Get Big Returns from the Low End

 | Oct 21, 2011 | 9:00 AM EDT
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The Census Bureau reported that retail and food services in September were up 1.1% from the previous month and up a healthy 7.9% above September 2010. The government also revised July and August sales figures upward.

The retail industry is performing better than expected, and deep discounters, including single-price-point retailers and those selling overstock inventory, are especially strong. That is because, in the current economic climate, consumers are looking to buy on the cheap. Perhaps when the economy becomes noticeably stronger, such stores will lose some of their luster. But now they are on solid ground. Retailers at the high end are generally doing well also, while those in the middle are struggling.

Three deep discounters are favorites of my guru strategies, which are the foundation of my stock market analysis. I have taken the strategies described by well-known investors like Benjamin Graham and Peter Lynch in their books, programmed them into computers and now use them to screen for very promising investment opportunities.

Dollar Tree (DLTR) is the largest operator of single-price-point retail stores, with over 4,000 locations in the U.S. and Canada. The strategy I devised based on Peter Lynch's writings focuses on the P/E/G, which is price-to-earnings relative to growth and measures how much the investor is paying for growth. A P/E/G of 1.0 or less is acceptable. Dollar Tree's P/E ratio is 22.29 and its growth rate is 26.67, giving it an acceptable P/E/G of 0.84. Also in its favor is a modest amount of debt, where equity is about six-times debt.

Another deep discounter worth considering is Family Dollar Stores (FDO), which sells at price points between $1 or less, on up to $10. The company operates 6,800 stores. It, too, is favored by the Lynch strategy. The stock's P/E ratio is 18.45 and its growth rate is 20.28, giving it a P/E/G of 0.91. Its debt level is not as desirable as Dollar Tree's, since equity is about twice debt. But in the stock's favor is a strong recommendation from a second guru strategy, this one based on James P. O'Shaughnessy's writings. This strategy likes the company's large market cap ($6.9 billion), earnings per share that have increased in each of the past five years, a low price-to-sales ratio of 0.81 (1.5 is the maximum allowed) and a relative strength of 86, which places it among the top 50 stocks passing the previous criteria.

Do not forget to also look at Big Lots (BIG), an operator of 1,500 stores that specialize in selling closeouts. Like Family Dollar Stores, Big Lots is a favorite of both the Lynch and O'Shaughnessy strategies. The company's market cap of $2.4 billion, earnings that have increased in each of the past five years and a low price-to-sales ratio of 0.48, are among the reasons why the O'Shaughnessy strategy favors Big Lots. And among the stocks that pass these criteria, Big Lots is among the top 50 based on its relative strength of 74. From the Lynch strategy's viewpoint, a big plus is the company's very favorable P/E/G ratio of 0.28.

 etailers at the high and low ends are often doing well, while those in the middle are being squeezed. These three companies are in the sweet spot at the low end.

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