Main Thesis

The purpose of this article is to evaluate the SPDR S&P Retail ETF (XRT) as an investment option at its current market price. While I have shifted to a more cautious outlook on equities as a whole, I believe XRT has the right makeup to perform well as we approach the end of 2020. The fund is exposed to the retail sector, which is certainly a challenging area. However, the fund holds many e-commerce related stocks, and these are companies that have actually been benefiting from the recent climate. Yes, traditional retailers are suffering, but the companies that have a strong online presence are picking up these sales. Further, retail sales as a whole have been climbing month-over-month, supporting the view that the U.S. consumer is resilient. This is a story I expect to continue in the months ahead, during the very important holiday shopping season. Finally, even though XRT has been handily beating the S&P 500, it still trades at a much lower valuation. This could entice value-oriented investors.

Background

First, a little about XRT. The fund’s objective is “to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P Retail Select Industry Index”. Currently, the fund is trading at $53.05/share and has an annual yield of 1.15%. XRT is a fund I cover regularly, and although I had a bullish take on the fund back in March, I am surprised just how strong its performance has been since then. I would not have guessed, given all that has happened in 2020, that a fund with “retail” in the title would be one of the best calls for the year. In fact, XRT has beaten the S&P 500 by about 2 1/2 times since the end of March:

Source: Seeking Alpha

Clearly, XRT’s strong performance is quite exceptional. While it makes sense to be cautious whenever a fund or sector leads by this wide a margin, I see a climate where XRT could post more gains heading in to 2021. As a result, I have a bullish rating on XRT today, and I will explain why below.

Retail Sales Headed Higher In September

To begin, I want to touch on the state of retail sales in the U.S., which is obviously of primary importance when evaluating XRT. While the pandemic has shuttered many businesses and put millions out of work, the U.S. consumer has been surprisingly resilient since the summer time. Even though many malls and traditional retail stores are closed or at limited capacity, sales have still been climbing month over month. This is due to a variety of reasons, including stimulus measures that have been enacted, an improving employment picture, and a marked shift of sales to online retailers.

In fact, despite August seeing a slowdown in sales growth, September numbers have shown strong month over month gains, as seen below:

Source: U.S. Census Bureau

My takeaway here is positive given the bullish momentum in total sales. Of course, there is no guarantee we will continue to see gains, especially as new stimulus measures have stalled and new Covid-19 cases are climbing across the country. This could lead many state governments to consider reversing course on some of the reopenings that are happening and could also put a big dent in consumer confidence. But, for now, the U.S. consumer appears willing and able to spend, and XRT is a primary beneficiary of this trend.

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Holiday Season Could Be A Tailwind

Expanding on the prior paragraph, I believe we will continue to see strong retail sales, in-store and online, in the months ahead. This stems from the fact that we are entering the holiday shopping season, which is always a critical time for retailers. Therefore, I would normally view October and November as smart times to play the retail trade, but this is especially true this year.

A key reason why has to do with how consumers plan to spend their disposable income. As readers are certainly aware, 2020 has been a year of disrupted travel plans, closed sports and entertainment venues, and partial lockdown orders. As a result, the growing trend of spending on “experiences” has taken a backseat. This refers to the growing consumer preference, especially among millennials and other younger consumers, to spend money on experiences instead of material goods. This could involve traveling abroad, attending a concert, or participating in any other recreational activity. This popular trend has siphoned-off consumer dollars that used to go to physical items, hurting retailers in the process.

Of course, this trend has been stymied in 2020, and it looks like it will still be the case heading in to 2021 as well. As a result, individual consumers are now planning on spending less on travel or other social experiences, for both themselves and for others as gifts. Instead, consumers plan to keep their spending high on material purchases this holiday season, including on gift cards, as shown in the graphic below:

Source: Bloomberg

My point here is retailers look set to capture back some of the dollars that, in the past, have been spent on experiences over physical items. With personal spending expected to rise, and spending on gifts and gifts cards to remain high on a year-over-year basis, retailers could be in for a pleasant surprise this holiday season. In fact, only travel/entertainment is set to see a significant drop-off in spend from 2019, which makes logical sense considering we are still in the middle of a pandemic. Therefore, while expectations for retailers may be quite low right now, the consumer may come through in a big way.

