Four retail survivors to buy now

Conventional wisdom holds that the golden age of retail is over. But professional investor Rahul Sharma isn't so sure. Here, he picks four strong players who have a tight grip on costs and will be able to rebuild their profits.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Rahul Sharma, sector manager, consumer stocks atMartin Currie Investment Management.

Conventional wisdom holds that the golden age of retail is over. A decade-long shopping binge has left Western consumers with unsustainable levels of debt. With unemployment rising, consumers are reluctantly being forced to save. That spells doom for retailers. But conventional wisdom is wrong. Times are tough on both sides of the Atlantic. But they are tougher for some retailers than for others. For the stronger players, consumer cutbacks are a blessing in disguise, leading to tighter inventory control and driving consolidation.

Retailers have cut their sales assumptions, in many cases to far lower levels than analysts yet appreciate. Inventory control is currently the tightest I've ever seen. As such, shoppers who hold off in the hope of finding the big bargains they saw last year will be disappointed. More importantly, retailers will be able to rebuild the margins lost in last year's round of discounting. For now, analyst forecasts still underestimate the positive impact of this rebound in margins.

Costs are also being tightly managed. Several big chains have reined in expansion plans, which should boost returns on capital. So there's plenty of scope for retail earnings to beat the market's very low expectations, despite weak demand. And if sales beat forecasts, even modestly, the potential upside would be substantial: despite the run-up in the market since March, retail stocks are still very cheap.

Weaker global demand has pushed down the cost of products sourced in the Far East. Pressure from rising rents is also easing as landlords struggle to fill space. This gives retailers a choice they can pass the savings onto shoppers via lower prices; invest in raising the fashion content of their offerings; or boost their bottom lines. It's a nice dilemma to have.

Sector consolidation also helps. Recessions tend to weed out the weak and give the strong space to grow. The survivors are likely to emerge from this crisis in an even stronger position. The impact of consolidation is more visible in some cases than others. The demise of electronics retailer Circuit City, for example, will directly boost rival Best Buy. Beneficiaries of the collapse of regional chains such as Mervyns are less obvious, but we believe that retailers across the US will gain market share. So how can you benefit? Firstly, by holding JC Penney (NYSE: JCP), the leading US value retailer. It does a good job of refreshing its fashion lines to drive repeat visits by shoppers while also stressing affordability. It has kept a good control of inventory, in contrast to last year, when excess stock decimated its margins. Compared to its peers, it has the largest portfolio of exclusive brands and should benefit the most from falling product costs.

Secondly, hold either or both of Gap (NYSE: GPS) and Next (LSE: NXT). Both firms have suffered anaemic sales growth for years. In response, they have evolved a laser focus on both inventory and expenses. Because most of their product lines are sourced in the Far East, they will reap big benefits from lower input costs.

Finally, consider car retailer Inchcape (LSE: INCH). It saw all of its markets collapse at once last year as confidence evaporated. The stimulus is now starting to boost new car sales, while margins on used cars are returning to more normal levels after huge write-downs last year. It also offers a broad spread of geographies and a stable after-sales service.

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The stocks Rahul Sharma likes

12-month high12-month lowNow
JC Penny$44.20$13.71$30.42
Gap$14.18$3.01$6.91
Next1,734p781p1,701p
Inchcape45.64p5.82p29.12p

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