Consumer Discretionary Underweighted

 | Oct 22, 2013 | 2:00 PM EDT
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In Monday's column we discussed on how important sector allocation was to overall portfolio returns. We also went through the reasons that financials have a significant underweight allocation in my own portfolio. Today we will talk about why consumer discretionary stocks are substantially underweighted in the portfolio I run as well.

There are myriad reasons to be skeptical on this sector over the next six months. The tepid job and economic growth that has been the hallmark of what has turned out to be the weakest post-war recovery on record should continue. Holiday sales this year are also expected to be weak and down from the levels of 2012.

In addition, the impact of the implementation of the Affordable Care Act has hit the retail and restaurant sector hard. Not only will these policies increase costs, but they have also forced changes to long-established business models.

Before the employer mandate portion of the healthcare policy was pushed back in early July, over 85% of net jobs created in 2013 were of the part-time variety. This not only hits the businesses in these establishments hard as they have to adjust hiring practices or absorb the extra costs -- it also impacts a segment of the population that is being shifted from full-time to part-time work. Obviously, this is negative for consumer spending on the margin.

I am particularly negative on the restaurant industry. Not only does the sector have to contend with the unintended consequences of the Affordable Care Act, but parts of the sector is seeing increased activism demanding huge increases to the salaries it pays to its low wage workforce. It is also vulnerable to rising food prices.

The only two restaurant stocks I have in my portfolio right now -- and they are small positions -- are Cosi Inc. (COSI) and Ruby Tuesday (RT). Both are speculative turnaround plays and have already taken their lumps in the market over the past few years.

I am also avoiding most retail stocks. The sector has quadrupled from the depths of the financial crisis but I do not believe medium-term earnings prospects justify an "Overweight" or "Equal Weight" allocation within my portfolio at the present time.

One of the few retail stocks I do hold Macy's Inc. (M). It has probably the best management team within the department store sector. The shares are also fairly cheap at around 10x forward earnings, a discount to its five-year average valuation (11.9). The stock also pays a 2.3% dividend yield that is a nice incentive to shareholders to wait until the health of the overall sector improves.

On Thursday and Friday we will go into two sectors that represent an overweight position within my portfolio.



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