'Excellent returns' possible for Macy's and Foot Locker

This week Money asks Roger Montgomery for a hot stock pick - Foot Locker and Macy's

Key statistics:

Macy's

1/12/15 closing share price:* $39.20

52 week high: *$73.61

P/E (ttm): 10.35

Dividend and yield: 1.44 (3.60%)

Foot Locker

1/12/15 closing share price:* $65.00

52 week high: *$77.25

P/E (ttm): 17.79

Dividend and yield: 1.00 (1.51%)

*Currency in USD.

Looking for a very high quality stocks, with economies of scale, demonstrated pricing power, underlying demand for its product and attractive growth prospects?

There are a few in the market locally but there are many more globally. Of the 1800-odd companies listed in Australia, 1200 made no money last year. Of the remaining 600, more than half can be cast aside for poor economics or poor prospects and that leaves us with about 150 businesses that we might find acceptable and investment grade.

The same proportions might be applied to the global universe of stocks, but the starting point is some 70,000 companies. That would mean over 5000 investment grade companies and many hundreds that we would class as A1.

Now you wouldn't think many of them are to be found in US retailing, which has been enduring pressure lately. Department stores such as Macy's (Number #1 in the US) and Nordstrom are reporting weak third quarter results and their guidance has not offered much cause for celebration.

Macy's reported its third quarter sales had fallen 5% as same store sales declined 4%. In early November Nordstrom's earnings missed expectations and attributed that slide to "softer sales trends that were generally consistent across channels and merchandise categories".

October US retail sales rose less than expected and auto sales were particularly weak suggesting consumers were zipping up their wallets.

But in an example of why you shouldn't invest based on economics or with broad brushes, we have uncovered excellent returns are possible investing where wider events cause other investors to throw the baby out with the bathwater.

US 'Athleisure' retailer and Nike footwear distributor Foot Locker is owned in both of Montgomery's global funds and it's a business that is bucking the retailing malaise with results driven by consumers swapping jeans for lycra and shoes for runners.

Foot Locker is no small concern. It distributes through 3400 stores around the world, generates $7.2 billion in annual revenues and has a market capitalisation of almost ten billion dollars. Revenue is split 70% US, 30% rest of the world. On a channel basis revenue it is split 88% Athletics Stores (9% year-on-year growth) and 12% Direct-to-Customer (18-21%YoY growth) with e-commerce sites in 10 countries, and earnings split in line with revenue.

We hold the view that Foot Locker will benefit from Nike's dominance and its lead will expand as the trend amongst younger generations towards casual wear at work sees them ditch leather formal shoes for sneakers.

Foot Locker is a business with a clean balance sheet, high free cash flow and a valuation that isn't stretched. The company grew same store sales by 9% year-on-year as prices for both footwear and apparel rose. That of course means that gross profit margins improved and by keeping its fixed costs in check, Foot Locker was also able to expand its operating profit margin, which would have expanded even more if not for store closures due to refurbishments. In the end, earnings grew by 16%.

That's a significant contrast to the results being reported elsewhere in retailing.

One of the reasons we like Foot Locker is its superior economics. Another is its bright prospects and the third is its valuation, which we believe is a function of the fact that analysts are treating Foot Locker like other retailers and missing the combined power of sales growth and margin expansion.

Same store sales growth of 9% in the US is encouraging but the company is also reporting double-digit sales growth in Europe, Canada and Asia Pacific.

Most recently the company noted that as they head into the fourth quarter and the holidays, they expect mid-single digit comparable sales growth, 30 basis points to 40 basis points of improvement in both gross margin and selling general & admin expenses and a double-digit EPS gain.

In a world that is mired in uncertainty and doubt, it's worth spending some time looking for diamonds, because there are plenty around.

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