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Better Buys in Consumer Discretionary Stocks

Stock prices have come down while earnings have gone up, making valuations more attractive today in the sector, says RS Growth's Allison Thacker. Plus: a pick in beauty supply.

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Ryan Leggio: Hi, I'm Ryan Leggio. I'm the Mutual Fund Analyst at Morningstar, and with me today, is Allison Thacker. She is a co-portfolio manager for RS Growth.

Hi Allison, thanks so much for joining us.

Allison Thacker: Hi Ryan, thanks for having me today.

Leggio: Well, it's been a few months since you were last in Chicago from San Francisco, which is where your firm is based, and the market has run up and then in the last few months settled down a little bit. Can you talk a little bit about how you are navigating the market swings and where you are finding values today, especially in the small- and mid-cap growth areas?

Thacker: Well, it has been a very volatile last few years and so to some extent, it's not surprising that we are having a period of volatility again in the stock market. I think, overall economic metrics are improving, but not at a dramatically fast pace, and so the early part of the year, the runup actually surprised us with its strength and low volatility.

And so, this pullback has provided us an opportunity to invest in some areas that we had felt were somewhat expensive as we entered the year 2010.

Leggio: And one of those, consumer discretionary…?

Thacker: One of those areas is consumer discretionary, and it was a big area of outperformance for our funds in 2009, with great stock selection, and we felt that we needed to take profits at the end of the year. At the end of 2009, stocks were trading at the high end of their historical valuation ranges. We weren't seeing a very strong jobs picture that was going to support those valuations, and so we did take profit in a lot of our names that had driven performance in 2009.

Entering 2010, I would say, we've been very surprised at the strength of the consumer discretionary sector this year. Our stocks have continued to do fairly well, within the sector, but given the valuations, we were somewhat underweighed in the early part of this year in that area.

The recent volatility has been a great opportunity for us to invest in companies again within this area that have our minimum $2 of upside for every $1 of downside, when we set price targets.

And I think there's two reasons that, that is going on. One is that stock prices have pulled back with the market recently. Additionally, earnings have come in extremely strong, and so we have seen both the P come down and E go up, and so valuations are quite a bit more attractive today.


A couple of examples of companies that we think of as being larger small caps getting close to the mid-cap status that have very long paths for growth. We have recently invested in a company named Ulta, which is actually based here in Chicago, out in the suburbs. They have just about 360 stores, in the U.S. They're strip-based center, beauty superstores. And so, you may be familiar with Sephora, which is a high-end mall-based retailer of beauty products.

What Ulta is really trying to do is capture the fact that women no longer really want to shop at department stores. They love the big-box format. This is what Home Depot and Lowe's and Best Buy have all been very successful in.

So, this is starting to happen in the beauty business. Women are not wanting to shop in department stores. Additionally, they want better selection across the brands for mass market, meaning what you might buy in a Target or a drugstore, all the way up to prestige products, which you mostly can only purchase in a department store.

So, Ulta has a full selection, a very large store, a new store base, dynamic merchandising, and what they really believe in is giving the consumer what she wants, and usually that's a winning combination in retail. What we like about Ulta is they have a substantive store base today around 360 stores, but they have the potential to go to a 1,000 over time, which will allow dramatic growth in the business over the next five to 10 years, we believe.

The other thing that the company is doing is as they bring in some of these new brands, as the brands leave the department store-only distribution, it boosts comp store sales and productivity of the Ulta stores themselves. And so, we do believe over time that investors will benefit from the new brands coming in to the store.

Leggio: So runway for growth, but is it then also your expectation that the company should deliver 10% to 12%-plus returns on equity for shareholders that invest at these prices?

Thacker: Yes, I think Ulta has very strong shareholder returns. This is a perfect example of a stock that we liked at the beginning of the year that looked too expensive. It was 28 times 2010 earnings. They had a decent return on capital, but it was about a 3.5-year payback on their store.

What has happened is the company has taken significant costs out of their store build. The chief financial officer has been very focused on this and they have taken their payback down from a 3.5 to 2.5 years. So, it made a substantial improvement in return on invested capital for shareholders.

The other thing that has happened is that I believe that at the beginning of the year, I thought they would earn around $0.80, maybe $0.85 per share. Today, my number is well over a $1 for 2010; they have had exceptional same-store sales in the first part of this year. They are bringing in some new brands into the store, which I believe will continue to drive that this year, as well as, just talking to their customer more frequently via e-mail as well as TV and newspaper inserts.

So, all the things are aligning. So the price has been fairly stable since the beginning of the year. The earnings have come up substantially, and return on invested capital is improving across the store base, and those are all the type of things that we look for in an investment.

Ryan Leggio does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.