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3 Quality Retail Stocks That Are Amazingly Cheap

The theme of e-commerce - especially Amazon (AMZN) - gutting traditional retailers has been a common theme over the last several years, and not one without merit.

We've seen company after company in the retail space post worse than expected comparable store sales and slow revenue growth as the acceptance and utilization of e-commerce just continues to grow.

However, what is under-appreciated is that a lot of quality retailers still generate substantial earnings and cash flows. Their business models and inventory management have been sharply honed over several decades. The ability for consumers to personally inspect items and the instant gratification of purchase and owning has value. These large companies have economies of scale in purchasing and marketing. And many of them are moving successfully into the e-commerce space itself to augment their traditional "bricks-and-mortar" stores.

Using the Spell Caster screener, I ran a Magic Recipe-style screen using just retail stocks and came out with some interesting results.

Some of the cheapest, highest quality (as measured by return on capital) retailers are ones everyone has heard of and likely shopped with recently. Of the 50 stocks screened, I picked 3 well-known names that ranked at the very top of the screen, with earnings yields and return on capital figures far above their historical norms and the averages for the retail sector at large. All 3 are large, quality retailers with strong balance sheets, substantial cash flows, and valuations that would seem to offer compelling upside for potential investors. Here they are:

GameStop (GME)

Earnings Yield: 18.6%
Return on Total Capital: 28.2%

GameStop

GameStop is one of the most aggressively shorted retailers in the entire market and has been for years, with a short ratio of 49%! However, despite almost a decade now of digital distribution competition, the company still has not suffered substantial revenue declines and has been able to maintain high returns on capital and free cash flows. Its used game program is an under-appreciated competitive advantage that nobody has been able to duplicate - and several have tried. Recent moves into used Apple equipment resale with Simply Mac and game merchandise with ThinkGeek are good attempts to diversify the business into adjacent categories. Financially, this is a value investor's dream, with a 4.7% dividend yield at a payout ratio under 40%, and share buybacks that have averaged an impressive 7% annual decline in share count over the past 5 years. The company's earnings yield of 18.6% is in the top 5% of the market. That seems too cheap for what is clearly a well-run business.

Best Buy (BBY)

Earnings Yield: 15.9%
Return on Total Capital: 41.9%

Best Buy

Best Buy is actually a pretty similar play to GameStop. The company still generates substantial free cash flows, pays a healthy 3.4% dividend, and buys back shares - although not as prodigiously. Considering the enormous impact that e-commerce has played in electronics sales (consumer electronics are the #1 e-commerce category), Best Buy has held up reasonably well. For their recently reported fiscal year, comparable store sales actually grew slightly, and they improved their operating margin by 30 basis points, a pretty big move considering the low margins in this business. Online sales, the avenue for Best Buy to survive, grew nicely at 13.5% for the year. The current earnings yield of almost 16% is far above the market average of about 7%, and considerably above the retail average of about 10%. Best Buy is another classic value-style cash flow play.

Bed Bath and Beyond (BBBY)

Earnings Yield: 15.5%
Return on Total Capital: 35.4%

Bed Bath and Beyond

Add an extra "B" for another very well-run retailer, Bed Bath and Beyond. Bed Bath has taken the GameStop playbook when it comes to buying back shares, putting its substantial cash flows into an 8.4% average decline in shares over the past 5 years, with share buyback activity increasing recently. The company has a history of excellent returns on capital and is widely considered to be well-run. While GameStop and Best Buy have both started adapting to the times, Bed Bath is still behind the curve when it comes to e-commerce. But this might be changing - in the most recent quarter, digital channels grew 25%. The company will have to continue to execute here to counter increasing competition from online-only competitors like Quality Growth stock Wayfair (W). The market is concerned, and rightfully so, about falling margins here, but I think Bed Bath can turn it around and become a strong online presence in time.

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