Experts name a key holding and deep value stocks in the retail sector

UK retailers have massively underperformed the wider stock market in 2022, and these analysts have spotted plenty of undervalued stocks with recovery potential.

A buy list of retail stocks includes JD Sports Fashion (LSE:JD.), Dunelm Group (LSE:DNLM) and Next (LSE:NXT) after they were named as best placed in a sector currently “rooted to the spot” by cost and recession fears.

Peel Hunt’s top picks of potential structural winners and key recovery names also feature Dr. Martens (LSE:DOCS), Hotel Chocolat (LSE:HOTC), Pets at Home (LSE:PETS) and ProCook (LSE:PROC). Longer-term bets for a two-to-three year horizon include ASOS (LSE:ASC), Boohoo (LSE:BOO), DFS (LSE:DFS), Lookers (LSE:LOOK), Superdry (LSE:SDRY) and Topps Tiles (LSE:TPT).

The note was published on Friday, when the sector was trading on 11 times earnings versus a 10-year average of 15 times, and after growth stocks derated from 20 times or more to between 11 and 12 times on fear of a consumer collapse and downgrade concerns.

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Peel Hunt’s retail team of Jonathan Pritchard and John Stevenson said that press headlines appeared “increasingly terrifying” as confidence has fallen to below financial crisis levels and energy costs and national insurance tax increases have added to cost pressures.

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However, they added: “This is not a rerun of the financial crisis; consumers are not retrenching in fear, they are facing an erosion of spending power. Retailers’ margins will carry some of the pain.”

But with further energy bill rises looming in the autumn, Peel Hunt’s model points to a 5-6% erosion in spending power for the average household.

It warns that consensus forecasts appear too optimistic and the sector is still vulnerable to further downgrades, but for long-term investors there now appears to be sufficient downside in the price of growth stocks to offset the risks.

Peel Hunt notes that most of the structural growth stocks have come through Covid with 50% higher revenues, stronger cash flows and market share.

The note said: “These are the companies least exposed to a consumer downturn and margin squeeze and all are trading on a substantial discount to their longer-term valuations, even after our downgrades.”

The list includes Dunelm with an 18% dividend yield and 11.5 times price earnings (PE) multiple. The broker has a target price of 1,375p, which compares with 885p today.

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Pets at Home is on 12x with a target of 475p, Dr Martens on 10.8x with a 320p target, and JD Sports on 11x but with a target of 280p.

On 11 times earnings and with enhanced returns from either buybacks or special dividends, Peel Hunt believes Next is another stock that deserves to trade on a higher rating based on a target price of 9,350p.

It added: “Next remains a key sector holding, offering strong long-term returns from a consumer-relevant platform and a strong level of resilience in tougher consumer backdrops.”

E-commerce forecasts have been savaged in recent months due to an inability to hurdle tough Covid comparatives and increased pressures from freight and payroll costs.

However, Peel Hunt added: “Step back to consider the two to three-year view from here and we see deep value in e-commerce names such as Boohoo, ASOS and brands such as Superdry. DFS can shoulder a 30% downgrade and still offer a PE of below eight times.”