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It's time to go bargain hunting for retail stocks

Robert Alexander | Archive Photos | Getty Images

In March, John Apruzzese began keeping a close eye on clothing business Ralph Lauren. The company looked interesting to Evercore Wealth Management's chief investment officer, but the price wasn't right back then.

It wasn't until mid-June that an opportunity to buy the stock presented itself. Shares dropped 10 percent since the beginning of the year—and about 20 percent since August 2011—and its price was hovering around its 12-month lows.

"That caught our attention," he said about the share price drop. "We looked at the company and determined that its earnings were intact and it still had growth potential. So it was a very good buying opportunity."

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For Apruzzese, who has a 25 percent weighting to consumer discretionary-related stocks—that's double the S&P 500's allocation—retail companies offer good long-term growth, and they're more attractively valued than they have been in years.

That may surprise many investors who have seen the sector plummet this year. In fact, retail has been one of the worst places to stash your savings in 2014.

Since January, the S&P 500 Textiles, Apparel and Luxury Goods Index is down 5 percent after a 36 percent gain in 2013, while the S&P 500 consumer discretionary sector index is nearly flat after being up 37 percent last year.

Several of the S&P 500's worst-performing stocks are also retail related. Coach, the biggest underperformer on the market this year, is down about 39 percent, while Whole Foods, Bed Bath & Beyond, Best Buy and Amazon have all dropped by at least 20 percent.

While investors like Apruzzese are taking advantage of the dip, people won't know for sure whether this is a short-term setback or something more long term, until the next batch of retail-related earnings come out over the next couple of months, said Brian Yarbrough, a retail sector analyst with Edward Jones.

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Blame it on the weather

There's one main reason why the sector sold off during the first half of the year: terrible weather.

Large snowfalls and bitterly cold temperatures forced people to stay indoors, and that wreaked havoc on consumer-spending numbers and first-quarter earnings, said Yarbrough.

"We saw multiple companies with disappointing earnings results," he said. "Now we need to know: Is this all weather driven, or is consumer [spending] slowing down?"

It's too early to tell if consumer spending will come roaring back. It only grew by a measly 1 percent in the first quarter, down from 3.4 percent during the same quarter last year. And while spending did rise 0.2 percent in May over April, the gains are due to higher prices, not actual spending. When adjusted for inflation, spending actually fell for the second straight month.

To make things more complicated, investors have been generally nervous about stocks and retail-sector equity, in particular. Some people have realized gains this year, while others fear that a major market correction is on the horizon, and that could continue to put pressure on retail stocks, said Yarbrough.

Betting on an economic uplift

For investors who are able to look past the immediate future, the sector still has a lot of potential, said Peter Dixon, manager of Fidelity Investments' Select Retailing Portfolio (FSRPX).

Despite a contraction in America's GDP last quarter, the U.S. economy is still improving overall, said Dixon. Personal incomes rose by 0.4 percent in May—the fourth consecutive month of income growth—and job growth remains steady, with more than 200,000 jobs added last month.

"The backdrop of economic improvement is good for consumer stocks," said Dixon. "There are always great opportunities to make money, because there's always a product or a brand that's resonating with consumers."

Yarbrough also thinks that the sector will eventually rebound. He, too, said that the economy will continue to grow, pointing out that middle-income and high-income earners still have money to spend.


Spotting strategic growth

However, investors simply can't buy retail stocks like they did in 2009, when every consumer company was cheap.

Investors have to be selective, said Apruzzese, explaining that they need to invest in businesses that are exposed to growing countries and segments of the market.

For instance, he's less interested in companies that derive most of their earnings from lower-income earners. He also likes companies that are improving their online presence and have a healthy exposure to markets outside the U.S.

It's for all of these reasons why he likes Ralph Lauren. Online only accounts for about 10 percent of the company's total sales, he said, which means it can grow its e-commerce business.

It's also expanding internationally, and it's investing in its women's division, which accounts for 40 percent of its sales, said Apruzzese.

While he knows that this stock could see some ups and downs in the short term, he's confident that with a better overall economic picture and several areas for growth, it will do well over time.

"It's not just how it does this quarter," he said. "We have a three- to five-year time horizon. That's what we're really interested in."

Analysts think the stock could jump by about 20 percent over the next 12 months, according to S&P Capital IQ.

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Riding market trends

It's also wise to buy companies that have exposure to growing domestic sectors. Dixon likes businesses that are tied into the still growing U.S. housing sector, and he's keen on e-commerce companies, too. Home Depot and Amazon are both in his fund's top 10 holdings.

When it comes to valuations, pay attention to price-to-earnings or enterprise value to EBITDA, said Apruzzese. Multiples have come up over the last few years, but he's willing to pay up to 20 times earnings for retail stocks.

That's a little pricier than the S&P 500, which is trading at about 19 times earnings, but since many of these operations are more growth oriented, the higher multiple is justified, he said.

While investors can expect a bumpy ride over the next few months, if second-quarter earnings do improve from last quarter, then stocks should rise, and they'll certainly move higher longer-term, said Yarbrough.

Although retail's fortunes have taken a hit, now's not the time to sell out of the sector. If anything, people should be buying, said Apruzzese.

"With a broadly improving U.S. market and expanding international markets, growth rates in this sector should be better than overall consumer spending," he said. "There are definitely some good growth opportunities here."

—By Brian Borzykowski, special to CNBC.com

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