Retail Stocks Are on Sale

The loss of 2.6 million jobs and declining home and retirement fund values have squeezed consumer spending. Retail sales dropped for the sixth consecutive month as consumers cut spending to save for the future, according to the U.S. Commerce Department. The decline is the longest since comparable records began in 1992 and there is still no end in sight as the economy continues to deteriorate.

Retailers have been struggling with this lower spending after one of the worst holiday seasons in history. Sales are down sharply as consumers shied away from stores while margins were pressured by steep discounts offered across the board. Unfortunately, these measures were necessary to get rid of large inventories built up when the economy was on track six months ago.

These losses may begin to curtail as pricing stabilizes and inventories are emptied. Shoppers accustomed to bargain prices now may find those gone within a month or two as retailers scale back and revamp their pricing to meet with market demand. This action should help stabilize margins, reduce losses, and create the grounds for a recovery in the troubled sector.

While consumers may be hard pressed to find deals at stores, investors will then have plenty of bargains to choose from among retail stocks. Earnings multiples are already near record lows for many stores while some have fundamental prospects that are enviable for any public company. And with inventory gone and pricing restored, they might just be stable enough to buy.

Some retailers like Wal-Mart [[WMT]] saw their first quarterly declines, but may end up being the strongest players going forward. Others like Target [[TGT]] are sitting on strong assets that hold substantial value when the market recovers. Finally, those clothing retailers that have seen discretionary spending disappear may begin to move upwards from their depressed levels.

Investors looking to get involved with these trends early on without putting a lot of capital at risk may want to consider using long-term options called LEAPS. These options give investors the right, but not obligation, to purchase shares anytime over the next one or two years at a fraction of the cost of buying the stock outright. This equates to reduced risk and increased leverage.

See “What are LEAPS Options?” for an introduction to these securities or check out “Using LEAPS as a Stock Substitute” for more information on this strategy.

Hedge Your Bets on Target with LEAPS

Target Corporation (NYSE: TGT) may be hurting from lower retail sales, but at least one investor has found value in the stock. Pershing Square’s Bill Ackman believes that the real estate under Target’s stores could be worth much more than its current market capitalization. As a result, the activist investor proposed spinning off the land into an REIT that would lease it back to unlock value.

The problem with the plan is that it is seen by Target as being risky in today’s environment. The new REIT may have a great renter and properties collateralized by hundreds of millions of dollars in buildings, but the retailer that is left over may be left in a weaker position. As a result, Pershing Square opted to wait until after the holiday season was over before resuming discussions.

The season is now over and investors are left with a predicament. The retail sector is expected to have one of the worst holiday seasons ever, which has pushed down shares of all retailers. However, Pershing Square’s analysis has clearly shown substantial value in Target’s real estates. So, how can investors get exposure to Target while reducing the risk of further declines in retailers?

The answer is simple: Hedge your bets using broad industry indexes! The Retail HOLDRs (NYSE: RTH) exchange traded fund is considered to be the best retail industry index. Investors looking to hedge against a decline over the long run may want to purchase LEAPS puts to hedge out their retail exposure. Currently, the $70 January 2011 LEAPS puts are trading for just $14.90 per contract. This means that investors can purchase roughly 100 contracts to offset every 200 shares of Target.

The resulting position is one that is hedged against a decline in the retail sector. As a result, investors can only make money when Target outperforms the retail sector as a whole and lose money when Target underperforms the retail sector as a whole. Since Target’s real estate is undervalued, this outperformance will occur when the value is unlocked over the next two years.

See “Using LEAPS as a Hedge” for more information on this strategy or take a look at our Tools & Products for more ways to make money!