The Daily Dose: Holiday Cheat Sheet

 | Nov 11, 2013 | 12:00 PM EST
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The bottom line these days is that Mr. Market is forgetting about the profit margins on the companies that comprise the stock market. Instead, day in and day out it's nothing but talk about the Federal Reserve and the possibility it will taper quantitative easing.

But what about the largely lackluster earnings season that the market chose to ignore while whistling a tune? Take a look at this an emerging trend that I am keeping an eye on.

On Thursday morning, L. Brands (LTD) beat October sales expectations due to higher levels of discounting. Merchandise margins for its various brands were "significantly" lower vs. the prior year. I found that to be disturbing, though apparently I was the only one. On Thursday evening, Gap (GPS) smashed October sales expectations and raised its fiscal third-quarter earnings guidance. However, the company also tossed in this line that echoed the comments from L. Brands: "Third-quarter merchandise margins are expected to be below last year."

Both of these events were deemed positive by market-goers. But how positive are they really?

In looking at these examples, as well as employees' persistently weak average hourly earnings and workweeks, one has to wonder if core margins of companies are now on a downtrend. If you believe that, then think long and hard about paying up to own many stocks whose prices are higher solely based on liquidity sloshing around the market.

Holiday Cheat Sheet

I think the above discussion segues nicely into picks and pans from the retail sector for the approaching holiday season. Over the past month, I have worked my butt off to emotionally reconnect with the malls and large-box retail chains. That has entailed traveling to an enormous number of stores, observing people, chatting with unsuspecting employees and even touching and feeling the merchandise itself. (Note that this is a usual pre-Black Friday ritual for me, but it started earlier than usual this year.)

I do believe the investment community appreciates the consumer weakness, as well as the lackluster initial fourth-quarter guidance that's poised to arrive on scene next week -- which may begin with Macy's (M) earnings, due out Wednesday. However, I do sense indecision on what exactly investors should do. With that in mind, here are two basic questions you should be asking:

First, let's say a company has warned on third-quarter sales and earnings, and has then missed that plan -- ahem, Abercrombie & Fitch (ANF). In this case, has the market slaughtered the stock to the point at which the risk-reward scenario is favorable into December and January? (Remember, retail quarters end in January.) By "favorable," I mean the company will have to boast the type of business momentum that will bring in-line sales and earnings results. In that case, you would be paying to own shares of a company that under-promised and over-delivered, even as the market remains tepid on the name or group.

Second, are outperforming companies -- that is, names whose sales and margin expansion are far superior to peers -- priced accordingly? If so, you have to hold reasonable confidence that, during a hyper-competitive fourth quarter, these companies will be winning at an accelerating pace. For instance, a company such as Starbucks (SBUX) is indeed a retailer, and one that is surprising investors with its accelerating operational performance.

Since I don't want to overwhelm you, let's begin with the "three As" in the mall: Abercrombie, American Eagle Outfitters (AEO) and Aeropostale (ARO).

With these in mind, here are some key themes:

  • Not enough fashion is tucked inside traditional East Coast prep store concepts.
  • We're seeing compressing margins due to heightened promotional activity.
  • These names are overstored -- that is, they have too many locations for the market to support.
  • Outlooks have been cut in the last six months.

Winner: American Eagle Outfitters

I like how, in one month's time, American Eagle shares have outperformed the S&P 500 and their peer group, as well as Gap. Unlike at its peers, the assortment at American Eagle stores is rather aesthetically pleasing, and inventory is not completely out of whack with sales trends. Granted, my inclination is to not be involved in the teen apparel sector at all for now. But, if you are so inclined into the holidays, this is the name to gamble on.

One Final Note

Wal-Mart (WMT) is likely to trim its full earnings guidance later this week -- again.

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