Buying retail stocks ahead of a potential recession… Obviously, a bad idea, right?
Maybe, but maybe not!
There are actually some types of retailers that can do well in recessions. Discount retailers (i.e., dollar stores) actually see their sales rise during recessions, as people seek to cut down on their spending. In the 2008/2009 recession — the most severe in recent memory — such retailers saw their stock prices soar, as their earnings grew with the influx of newly price-sensitive customers.
Which brings us to today. Many economists are still calling for a recession. In fact, Canada may be in a recession: the most recent gross domestic product report showed negative growth! So far, the U.S. economy is still growing, but if rates keep rising, then we may see the entire continent plunged into recession. With that in mind, here are some tips on how to invest in retailers with a possible recession looming on the horizon.
Focus on discount retail
The number one rule about investing in retailers during recessions is to focus on discount retail. There are times when expensive retail outlets make lots of money: recessions are not those times. During recessions, it’s dollar stores and other “discounters” that tend to thrive.
Consider Dollarama (TSX: DOL), for example. It’s a Canadian dollar store that tends to perform brilliantly during recessions. In 2020, the year of the COVID recession, Dollarama delivered the following:
- $4 billion in sales, up 6.3%
- A 43.8% gross margin, up 0.2%
- $1.81 in diluted earnings per share (EPS), up 1.7%
Now, a 1.7% increase in EPS might not seem all that impressive, but keep in mind that DOL was on the hook for extra pay and other benefits because of the pandemic. Also, other, more expensive retailers were going out of business and defaulting on rent in 2020. Compared to its more costly peers, Dollarama crushed it in 2020.
Another good example is Walmart (NYSE:WMT). One of the cheapest stores around that’s not a dollar store, it fares well in recessions just like Dollarama does. In 2008 and 2009, its stock rose, while other businesses were getting decimated. That’s because its revenue and earnings also increased in those years. That was not a fluke but actually an expected result. In recessions, when people tend to be laid off, they increase their shopping at dollar stores and places like Walmart, because such stores have cheap prices.
Mind the valuation
While you can certainly make money investing in discount retailers during recessions, you do need to pay attention to such stocks’ valuations. To turn to Dollarama again, that stock currently trades at the following:
- 30 times earnings
- Five times sales
- 132 times book value
These multiples are certainly not low. So, while DOL helps to illustrate the principle of how dollar stores do well in recessions, it’s not necessarily the best dollar store to invest in today.
Foolish takeaway
It’s certainly possible to make money investing in retailers in recessions. Discount retailers, in particular, can do really well. However, you need to pay attention to these stocks’ valuations. The markets aren’t dumb, and it looks like some dollar stores are already priced for their potential “moment in the sun” during a future recession.
