Categories of Retail Stocks to Consider

Categories that attractive retail stocks tend to fit into.

Tiffany & Co. is the perfect example of a stalwart stock. Dimitrios Kambouris/Getty Images Entertainment/Getty Images

In his best-selling book One Up On Wall Street, investing legend Peter Lynch detailed various categories of stocks. Lynch broke stocks down into many categories, including  three that I feel encompass any retail stock worth buying: stalwarts, fast growers, and turnaround plays. While Lynch had additional categories and industries in his universe, these three, in my opinion, are what matter to retail investors.

Here's a breakdown of each category for potential retail stock picks. 

Stalwarts

Stalwarts are the steady growing, predictably strong, firms of the sector. In this category think of stocks like Home Depot, Advance Auto Parts, and Tiffany & Co. Each has proven it can consistently grow, even as a large-cap, and fend off competitors. A true stalwart is usually a dividend play as well but should never be bought for its dividend alone. What you want to find is a stalwart with a competitive edge, that can raise prices and expand gross margins. Ultimately, this will lead to higher profits and higher dividend payments. For that reason, a stalwart with a strong competitive position and growth potential, but a low dividend, is far better than a stagnant high dividend stock. It's the combination of safety and growth that makes a true stalwart; while they will grow slower than fast growers, they should be surer bets.

 

Turnaround Plays

Turnaround plays are your Lumber Liquidators, Coach, and Tile Shops' of the world. These companies have been beaten down, either by headlines or earnings and represent a high risk, high reward, scenario for investors. Turnarounds are tough to evaluate because their stocks often fall for good reason.

Yet, the ones with the best potential for a rebound tend to be beaten down due to cyclical or macro economic factors, like a strong dollar or a recession, that can be weathered. Sometimes, a great buying opportunity can also present itself when a stock price is beaten down due to rumors or poor headlines, assuming the headlines are worse than reality. What you want to avoid are stocks that have been beaten down due to systemic problems, either at the company or within the industry. J.C. Penney is a perfect example of this. Some investors have been drawn in due to a cheap share price, but Penney's industry is facing massive headwinds. It's facing pressure from online retailers who can undercut it on price, and brick-and-mortar retailers are offering a superior experience. When ex-CEO Ron Johnson took Penney's one advantage, door-busting sales away, the odds of "turning" took a huge hit. So, when your considering a turnaround play ask yourself are the problems systemic? If the answer is yes, stay away. 

Fast Growers

Another high risk, high reward category are fast growing retail stocks. Examples of this category are Chipotle, Zoe's Kitchen, Etsy, and social media stocks. Fast growers are the stocks growing top-line revenue by double digits, eating up market share, and raising expectations along the way.

These stocks have sky-high expectations, so any hiccups may send shares plummeting. For that reason, you may want to limit your fast grower exposure to a stock or two in a portfolio--but just one fast grower can transform your portfolio. The reason: a high-risk growth stock can only fall 100% (to zero), but a fast growing winner, held for years, can rise 1,000% or more. If you don't believe me, ask anyone who invested in Amazon.com in the 90's. 

In the next article of this series, we'll discuss which categories of stocks aren't good options for retail stock investors, as well as which buying rules apply to different categories. 

Disclosure: I do not own any of the stocks mentioned in this article, nor do I plan on buying shares in the next 72 hours. Never buy any stock mentioned here (or anywhere else) without doing your own research.