difficult for a lot of these retailers. But Walmart has been a cash flow generating machine. And the more cash flow that you have, that you can reinvest in your own business without having to leverage right now is going to be a key difference as we go forward.

I agree with a lot of the other comments made earlier today in that interest rates are likely just to stay higher for longer than the equity markets currently have priced in. Not that we have a huge disagreement about we might be at the top terminal rate or one more hike to go, but we don't see the rate cuts in the future. That just simply means the cost of doing business in the future continues to stay high.

So these companies like Walmart, that continue to generate an enormous amount of cash flow, have that capital to reinvest in themselves organically and grow. And they've done so. They've made huge investments in their e-commerce segment, primarily to combat what they have in terms of direct competition with Amazon. And they're gearing up their home delivery services. And so they're using that cash flow to their advantage in this highly competitive sector.

AKIKO FUJITA: So, James, let's pick up on that point. I mean, you know, Brian, looking essentially where consumers are going right now, especially with tighter wallets, talking about cash flow investments in e-commerce, is this a name that you would get in on? How are you looking at the retail space?

JAMES DEMMERT: It is a name that we find attractive without question. And one of the few rules that we have, particularly in what I consider a stock picker's market, is the three most important things in retail which is brand management, brand itself, management, and as Brian mentioned, indebtedness.

It's very important here that companies have very strong balance sheets and that brand awareness and really, really great management. And I think that's going to be a key issue as we go through the hurdles of stickier inflation and quite some time before the Fed cuts. So we've got a couple names beyond the Walmart that we find very attractive here.

SEANA SMITH: And what are those, James?

JAMES DEMMERT: The first is, back to our global style, a company like LVMH. Obviously, lifestyles of the rich and famous type of stock. But there again, the one-percenters tend to be pretty consistent through all kinds of economic climates. When we go back to our brand is important, these are probably some of the highest end brands in the world and well known and recognizable. Arnault is probably one of the best managers of a business, and we do buy businesses.

And again, debt levels are important. So we want to make sure the company isn't over its skis, let's say, in indebtedness. So really the right mix. And here, you have the stock down about 8% from its high. Really love that as an opportunity to add to the position. Or if investors don't own it, here's a great time to do so.

AKIKO FUJITA: James, really quickly. I'm curious to get your thoughts on the announcement that we got today of Capri and Tapestry because we were talking earlier about as much as those companies combined bring in brands under one umbrella, it's still tough to compete with a name like LVMH, which you're invested in.

JAMES DEMMERT: I think it is. That's a very good question. And Etsy sort of falls into that same trap, where you've just got too many-- you don't have any brands of significance. You've just got a lot of brands. And I think that's going to be the differentiator for the successful companies over the next 12 months versus the others. So again, I would want to stick again with brand awareness, like a Tractor Supply, which we can talk about as well, has got that very significant presence, as in brand awareness. Really, really important.

SEANA SMITH: All right, James, we'll talk about Tractor Supply in just a minute. But Brian, I want to get your thoughts here just on the luxury consumer given the fact that it sounds like you see a lot of the opportunity being at the other end of the market, the lower income market.

BRIAN MULBERRY: Well, and it's certainly that we don't acknowledge the luxury brand. There has been a lot of durability there in spending from consumers. And we think a lot of that has to do with the fact most of those higher end, higher income individuals were able to take advantage of the low in the rate hike-- in the rate cycle and refinance usually what is their biggest debt, which is their mortgage. And that has cleaned up their balance sheet. And so their spending has been growing even more so than what you would see in the low to mid-income range.

So there's absolutely a reason to have those types of companies in your portfolio. We think it absolutely makes a lot of sense. It doesn't mean that we don't like them. It just means that at this point, we're a touch more defensive, leaning a little bit more on free cash flow and operating income. And there's definitely going to be some consolidation, we think, in those brands that James was just talking about.

AKIKO FUJITA: With that said, Brian, we started the conversation by talking about Walmart. There's another name that you actually surprisingly don't like, a direct competitor to Walmart. What's different here when you look at a name like Walmart versus Target?

