Sector Screener: two retail stocks to own as inflation crisis recedes

The cost-of-living crisis is having a hugely detrimental impact on retailers. Rampant price rises for food and a variety of other goods mean that disposable incomes are under severe pressure. And while annual inflation has fallen from a 41-year high of 11.1% a year ago to 6.7% today, it remains more than three times higher than the Bank of England’s 2% target.

In addition, a rise in interest rates of 5.15 percentage points in under two years means mortgage costs are increasing for the approximately 65% of UK individuals who are homeowners. Higher borrowing costs are also prompting consumers, who habitually use debt when buying a range of goods and services, to struggle to maintain their spending habits.

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Furthermore, the UK economy has continually flirted with recession over recent months, with it expanding by just 0.2% in the third quarter of the year. The unemployment rate, meanwhile, has risen from 3.5% to 4.3% over the past 12 months in response to a weak economic performance. This is further weighing on the performance of retailers, as worried consumers hold back on their spending.

Ongoing challenges in the short run

In the coming months, the operating environment for retailers could worsen before it improves. After all, the impact of higher interest rates is yet to be fully felt due to time lags. Some believe the Bank Rate could rise to 6% within the next year in response to “sticky” inflation that the Bank of England forecasts will take around 18 months to return to target.

During this time, the cost-of-living crisis could realistically deepen as a slow-growing UK economy, which is expected to expand by just 0.3% this year, and rising unemployment that is set to peak at 4.8% over the next two years, pose further challenges for consumers. The end result is likely to be weaker demand for a range of goods sold by retailers that acts as a drag on sales and profitability across the sector.

Long-term investment potential

While a tough near-term outlook may dissuade some investors from buying shares in retailers, the sector offers significant capital growth potential over the long run.

The cost-of-living crisis, while not yet at an end, is nevertheless in the latter stages of its existence. Inflation is expected to undershoot the Bank of England’s 2% target within two years. In response, interest rates are due to fall to 4.5% over the next three years.

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This is likely to act as a positive catalyst on the economy’s growth rate, which is set to more than double to 0.8% next year. In turn, this could have a positive impact on the operating environment for retailers as pressure on disposable incomes dissipates.

Consumers already appear to be looking ahead to a brighter future for their finances. Having slumped to a record low just over a year ago, UK consumer confidence has materially improved over the past year. And while retail spending figures remain highly volatile and unpredictable, they are likely to improve as the era of high inflation, rising interest rates and subdued economic growth abates.

Identifying sound retail stocks

Some investors have already determined that retail stocks offer attractive long-term prospects. The FTSE 350 Retailers sector, for example, has surged by 12.5% since the start of the year as demand for its undervalued constituents has risen. In doing so, the sector has become the index’s sixth-best performer in 2023.

Source: SharePad as at midday 25 October 2023. Past performance is not a guide to future performance.

With a challenging near-term outlook, though, investors must ensure that any retail stocks they purchase have the financial means to overcome ongoing industry-related difficulties. As such, a generous interest coverage ratio amid weak profitability is highly desirable.

So, too, is a margin of safety that sufficiently compensates investors for short-term uncertainty that could prompt elevated share price volatility. Most importantly, though, any retail stocks purchased should be well placed to benefit from the cost-of-living crisis’ ultimate end and its replacement with a more prosperous era for the wider sector.

Undervalued – even after a 70% share price surge

Marks & Spencer Group (LSE:MKS) shares have surpassed even the retail sector’s impressive year-to-date performance. They have risen by over 70% in the current calendar year following upbeat results that prompted a material improvement in investor sentiment.

In its latest trading update, the firm reported continued market share growth across its operations. This means it is becoming increasingly well placed to capitalise on improving operating conditions in the retail sector.

Already, its financial performance is gaining momentum. Like-for-like food sales in the first 19 weeks of its current financial year increased by 11%, while clothing and home sales grew by 6% on a like-for-like basis over the same period. This was in spite of the company reporting “robust” profit margins, with guidance for the full year subsequently raised.

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Crucially, the firm’s financial position shows that it can continue to overcome a tough operating environment. Its net interest cover amounted to 13 in its 2023 financial year. This figure is likely to grow over the coming years as profitability improves. And with a net promoter score (a market research tool measuring how likely someone would recommend the store) that increased from 29 to 36 over the past year, the firm is making encouraging progress in convincing shoppers that it is attractive relative to sector rivals.

Although the company’s turnaround has taken many years to come to fruition, a focus on efficiency, e-commerce and improved product quality is starting to have a marked impact on its top and bottom lines.

And even after a strong performance over recent months, Marks and Spencer’s shares continue to offer a wide margin of safety to new investors. They currently trade on a forward price/earnings (PE) ratio of around 11.6, which is attractive compared with other retail stocks. Therefore, they remain a worthwhile investment opportunity on a long-term view.

A sound business model with long-term growth potential

While the retail sector has surged in 2023, shares in WH Smith (LSE:SMWH) have slumped by 21%. However, the company’s financial performance has been relatively strong. In its pre-close trading update, released last month, the firm confirmed that it was on track to meet the upgraded full-year financial performance that was announced in its third-quarter trading update.

Encouragingly, passenger numbers are continuing to recover. This boosted the performance of the firm’s travel division, which has stores located at airports and railways stations across several countries. Indeed, the division’s sales rose by 42% in the full year and, with around 15 new stores slated to open in the UK in the current financial year, the company is well placed to capitalise on continued growth in passenger numbers.

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WH Smith is also growing its international travel business, with 65 new stores expected to open in the US and across several other countries this year. As such, it continues to become less reliant on its legacy UK high street business, which has struggled to remain relevant amid declining footfall in town centre locations.

Importantly, its travel locations provide a captive audience and significant pricing power due to a lack of competition. And even though its first-half results continued to be impacted by a tough operating environment, its net interest costs were still covered more than three times by operating profit.

Trading on a forward PE ratio of around 15.3, the company’s shares offer good value for money given an improving financial performance. Certainly, there are cheaper stocks within the retail sector, but with significant growth potential, WH Smith offers long-term investment appeal as it benefits from an improving industry outlook.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.