Shares of small-cap consumer-discretionary companies are outpacing the market on investor optimism about U.S. growth prospects, a sign analysts could increase earnings forecasts for these stocks.
The Russell 2000 Consumer-Discretionary Index -- comprising 290 members including Kate Spade & Co. (KATE:US), Brunswick Corp. (BC:US) and Sotheby’s (BID:US) -- has risen 0.4 percent since Feb. 18, compared with a 0.5 percent decline for the Russell 2000 Index. This follows three months when the consumer group lagged behind the small-cap benchmark by 6.9 percentage points.
The recent rally in companies providing nonessential goods and services shows that investors still are optimistic American consumers will unleash some pent-up demand this year, said Boniface “Buzz” Zaino, a portfolio manager in New York at Royce & Associates LLC, which oversees about $38 billion. These small-caps generate a majority of revenue domestically, and they’re important to watch because consumer spending makes up about 70 percent of U.S. gross domestic product, he said.
Earnings expectations for these stocks “will increase because employment numbers will get better and the slowdown from bad weather will dissipate,” Zaino said.
The shares historically tend to lead analysts’ earnings forecasts on a relative basis because traders incorporate new information instantaneously into investment decisions, said Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees $376 billion.
The harsh winter and a late Easter holiday disrupted normal seasonal patterns of consumption earlier this year, which partly coincided with the group’s relative underperformance, particularly in January, he said. Now investors generally are pricing in a better economic backdrop for these equities.
U.S. GDP will accelerate 3.1 percent in the fourth quarter this year on an annualized basis, according to the median forecast of economists surveyed by Bloomberg. That’s up from an estimated 1.5 percent gain in the three months ended March 31. Nonfarm payrolls expanded 204,000 this month, which would be the most since November, based on the median estimate in another Bloomberg survey. Monthly hiring averaged 194,250 in 2013, Labor Department figures show.
Analysts have reduced earnings expectations for a variety of industries, and consumer-discretionary companies are “part and parcel of that,” said Scott Chronert, U.S. small- and mid-cap strategist in San Francisco with Citigroup Global Markets Inc. He maintains an overweight recommendation on these stocks even after “strong market performance” in the first half of 2013 because many will benefit from the improving economy, he said.
“In addition to having a great opportunity set for growth, this group also has a quality aspect that’s somewhat differentiated from other sectors,” Chronert said. Small-cap consumer companies tend to have better balance sheets, with less debt, and higher returns on average, which translate to “decent” earnings, he said, adding that this sector had the highest number of mergers or acquisitions in the past two years.
“There’s a combination of offensive and defensive characteristics at play,” Chronert said.
Still, investors may be wise to pick and choose among these companies, he said. That’s especially true after the Russell 2000 Consumer-Discretionary Index broke a long-term uptrend in January relative to the broader benchmark, said Jim Stellakis, founder and director of research at research company Technical Alpha Inc. in Greenwich, Connecticut.
“The group is technically in a downtrend now,” Stellakis said. While investors still could be overweighting particular companies, the bet on the group as a whole has become less appealing, he added.
Central Garden and Pet Co (CENT:US)., which sells supplies to big-box retailers such as PetSmart Inc. (PETM:US) and Home Depot Inc. (HD:US), is attractive as a “turnaround story” under new management, Zaino said. Similarly, Sears Hometown and Outlet Stores Inc (SHOS:US). is getting earnings leverage after increasing the number of its franchised outlet locations, while it’s also poised to benefit from further rebounds in the housing market, he said.
Zaino’s fund currently holds both companies, which are members of the Russell 2000 consumer index. Central Garden and Pet is up 20 percent (CENT:US) this year, while Sears Hometown has fallen 8 percent (SHOS:US).
Denny’s Corp. (DENN:US), which closed at $6.50 yesterday, is an example of a company that’s “controlling its own destiny,” said Bryant VanCronkhite, portfolio manager in Menomonee Falls, Wisconsin, at Wells Capital Management. His fund has held the restaurant chain for several years, and it’s undervalued based on a model that takes into account its cash flows and balance sheet, he said.
“If the market fully appreciated the opportunity, the stock would trade above $8,” he said.
Meanwhile, Creatura’s fund is invested in consumer companies whose products have brand recognition, he said.
Deckers Outdoor Corp. (DECK:US)’s brands, which include UGG Australia and Teva, have a “strong value proposition” and are expanding beyond weather-focused footwear and apparel, Creatura said. Lions Gate Entertainment Corp. (LGF:US) is producing serial television shows -- such as “Mad Men” -- that are released more frequently than movies, helping to reduce some unpredictability of relying on blockbuster hits, he said.
Even so, the consumer-discretionary group was “beat up” after a weak holiday season and frigid weather stymied consumer spending, VanCronkhite said. Some investors already are skeptical about second-quarter earnings expectations, while there’s also “concern about the quality” of U.S. job creation.
Amid this backdrop, some portfolio managers question whether they’re being paid to take on the risk of these stocks, VanCronkhite said, adding that his fund has an underweight or neutral recommendation on this group, seeing the Russell 2000 Consumer-Staples Index as more attractive.
“This is still a time to remain cautious, but diligent, in looking for ideas that will be positioned properly when this rough patch in the economy ends,” VanCronkhite said. Investors aren’t “getting a free lunch” just because of the group’s sell-off earlier this year, though retailers -- which were especially hard hit -- are more intriguing than some of their peers, he said. His fund currently holds Guess? Inc. (GES:US) and Ascena Retail Group Inc. (ASNA:US)
There are signs Americans are feeling more confident about spending again. Retail sales jumped 1.1 percent last month, the biggest increase since September 2012, following a 0.7 percent increase in February, based on data from the Commerce Department. April figures are scheduled to be released May 13.
In addition, earnings expectations for small-cap stocks generally could be too pessimistic, Chronert said. Analysts are projecting about 12 percent earnings growth for the Russell 2000 Index on a forward one-year basis, he said -- “near the low end of historical trends, and the only time these forecasts have been lower was in the midst of the financial-crisis triggered recession.”
Although consumer-discretionary stocks have had a “tremendous” run -- outpacing the benchmark in four of the past five years -- there’s still room for further gains, Chronert said. “This year is less about sectors and more about stocks,” with “some opportunities'' in this sector that “play into that.’”
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