BRIAN MULBERRY: Yeah. Target really over the last couple of years has had a difficult time managing their inventory. And they now have a new problem where they just acknowledge that they have $500 million worth of shrink or theft coming out of the stores, and a lot of it is because they have so much on clearance and on sale that's really impacted their margins for a very long time coming out of COVID.

And this affected a lot of people trying to get their actual goods landed in stores. And it had a ripple effect when you had a whole bunch of nonseasonable wares in the wrong place at the wrong time. And so they made a decision to try and clear out that inventory and not have to wait on it, but it has impacted their margins to a point where there's a little bit of a capitulation in confidence in the company, and that's starting to get reflected in their margins going forward as well.

And so it's not that target is a bad company, they're just kind of stuck in a bad spiral, and they're really going to have to work hard to get out of that. Again, this puts pressure directly on those metrics that we like. Operating income, free cash flow, they've all been in pretty substantial decline over the last three or four quarters. And we don't see it improving until maybe three years from now that they can work themselves out of this particular hole.

SEANA SMITH: Yeah. Target shares off just about 12% so far this year. James, getting back to what you just said a moment ago, and that's Tractor Supply. You talked about the brand awareness, but this is also a stock that hasn't done much since the start of the year. What's the bull case here for Tractor Supply?

JAMES DEMMERT: Yeah. It's a stock like many of the stocks outside of the Super Seven tech that has gone a long way this year. And I think that the valuation should be the first thing that's attractive, right? PE, multiple versus growth. Then back to brand awareness. This is the leader in gardening, and even farm equipment, and all kinds of stuff that you'd like to do in the garden.

And so one of the things and themes outside of brand awareness, which of course, they're the kingpin, is this incredible move by millennials to the outer parts, the more rural parts of the country and not just here in the United States. So Tractor Supply started in 1938. I mean, they are the brand. They're continuing to open new stores. So you have that expansion growth story.

You've got brand awareness, as we talked about before. And wow, do they have high margins and extremely well managed business, as opposed to what Brian mentioned, the Target situation, which is sort of a mismanagement there. On the Tractor Supply, you've got excellent management, great valuation, and you've got that millennial push. They're opening stores. All the right mix of a company that yes, maybe hasn't done tremendously well so far this year but probably will in the back half of this year into 2024.

AKIKO FUJITA: Finally, Brian, let's end on a positive note, sort of staying in the home improvement space. Home Depot, one of those stocks that you say you like. We've seen a bit of a transition in terms of what is driving revenue for Home Depot. We kind of went through the pandemic where there was this huge, huge push in DIY. Since then, it's kind of moved in a different direction. What are you liking what the company is doing right now?

BRIAN MULBERRY: Yeah. Again, a lot of investments in where future revenue is going to come from at Home Depot. They moved away from that DIY segment and put a lot into their pro development. And these are the licensed contractors, the actual professionals that can come in and do projects for you. And that's been a big transition in their business. The last 20 years, they've been the DIY kings along with Lowe's. But now they've actually made substantial investments in where they see the future of revenue coming from.

And there's a bit of a cycle in the consumer here where they absolutely did home improvements on their own. And then the value of their home went up so substantially, they started to sell it and trade up. And now it's coming back around to where people are going to want to have some projects and some improvements done. and Home Depot has by far and away made great investments in being ahead of that curve, so that they can supply the contractors with everything that they need to get those jobs done.

And that's important right now because the contractors are making more money now than they ever have been because of the short supply of their skill set and skilled labor. And so being able to have a trusted partner where you can actually work very conveniently with your own personal representative online again in an e-commerce way, go pick up the materials that you need, it makes you more efficient. It makes you able to do more projects that's better for your bottom line and Home Depot. That's why we like them.

AKIKO FUJITA: You've given us a lot to think about in the retail space both of you, James Demmert and Brian Mulberry. Good to talk to both of you. Really appreciate the time.