Higher wages to lift spending. What to buy

Published Wed, Mar 4 20156:00 AM ESTUpdated Tue, Mar 10 20154:11 PM EDT

Evelyn Cheng @in/evelyn-cheng-53b23624 @chengevelyn

Pay raises and cheap gasoline make low-end retailers like Wal-Mart and Kohl's better buys than those at the high end, several analysts said. The increase in spending from higher salaries will outweigh the short-term cost of the wage hikes for companies, according to analysts and investors. Wage gain is "one of the biggest catalysts for retail stocks," said Art Hogan, chief market strategist at Wunderlich Securities. "That's a driver of consumption. You have more disposable income." Wal-Mart announced in February that it would raise wages for 500,000 employees, a move that adds to hikes in the past year by Aetna , Disney and Starbucks . Several states also have raised their minimum wage, adding to pressure on other employers to increase hourly pay. Jack Ablin, chief investment officer at BMO Private Bank, pointed out Wal-Mart raising wages and Disney raising ticket prices shows that demand is picking up. "Low-end retailers continue to outpace their high-end counterparts," Ablin said, adding he expects low-end retailers to continue to do well. "I suspect that we're in the process of rotating to low-income households between low oil prices and tightness in the labor market," Ablin said. With the U.S. Energy Information Administration expecting the average American to save $750 this year on gasoline bills, Hogan pointed out that the percentage savings is greater the lower the household income. The money play: "The middle to low end is where action is going to be. The money is being made where you'd expect it to be," said Marc Chaikin, CEO of Chaikin Analytics. He said Best Buy , Ross Stores , and Dollar General are "all very, very favorable." Read More Wal-Mart ripple effect begins with this retailer Best Buy and Ross Stores both posted solid fourth-quarter earnings, while Dollar General is expected to report results on March 12. Analysis using quantitative tool Kensho showed that when crude dropped more than 20 percent over six months since 1980, Wal-Mart, Dollar General and Target outperform the S & P during the next six months, while Nordstrom , Coach and Macy's underperform or have negative returns. In addition, low-end retailers Target and Dollar General have had better returns than Nordstrom and Macy's since crude began plunging last July. Recent reports indicate strengthening in employment, with over a million jobs created in the three months from November to January. Importantly, the nonfarm payrolls report for January showed hourly earnings gained 0.5 percent after a decline in December. Other data from personal consumption expenditures to consumer confidence also indicate an increase in household income. Salaries rose 0.6 percent and net income rose to the highest since 2007, data for January showed. While economic growth overall is still moderate, that tepid growth benefits the low end, said Lance Roberts, general partner at STA Wealth Management. "We are definitely seeing signs of consumers moving to lower-cost providers," he said. His favorites are Ross Stores, Kohl's and TJX , the owner of discount retailer TJMaxx stores. To be sure, wage increases alone could be negative in the short term for the shareholders as the company diverts cash away from dividends to employees, said John Tomlinson, head of retail at ITG Investment Research. "Long term (raising wages) could be a strategic advantage, but not in the next year or so," he said. Nick Raich, CEO of The Earnings Scout, pointed out that even as fourth-quarter results for several retailers beat, "the majority of consumer companies are seeing estimates lowered even as oil prices have collapsed." "Worse, the magnitude of the downward estimate revisions has been steeper this quarter than in any other since the financial crisis of 2008," he said. However, other analysts said the more conservative downward revisions are expected. The most recent earnings report from S & P Capital IQ shows that the consumer discretionary sector has the highest expected earnings growth rate of the 10 sectors for the second quarter of 2015 at 11.6 percent. Consumer discretionary also has a moderate price-earnings ratio of 19 among the cross-sector earnings multiple range of 14 to 28. Finally, the strong dollar is another reason analysts like the low-end retailer. Mark Spellman, portfolio manager at Alpine Funds, said that high-end names such as Ralph Lauren and Tiffany have a large percentage of foreign buyers, who tend to buy less as the dollar strengthens. Read More Workers may finally get more—on Wall Street's dime "Due to employment, higher wages and low gasoline, we like the middle-income names TJX and Ross Stores. They don't have Internet competition. They get (foot) traffic. They have an aspirational customer," Spellman said. He also likes VF , which owns popular middle-class brands such as The North Face and Vans, and sees a 15 percent upside in the next 12 to 18 months on all three stocks. Disclosure: NBCUniversal, parent of CNBC, is a minority investor in Kensho.

Target employees at the checkout registers at a Target store in Torrance, California.

Patrick T. Fallon | Bloomberg | Getty Images

Pay raises and cheap gasoline make low-end retailers like Wal-Mart and Kohl's better buys than those at the high end, several analysts said.

The increase in spending from higher salaries will outweigh the short-term cost of the wage hikes for companies, according to analysts and investors.

Wage gain is "one of the biggest catalysts for retail stocks," said Art Hogan, chief market strategist at Wunderlich Securities. "That's a driver of consumption. You have more disposable income."