Dollar Stores Look Like Bargains Again

 | Mar 04, 2013 | 4:00 PM EST
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If you want proof that Mr. Market operates with very little temperament, look no further than what has happened to the share prices of the deep discount retailers, which are also known as dollar stores. Six months ago, shares in dollar stores were climbing to new highs. Today, shares have fallen back 20% to 40% as market enthusiasm for this retail category has quickly cooled off .

You can point to the usual suspects to understand the share decline: continued competition from Wal-Mart (WMT), an improving economy and concerns that dollar stores are reaching over-saturation in the U.S. These concerns, if accurate, would undoubtedly restrict growth, and that is why these shares are selling off.

But I believe the market is not fully connecting the dots and is making a lot of assumptions that may prove premature. Indeed, the economy is on the mend, but what is really improving is the stock market, which doesn't have an equal impact on economic performance. What drives the stock market in the long run is corporate profit growth, and what is driving corporate profit growth today is an excess supply of labor.

Profits are growing because companies are doing more with less, not because the economy is firing on all cylinders. Unemployment remains high, and consumers' penchant for savings is still strong. The Wal-Mart threat is indeed real, but it has been for years. Wal-Mart's prices are in fact generally lower than prices at dollar stores. From my observations, the price difference on average is in mid-single-digit percentage points. But I believe the slightly higher costs at dollar stores are more than justified by the superior convenience they offer.

Dollar General (DG) has more stores than Wal-Mart. In fact, most people live a lot closer to a dollar store than they do to a Wal-Mart. The additional time and travel expense -- not to mention other annoyances such as parking and navigating through Wal-Mart -- are not worth a 5% to 7% savings unless you are planning on spending $100 or more.

As for market saturation, it's the proverbial "you won't know until you get there." There are about 26,000 discount dollar stores in the U.S. Keep in mind, however, that discount dollar stores are very small in size -- less than 10% the size of an average Wal-Mart. They serve consumers the way gas stations or fast-food restaurants do, so a disciplined growth strategy in store count remains crucial.

Another interesting point: Over the years, the sales mix at dollar stores has shifted more toward non-discretionary items. Analysts estimate that more than 60% of sales at dollar stores are non-discretionary items. The top three names in the public markets are Dollar General, Family Dollar (FDO) and Dollar Tree (DLTR). Dollar General remains my favorite -- it has excellent management, great merchandising and a very stick customer base. Still, the entire sector is being sold off, and if that continues in the face of this rising stock market, stocks of these businesses will provide a solid hedge during the worst of times.

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