A good time to invest in discount stores

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Mark Jewell

The economic news is gloomy, and the stock market is a roller coaster.

So where are mutual fund managers finding real values, aside from bargain-hunting among stocks with depressed prices?

Top fund manager Chuck Akre sees lasting value in the stocks of three discount retailers, each with a gain of more than 20 percent this year. They’re among the top holdings in the Akre Focus Fund.

The stocks of bargain retailers tend to hold up in good economic times and bad. One of Akre’s largest stakes is in Dollar Tree Stores Inc., a purveyor of everything from soap to packaged food to novelty toys, such as dancing plastic solar sunflowers, all for $1 or less.

The other two are off-price apparel rivals: Ross Stores Inc., owner of Ross Dress for Less stores, and TJX Cos., which runs the T.J. Maxx and Marshalls chains.

Double-digit returns

The impressive rise of these stocks in a down market — 27 percent for Dollar Tree, 24 percent for TJX and 22 percent for Ross — reflects the struggles that consumers face. Household budgets remain stretched two years after the recession officially ended, unemployment is still above 9 percent, and the economic recovery is slowing.

That financial squeeze is one of the key reasons why consumer confidence has plunged to a two-year low. The implications are huge, because consumer spending drives about 70 percent of U.S. economic activity.

Periods of economic stress play to the strengths of discounters that cater to shoppers looking to curb spending. Consider Dollar Tree. The company last month reported a 22 percent jump in quarterly earnings, increased its earnings forecast, and announced plans to buy back $200 million worth of its stock.

Akre’s three discount retail stocks make up nearly one-quarter of the fund’s portfolio. Their strong results have helped Akre Focus (AKREX) outperform its mid-cap growth fund peers this year, with a 1.4 percent return, compared with an average loss of 3.6 percent for the category.

Akre, 68, struck off on his own to launch Akre Focus after averaging annual returns of nearly 13 percent when he managed FBR Focus (FBRVX) from 1997 through August 2009. The performance earned that fund a top-rung 5-star Morningstar rating.

Below are excerpts from an interview with Akre on prospects for discount retail stocks:

Q: When you launched Akre Focus two years ago, you quickly purchased these three discount retailers. Why?

A: They’re well-suited for times when the consumer is constrained. A large part of our population has no discretionary income. They didn’t really have it before 2008, either. But they thought they did, because of the availability of credit, through credit cards and home equity loans.

But that’s no longer the case, because credit isn’t as easy to get now. So businesses that can stretch consumers’ dollars are particularly well-positioned.

Q: What is preventing a sustained economic recovery?

A: Corporate balance sheets are probably as strong as they have been in my lifetime. There is an economic recovery, but it has come in fits and starts.

It’s being held back by high unemployment — both the reported number [9.1 percent], and people who aren’t figured into the official unemployment rate. That’s because they’ve given up looking for work, or are working, but not as many hours as they’d like.  If you add those people in, the rate is closer to the teens.

Since our economy is driven by the consumer, and you’ve got one out of eight people either not working, or not working enough hours to make ends meet, it’s not going to be a robust economy.

Another problem is that businesses have no confidence in our political leadership to solve our fiscal problems. So companies are not using the cash they’ve got to expand and hire.

Q: What do you like about Dollar Tree, Ross and TJX?

A: Each is a financial powerhouse. They’re all net debt-free — they have more cash on their balance sheets than any outstanding debts, if they have any at all. They’re tremendously strong businesses, and their managements have made terrific judgments about how to use the free cash they generate.

Over the past five years, each has consistently managed to increase free cash flow and earnings, while also boosting customer traffic and spending. [Eds. note: Free cash flow is a way to measure a company’s capacity to grow, pay dividends to shareholders, or buy back shares.]

Q: What do you think about other discount retailers, including Walmart, a stock your fund doesn’t invest in?

A: There are tremendous opportunities, including Walmart, which has extraordinary cash generation.

Some of these companies have lots of cash, but may find they’ll run out of opportunities to grow in a meaningful way. So they’ll create opportunities for investors.

They’ll do that either by raising dividends, or by repurchasing shares, which increases the value of remaining shares on the market.

If discount retail weren’t a good place to be, I wouldn’t have 24 percent of my fund’s portfolio in three stocks in that category. Those three are, in effect, dirt cheap.

— AP