Buying shares in UK-focused retailers may sound like a foolhardy move at the moment, with profit warnings becoming increasingly common as low levels of consumer confidence start to bite.
However, for long-term investors, the sector could offer recovery potential. Valuations and yields appear to be low across a number of FTSE 350 retailers, while an improved outlook for consumers could be ahead.
Volatility and risk may be above average, but for investors who can stomach a challenging outlook, the rewards on offer from these two retail stocks could be high.
While consumer confidence has been negative since early 2016, there could be scope for an improvement over the medium term. Since the end of 2017, there has been a gradual improvement in the Gfk consumer confidence index, with it rising from minus 13 in December 2017 to minus 7 in May 2018. Furthermore, with inflation falling to a level that is below wage growth and forecast to remain so over the next year, the pressure on household incomes that has been present may start to decline.
This would be good news for the retail sector, where trading conditions have been among the most challenging since the financial crisis. Certainly, the progress made in Brexit negotiations could have a direct impact on the performance of the economy. But for many consumers, the fact that their monthly pay cheque is likely to allow them to consume more could lead to improved confidence and higher spending.
As mentioned, profit warnings have become alarmingly commonplace in the retail sector. Within the last month, home furnishings specialist Dunelm (LON:DNLM) and bicycle and car parts retailer Halfords (LON:HFD) have both warned on their outlooks. This has caused their share prices to come under pressure, and in the near term, there could be more volatility ahead.
In both cases, though, the fundamentals appear to be sound from a long-term investment perspective. For instance, Dunelm is forecast to record a negligible rise in EPS this year, with growth of 7% expected next year. Given that it is focused on delivering a programme of major change which will see it boost store appearance, customer service and efficiency, its outlook could be reasonably positive.
Similarly, Halfords’ new CEO warned in May that profit growth could be limited in the near term. However, it is making sizeable investments in its customer offering and continues to see good growth prospects for cycling products. With the company expected to report EPS growth of 7% next year, its outlook remains relatively strong.
Clearly, for many income investors, a key consideration is the likelihood of dividends being paid. In both cases, dividends are due to be covered by 1.6x earnings in the current year. This should provide adequate headroom for the continuation of dividend payments even if profitability comes under further pressure in the near term.
As a result, the two companies appear to offer long-term investing potential. While they are facing very uncertain futures, ultimately their reward potential may be higher than for many of their FTSE 350 peers over the next few years.