Limited Opportunities in Consumer Cyclical

The consumer cyclical sector built on gains from the third quarter, outperforming the market in the fourth through Dec. 21, with a return of 15.4% compared with the market’s 12.8% gain. For the year to date, the sector returned 47.2% versus the market’s 19.4%.

Consumer cyclical has outpaced the broader market - Morningstar

The median consumer cyclical stock is trading at a 4% premium to our fair value estimates, and we view the sector as fully valued overall. However, there are pockets of value in the autos and restaurants subsectors, where around one fifth of our coverage trades in 4-star territory. While the sector was plagued by shelter-in-place mandates at the onset of the pandemic, extra disposable income and a rise in e-commerce have since advanced consumer cyclical gains.

Modest opportunities still exist in autos and restaurants - Morningstar

Though the recent acceleration of e-commerce sales should moderate as COVID-19 vaccines become more widely available, we don’t expect this will stem the erosion of the department store channel. According to the U.S. Census Bureau, department store revenue was already on a steady decline, and the pandemic only exacerbated an existing trend. A flurry of bankruptcies (six this year) and store closure announcements (even from those that continue to operate) confirm that the current model is unsustainable and indicate that the department store landscape will look quite different going forward. We anticipate a greater focus on online sales, with smaller-square-footage spaces acting as more of a showroom.

Department store sales were declining even before the pandemic - Morningstar

But the retail landscape isn’t the only area feeling the heat the past few months. Even with the winter holidays providing an impetus for trips, airline travel is still less than half of what it was in 2019 based on airport checkpoint numbers. This supports our belief that those who are traveling are taking more local trips they can drive to, though this could languish a bit in the colder winter months. We expect a preference for local travel to continue into 2021, as regional lockdowns persist and virus cases remain high. However, we’ve begun to see signs of recovery in regions such as China, which has managed the pandemic better, and our long-term forecast has travel recovering fully by 2023.

As COVID-19 persists, airline travel still less than half 2019 levels - Morningstar

Top Picks

Macy's (M)
Star Rating: ★★★★
Economic Moat Rating: None
Fair Value Estimate: $37
Fair Value Uncertainty: High

While no-moat Macys faces vast uncertainty as the rising number of COVID-19 cases has forced restrictions on store and mall visitation, it’s trading at a 37% discount to our fair value estimate, and we view it as undervalued. The firm reported a slightly better than expected third quarter on strong e-commerce, but its in-store productivity remains very low. Even the normally strong flagship stores have struggled, as COVID-19 keeps both local shoppers and international tourists at home. Yet, over the next three years, we expect Macy’s to continue to close stores and sell some of its real estate, which should enhance its financial health.

Hanesbrands (HBI)
Star Rating: ★★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $24
Fair Value Uncertainty: Medium

We believe that Hanesbrands, currently trading at a 42% discount to our fair value estimate, offers good opportunity for investors. While the firm’s fourth-quarter guidance slightly undershot our expectation due to COVID-19 restrictions, we view the impact as temporary and do not believe the firm is in any danger of falling into economic distress. New CEO Steve Bratspies announced an in-depth strategic review to increase production speed and efficiency and identify cost savings that can be reinvested elsewhere, a plan that we view favorably.

Tapestry (TPR)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $37.50
Fair Value Uncertainty: High

We view Tapestry as attractive, as it trades at about a 21% discount to our estimate of its intrinsic value. We assign a narrow moat rating to Tapestry based on the brand strength of Coach, its largest and most profitable label by a wide margin. While Tapestry’s smaller brands are struggling to find their footing, we anticipate consistent growth for Coach in all regions, including China, the world’s fastest-growing luxury market. Moreover, we believe Tapestry’s new restructuring plan aimed at reducing expenses and strengthening e-commerce will be successful.