What About The Risks Of E-Commerce? XRT Holds This Exposure

So far, I have laid out a positive message. But readers may be thinking, why would I want retail exposure right now when e-commerce is dominating the landscape? While a fair point, we have to consider that not all retail funds are equal. While I would certainly advocate taking a cautious view of traditional brick and mortar retail, such as malls or retail outlets without a strong online presence, XRT holds a variety of companies, many of which are strong e-commerce players. In fact, Internet and Direct Marketing Retail is actually XRT’s largest sector by weighting, followed by multiple other sectors that give the fund quite a bit of diversity, as shown below:

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Source: State Street

In fact, a look through XRT’s sector weightings actually puts my mind at ease, which one might not expect from seeing the word “retail”. Aside from the direct e-commerce weighting, XRT holds sectors that are less discretionary, such as companies in the automotive, food, and prescription drug areas. While apparel comes in at 17%, which could be a concern, we should remember that this is a sector where many of the established names also have a strong online presence. Therefore, encouraging their customers to become online buyers is not as hard as it might be in other areas. Simply, the areas I truly want to avoid, such as mega malls and department stores, actually make up the minority of fund holdings, which supports my outlook for this fund.

With this in mind, it is worth considering just how important the rise of e-commerce really is. While internet sales have been growing over the past decade, so have total sales, so the thesis of the “mall apocalypse” has been disproved so far. While it has absolutely challenged traditional retail, it has turned out there is room for both. Yet, 2020 has upended the consumer experience, and the internet play has gotten a shot of adrenaline. With consumers options more limited now than ever before, the percent of e-commerce sales have soared. While the total percentage of sales have hovered around the 10-12% mark during 2019, this figure has shot in to 15-16% range as 2020 has progressed, as shown below:

Source: Census Bureau of the Department of Commerce

My takeaway here is e-commerce is more relevant than ever before, and this trend will not be reversing any time soon. Therefore, investors need to factor this in when making investment decision. Fortunately, XRT is a fund that offers investors exposure to this growing trend, so I would encourage readers not to overlook funds simply because they hold the word “retail”.

Despite Leading The S&P 500, XRT Is A Cheaper Option

My final point looks at XRT’s valuation, as this is a metric that initially piqued my interest in the fund last year. Simply, XRT has traded at a marked discount to the S&P 500 for a long time, which could be enticing to value investors. Of course, there are valid reasons for that, as many retailers have gone bankrupt, some are stuck offering only limited capacity, and others have slashed or eliminated their dividends. Therefore, many investors have written off retail, allowing funds like XRT to trade at multiples well below the market average.

In fairness, this is a recurring theme, so it does not automatically signal a buy opportunity. But it is worth pointing out now because the spread between the two has been widening, even during a time period when XRT has been leading the market. To illustrate, let us consider how XRT compared, in terms of valuation, to the S&P back in May. At the time, the fund had a 40% discount to the S&P 500. Today, this discount is over 50%, as seen in the chart below:

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XRT P/E (May) S&P 500 P/E (May) XRT Valuation Discount to the S&P 500 (May)
12.2 20.5 40%
XRT Current P/E S&P 500 Current P/E XRT Valuation Discount to the S&P 500
15.9 34.2 53.5%

Sources: State Street, Multpl.com

To summarize, XRT is now “cheap”, and its valuation has risen by about 25% over the past five months. Therefore, investors do need to manage expectations to some degree if they were to buy-in now. A repeat of recent performance may be difficult, so even if gains do occur, they may not be as generous as what we have seen.

Yet, this valuation disparity is very interesting, especially since XRT has been beating the S&P so handily. The takeaway from this reality is that the average S&P 500 company’s earnings are not keeping pace with the share price. The multiple to own the S&P 500 is up because earnings have been under pressure. By contrast, XRT has seen its value rise measurably, yet its discount to the S&P 500, in terms of P/E, is actually more attractive. I see this as a sign that XRT holds some of the right companies for our current environment and, since I do not expect the macro-environment to change much in the next 3-6 months, I believe XRT continues to be a buy.

Bottom line

XRT has been dominating the market of late, offering investors exposure to both traditional retail plays and those capitalizing on the booming e-commerce trend. Traditional retail, while facing difficulties, has seen an uptick due to state re-openings and improving employment numbers. E-commerce, by contrast, has actually benefited from the macro-environment, as more consumers prefer to shop and click, rather than venture out in to stores. With total sales rising and the holiday season on the way, I see important tailwinds on the horizon to drive XRT higher. While the equity market as a whole concerns me right now, XRT actually offers some value, compared to the S&P 500, which should limit downside if we see post-election volatility. Therefore, I believe a bullish rating for XRT is justified, and I would encourage investors to give this fund some consideration at this time.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XRT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com