Now that markets are cooling off after the presidential election results in the United States, investors might be left wondering where the next best place to allocate some capital effectively and safely might be. While there are many theories in the market today, one specific sector could offer an attractive risk/reward ratio in the coming quarters.
This set-up could come from retail stocks, especially as they now have a lot of fundamental momentum behind them, coming from both the manufacturing sector and its distant cousin in the business services sector. More than that, a brief expansion in the transportation sector, as seen in the price action of trucking stocks, means potential consumer activity heating up, leading markets to the retail sector this time around.
To ride this expansion trend higher, investors might want to look into the SPDR S&P Retail ETF (NYSEARCA: XRT) as a diversified way to get exposure to the space. But for those who like to take a bit more risk in exchange for a potentially better reward, there are two names—Floor & Decor Holdings Inc. (NYSE: FND) and Shake Shack Inc. (NYSE: SHAK)—that offer above-average upside.
XRT: Key Tailwinds Driving the Retail Sector’s 2024 Comeback
Starting with the Services PMI index, investors can see that the retail trade industry had the most expansion in the past month after falling behind in a quarterly contraction. This expansion means more business activity, new orders, and all the good news that could lead to higher earnings per share (EPS).
Then there is the rising consumer spending as a share of GDP. The latest report shows that consumer spending rose by 3.7% during the year. This should put some fears of cyclicality to rest, letting investors know that the trend and environment in retail stocks are going to stay strong for the coming months.
And that’s where the Retail ETF comes into play. Despite already trading near its highs, the momentum is there, and so are the fundamental reasons. Knowing that the trend is favorable here, some institutions decided to buy into the sector ahead of the wave.
Those at the Healthcare of Ontario Pension Plan decided to boost their holdings in the ETF by 44.7% over the past quarter, bringing their net position to $715.6 million, giving investors a reason to start looking at adding retail exposure to their portfolios.
Floor & Decor: Why Institutions and Markets Are Bullish on the Stock
Whether fears of inflation or slowdowns become a reality, it shouldn’t matter for companies with big enough margins to weather the storm—and Floor & Decor has a 43.6% gross margin.
With this high margin, management keeps enough capital from each sale to manage the business effectively and profitably, as judged by the 13.7% return on invested capital (ROIC) rates. Now, are these figures enough to get markets to buy the stock? So far, they are.
As recently as November 2024, FMR LLC allocated up to 34.7% more into Floor & Decor stock, bringing their positions to a high of $622.8 million, or 4.7% ownership. Considering that this acquisition came after the ETF buying activity, investors can deduce that momentum hasn’t slowed down yet.
By trading at a price-to-earnings (P/E) ratio of 57.4x today, Floor & Decor stock calls for a significant premium to the rest of the building materials industry, as peers trade at an average of 17.8x today. While some may call, this expensive, professionals would say, “It’s expensive for a reason,” and investors can’t wait until they know what that is.
Ultimately, analysts at Piper Sandler see a price target of $118 a share for Floor & Decor stock now, calling for an additional upside of 14.2% from where it trades today.
Shake Shack: How Margin Expansion Could Propel the Stock Higher
Since high margins are being rewarded in today’s market, a way for investors to justify the higher valuations in some stocks alongside more buying decisions despite some inflation resurgence concerns, Shake Shack becomes a prime buy target today.
Before COVID-19, Shake Shack's operating margins were 67%, which is impressive for a restaurant stock. However, as management started to invest heavily in technology and automation, not to mention a larger share of sales through digital channels, operating margins have now risen to over 72%.
According to analyst forecasts, this growth translates into higher EPS, with earnings projected to reach 35 cents over the next 12 months—a 40% increase from the current 25-cent estimate. Similar to Floor & Decor, the strong margins and robust growth rates justify the market's willingness to pay a premium for this stock.
Shake Shack trades at a 10.8x price-to-book (P/B) ratio, a significant premium of 63.4% from the retail sector’s average valuation of 6.6x today.
