Shop carefully for retail stocks this year
If you're thinking of giving yourself the gift of a few retail stocks for the holidays, you'd better choose carefully this year.
With consumers struggling to make ends meet, retailers are already slugging it out with promotions and deep discounts earlier and harder than at any time since the start of the Great Recession. That means investors in these share are bracing for even more profit disappointments after all the presents are unwrapped, the egg-nog is gone and Santa has scarfed down the last of the cookies left by the chimney.
"It's going to be very promotional (this year)—the customer wants great value and great bargains," former Kohl's CEO Jay H. Baker told CNBC. "The key is to take market share from your competition."
The competition for holiday shopping dollars has been intensified this year as American households continue to feel the impact of higher payroll taxes and stalled wage growth. While retail stocks as a group have been outpacing the overall market this year, the performance of individual stocks has mirrored varied fortunes of the American shopping public.
Tight household budgets have helped lift stocks of deep discounters—like Dollar General (up 20 percent in the last 12 months) and Dollar Tree (up 36 percent) and Big Lots (up 38 percent). But the fierce competition has left others behind, including Family Dollar (up 2 percent).
With the stock market setting new highs, those at the top end of the wealth ladder are also in a spending mood this year, boosting profits for high-end retailers.
One big reason: Not all luxury retailers' customers are rich.
"Going into the holidays, I would stick to stocks of companies that are selling things that people really want to buy—Michael Kors, Nike—where the customer will pinch pennies elsewhere," said Faye Landes, who follows the retail industry at Cowen & Company. "These companies are making things that people are dying to have, waiting in line to have."
Kors' stock this year (up 57 percent) has been as hot a seller as his $2,000 crocodile-embossed leather satchels, available at the company's chic Fifth Avenue storefront in Manhattan, or online from Sears. Even as stretched households are having trouble making ends meet, they're still finding ways to get at least a taste of the good life.
Roughly half of U.S. consumers are expected to buy at least a small luxury item in the next six months, including 53 percent who are likely to buy specialty food or drinks, 48 percent to buy luxury clothing and 48 percent to buy personal care products, according to a survey last week from Accenture.
(Read more: How savvy retailers are reinventing the pop-up model)
"Consumers want a taste of luxury in their everyday lives and are willing to spend a little extra for the experience," said Tom Jacobson, a consultant with the firm. "But the emphasis is on small items."
Retailers like Tiffany, whose stock is up 33 percent, are happy to oblige. The classic brand name is available on everything from a pair of entry-level silver bead earrings ($125) to a diamond-encrusted, white gold Tonneau cocktail watch ($75,000).
While retail stocks at the high and low end are faring well, those in the middle are fighting for increasingly scare consumer dollars. Despite recent savings from a break in prices at the gas pump, millions of households already had scaled back their holiday shopping lists. Consumers are expected to shell out about $740 each this year—down about 2 percent from last year's lackluster shopping season, according to the National Retail Federation's annual spending survey.
Price conscious shoppers are already finding bargains at industry giant Wal-Mart. Mass merchandiser kicked off their price wars earlier than usual this year, in part, because the holiday calendar robbed them of six selling days. In response, industry giant Wal-Mart has begun serving up deeper bargains than in the past, and serving them up earlier, forcing competitors to follow suit.
(Read more: Sales come early: Wal-Mart starts Cyber Saturday)
"Wal-Mart has stepped it up the promotional environment more than it has probably in 20 years," said David Strasser, a retail industry analyst at Janney Capital Markets. "These are things that we have never really seen before. I think everybody in retail is being forced in some way, shape or form to react to that."
As price wars intensify, expect profit pressure on retailers to increase. Wal-Mart stock—up 15 percent for the year—recovered from a brief hit this week after forecasting disappointing holiday profits and its third-straight quarterly decline in U.S. comparable sales because of fewer shopper visits.
Stocks of other retailers catering to price-conscious shoppers also face a profit squeeze as battle for market share heats up. Kohl's—with a 12-month gain of just 5 percent—this week said sales fell 1.6 percent last quarter. The company warned investors fourth quarter profits would likely come in 15 percent lower than forecast.
Target, whose stock hasn't budged in 12 months, also reported a slowdown in traffic and warned of a 6 percent profit shortfall. Sears (up 26 percent) recently reported a 3 percent sales drop—the company's 14th-straight quarterly drop in sales. Dillard's also recently reported disappointing sales.
J.C. Penney, whose stock is this year's retail road kill (down 47 percent), is fighting for survival after a disastrous overhaul that failed to attract the higher-income shopper. The company recently slashed fourth-quarter earnings expectations by 40 percent.
Macy's, which caters to a relatively uncrowded field of middle-income shoppers, has bucked the trend of profit warnings. The company's stock (up 24 percent) recently bumped up its fourth-quarter earnings forecast by a few percentage points.
With the sales outlook clouded by weak consumer spending, investors shopping for retail stocks may want to wait until January's white sales roll around.
Retailers are slashing prices and getting an earlier start for another big reason: With sales slowing, they're terrified of getting stuck with unsold goods after the last New Year's Day sales have ended.
"When you go into a tough season, you want to come into January as clean as possible," said Baker, the former Kohl's chief. "It's the slowest part of the year. You just have to basically give merchandise away."
(Read more: Early Black Friday sales let shoppers sleep in)
Some retailers this year have more to worry about than others, according to Cowen's Landes. "Clearly some retailers are very over-inventoried," she said. "There is plenty of inventory out there. Some retailers, Macy's for instance, is managing it a lot better than others. For Target, it's clearly an issue."
—By CNBC's John Schoen. Follow him on Twitter