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Shopping For Retail Stocks

Retail sales rose 0.3% in January, seventh month in a row of gains. However, today’s report released by the U.S. government indicated that this was the smallest increase since last summer.

So it may be a bumpy road ahead given the run-up in the retail stocks. Analysts believe it may be too late to jump on the bandwagon, so it may pay off to wait. Both Liz Dunn, Retail Analyst with FBR Capital Markets and R.J. Hottovy, Director of Consumer Research at Morningstar are cautious in the near-term.

Cost Inflation

Clothing on hangers for sale
UpperCut Images | Getty Images
Clothing on hangers for sale

Because retail stocks have posted nice gains since last September, Hottovy said most of the sector is “over-valued” now. He “believes the difficult comparisons and inflationary costs will weigh on the bottom line and ultimately put pressure on the stocks going forward.”

Dunn is also in the camp that inflationary concerns may hurt this sector as the industry faces a “seismic shock in the form of massive cost inflation.” With rising cotton prices, and higher labor costs in China, and increased freight costs, retailers may be in for a rough ride. The key to watch, Dunn said is whether or not “companies can pass along cost inflation to consumers.”

Bright Spots

It’s not all bad news. As you go through the various segments of the retail sector, Hottovy expects the home furnishings and home improvement to post some gains. “These retailers are under valued and we're expecting as the macro economy stabilizes that we could see a recovery in housing and home improvement will benefit,” said Hottovy.

Hottovy sees an opportunity for the upside for shares of Home Depot and Lowe's .

Dunn, on the other hand is looking at specialty retailers like Ann Taylor , Chico’s and Macy’s . “We see less risk for the women’s retailer,” said Dunn.

Retail Buyouts

Watch out for M&A in this space in the next few months.

Hottovy expects a few takeovers in this sector. “We see most of the activity in small cap names, companies under $5 billion in market cap is a viable candidate. Retail is a sweet spot as it is a strong LBO candidate, these companies don't have a lot of debt on their books,” said Hottovy. Within retail, Hottovy thinks teen retailers and specialty retail are poised for a takeover. In the specialty retail, names like BJ'sWholsale , Office Depot , and Williams Sonoma are on Hottovy’s list.

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Disclosure:

R.J. Hottovy, Director of Consumer Research at Morningstar has no conflicts to report.

Chico's is a client of FBR Capital Markets, Liz Dunn’s firm.

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Questions? Comments? Write toinvestoragenda@cnbc.com

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HD
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LOW
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ODP
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WSM
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