The Trouble with Stocks in the Retail Sector

If you're thinking about investing in the retail sector, you may want to think again. The retail sector of the stock market has caused pain to a lot of investors in recent years, and was one of the worst performers in the fall of 2008, as many companies closed their doors never to reopen again. Most of the companies that did survive have been trying to regain their footing to the status that they enjoyed before the economic crisis. It looked as though they were making headway, which may have enticed some people to invest in them once again, but the earnings announcements last week weren't favorable. Still undecided about investing in retail? Here are five reasons you should be wary. 1. Material costs The top line growth at many retailers has been steady, with revenues actually growing as consumers are shopping again. The problem is that operating costs are outpacing the rate of revenue growth which is leading to less profitability. Margins are contracting as companies are battling with higher material costs - and every investor knows that shrinking margins are an early warning sign of trouble for many companies. 2. Less Pricing Power In a perfect world, retailers would be able to pass the aforementioned increased costs onto the consumer. The problem is that retailers have little pricing power since there is so much competition in the industry. Most of the retailers have been afraid to raise prices for fear of losing market share - and with good reason. Consumers can easily turn to discount retailers like Walmart WMT and Target TGT if they can't or don't want to pay higher prices for goods. 3. Earnings Estimate Revisions Retailers are slashing earnings estimates to reflect the much weaker outlook for the sector. The stocks of Gap GPS and Aeropostale ARO were down double digits last week as both companies stated that earnings will be much weaker than expected for the full year. Those retailers are not alone as many companies are having a difficult time meeting earnings expectations. Even computer companies like HP HPQ have guided down as they expect PC sales to be soft for the remaining quarters of the fiscal year. The only safe area so far has been in luxury retail where shoppers are not so price conscious. 4. Transportation Costs Retailers like home improvement company Lowe's LOW are seeing less foot traffic in its stores. The company blames rising gas prices for the changes in consumer behavior. Gas prices near $4 a gallon are causing homeowners to be much more frugal and make less trips to retail stores. As long as energy prices remain high, retail companies will have a difficult time beating Wall Street expectations. 5. Jobless recovery Although many companies may have healthy balance sheets, the American consumer has not recovered financially. Real estate markets are still depressed and the unemployment rate is still high. The retail sector is directly ties to consumer confidence. Consumers will feel more confident - and will shop more - when the unemployment rate is back to a more normalized level and real wages are growing again. Final Thoughts As the above factors illustrate, the retail sector is one that investors should sit on the sideline with until companies prove that they are getting costs under control, consumer confidence grows, and margins start heading north again. Mark Riddix runs his investment management company, New Horizons Financial Management, and is also a contributor for Money Crashers, one of the top personal finance sites covering investing, retirement, smart shopping, small business, and frugality. Mark writes a weekly column for Benzinga.