Investment: Pain turns to gain for hard-hit high street

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The Independent Online
THE RETAIL SECTOR has been a grim place for investors this year, with share prices scarred by profits warnings and downgrades as higher interest rates and the consumer slowdown have taken their toll.

But after such a steep decline - the general retail sector has underperformed the FT All Share by 16 per cent so far this year - are we now at or near the bottom? Could it be time to selectively start buying back in?

Valuations certainly look tempting. The sharp fall since the start of the year has taken the overall under-performance of the sector to 30 per cent since its peak in July 1996.

According to a recent research note on the sector by Credit Suisse First Boston relative valuations are now comparable with those last seen in the last recession. The sector average p/e is 16 while the gross yield is 3.4 per cent.

There are a number of reasons for this, of course. After the false dawn of 1997, when sales were inflated by building society windfalls, this year has provided a rude awakening.

Higher interest rates have been a key factor in dampening demand, but profitability has been squeezed further by costs rising faster than inflation.

Return on capital has come under pressure as retailers have found demand slowing just as many have started to increase capacity

The question now is whether the de-rating has gone too far. Consumers are in better shape than they were at the start of the last recession as individuals have been borrowing less and saving more.

The savings ratio currently stands at just under 10 per cent, for example, compared to just over 6 per cent at the start of the last slump. This should limit the downside.

Interest rates may now be at their peak and many commentators expect the next move might be down, thereby reducing the pressure, on consumer spending. Retailers also tend to be an early cycle mover, so while their ratings have been among the first to suffer, they could also recover fastest.

According to Credit Suisse First Boston's note entitled "Pain turns to Gain", it will be the FTSE 100 retailers - Marks & Spencer, GUS, Boots and Kingfisher - that will feel the benefit soonest.

However, for sentiment to change the market will need to reassured about M&S, which still accounts for a quarter or the whole sector. It has been hit by a series of downgrades and until that stops, little will happen.

Other companies that look under-valued are Dixons, where the digital boost does not appear to have been fully factored in, and Next (now yielding 5 per cent) whose profits warning was due to too much demand rather than too little. Smaller fashion stock like New Look and Monsoon have seen vales fall sharply, but the uplifting breeze could take a while to reach these second liners.

The jury is still very much out on retailers of higher ticket items where valuations have been savaged in recent months. Companies like MFI and Carpetright now yield more than 10 per cent. That cannot carry on but sentiment is weakest here.

There is no reason to hurry, either. An interest rate turn on its own might not be enough to trigger a change in sentiment as the market will start to become obsessed by Christmas trading before too long.

So there is no harm in investors sitting on their hands for a few months, but bolder souls might like to start picking out a few favourites.