Ring up profits with these three traditional retail stocks

Two professional investors tell us where they'd put their money. This week: Rupert Howard, head of portfolio management, and Ed Klinke, portfolio manager, at Saranac Partners.

The retail sector has been a focus for investors for some time, but not in a positive way. Lack of wage growth among the lower-paid and the existential threat posed by e-commerce has seen traditional retailers underperform. Investors' concerns have been justified, as evidenced by some high-profile bankruptcies. However, the reaction to these threats has thrown up some interesting investment opportunities.

Tap into demand for dollar stores

Dollar stores are US discount retailers that focus on lower-income consumers and should benefit from two concurrent themes: an acceleration in real wage growth for lower-income workers, and a business model centred on convenience and low-price products. Given the lack of discretionary spending power among lower-income families, a rise in wages has a direct effect on that spending and feeds demand for the dollar stores' products. As the typical dollar-store customer engages less in online shopping, convenience is the key. With nearly 30,000 shops and growing fast, these stores more than meet this need.

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Dollar General (NYSE: DG) operates 14,750 stores, predominantly in small towns and rural areas across the US, and prices its products at $10 or less 75% of which are "consumables", such as food. It still has room to grow, aiming at 6%-8% growth in store square footage. That, combined with modest sales growth, should see revenues rise 8%-9%, while operational leverage and cash generation help drive earnings higher at mid-teen rates. Valued at a 10% discount to the market despite faster growth and superior returns, the stock looks cheap.

Dollar Tree (NYSE: DLTR) is of a similar size but differentiates itself by selling everything at $1 or less with fewer consumables and more discretionary items, such as festive gifts, toys and housewares. It bought struggling rival Family Dollar in 2015 and a turnaround of this franchise is a key tenet of the investment thesis. Strong management, a robust core franchise and attractive valuation give us confidence in the outlook, despite disappointing progress so far.

An e-commerce latecomer

Another opportunity in retail lies in the differentiating factor of how products are sold, as opposed to what is sold. Zara and Gap both sell apparel, but in very different ways. Zara's parent, Inditex, is the champion of short-lead-time production, getting new apparel styles onto the shop floor within a month of design, compared with six to nine months for traditional retailers. Its superior supply chain and inventory management means less discounting, higher margins and a product line up far better equipped to meet the challenges facing retailers.

Inditex's (Madrid: ITX) fast-fashion business has 7,475 stores in 89 countries. Late to e-commerce, it integrated its stores and online offering in 2012, and now embraces technology such as augmented reality and hologram displays to enhance the buying experience, with robot arms for "click and collect" customers. The stock is down from 2015 highs, presenting an interesting entry point.