XRT: I See Value In Buying The Weakness (NYSEARCA:XRT)
Main Thesis & Background
The purpose of this article is to evaluate the SPDR S&P Retail ETF (NYSEARCA:XRT) as an investment option at its current market price. 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.”
Going in to 2023 I suggested readers approach this fund carefully. I saw limited chance of strong gains or “alpha”, and the performance since then shows that I was correct in my thinking:
As we push in to Q2, it was time for me to reassess my outlook. After careful thought, I think a “buy” rating is warranted here. While I do expect more volatility ahead, these are times when beginning to start a position / amplify exposure often win out in the long run. Retail is a beaten down, unloved sector and those are precisely the areas that can generate alpha when the longer term backdrop should correct itself. That is something I do expect, and I will explain why in detail below.
I Like To Buy Bear Markets…
The first thought I have is to discuss why I see value in XRT (and retail as a whole). This is not just about the P/E ratio or the fact the sector is down. Those are two valid points, but I also like the relative value here as markets often correct. What I mean is, XRT has been down over the past year like much of the market. But the size of the drop is much more pronounced than that of the S&P 500 over the same time period:
I have two basic takeaways. One, retail is clearly in a bear market. While that isn’t “good” necessarily, it is often a buy signal if one is expecting a future turnaround. Sure, stocks can, and often do, drop much more than an arbitrary 20%. This is by no means a science. But drops in the 10% and 20% range are technical signals of correction and bear markets. When one follows individual stocks or sectors and likes them for the long term, these types of drops signal “buy”. For me, that story fits here.
Two, retail has been hurt worse than the S&P 500 and that means there is relative value by comparison. As my followers know I had used the early ’23 rally to build cash. Now that the markets have sold off a bit I want to get that money back in play. But finding where to put it in play is the challenge. Rather than just plowing more in the S&P 500 – which my portfolio is already very heavy in – I want to be more creative. A sector like retail with a beaten down backdrop in excess to the S&P 500 seems like a reasonable option.
…But Only When Conditions Are Right
Of course, bear markets often exist for a reason. The company or sector is performing poorly. The future outlook is dim. There is too much uncertainty to get excited about a buy these. And many other reasons.
I bring this up to highlight that just because a stock or fund is down doesn’t mean it will end up being a profitable buy. Quite the contrary – and folks in Silicon Valley Bank and First Republic Bank are finding out to their misfortune!
The good news is this is not what I see playing out in the retail sector primarily because the U.S. consumer is actually in better shape than one might surmise from watching the news. There is no doubt that things are worse than they were a year ago from the consumer’s point of view. Inflation has remained high and interest rates have risen dramatically. Still, despite taking on more debt, American households are in a position to manage it. On a historical basis, debt as a percentage of disposable income is below long-term norms:
What this means to me is that households are in a position to continue to support the economy. Money is tighter than it has been of late – given that a higher percentage is going towards debt obligations. But U.S. households are used to holding up in even tougher conditions. This is not an automatic buy signal by any means, but it does support buying in given how beaten down the sector is right now.
To understand why, let us consider how retail sales are doing. In February sales did dip a bit on a month-over-month basis. But as the data shows the drop was not very big:
What I see is a consumer and broader sector that is holding steady. In this difficult climate that is something to welcome, in my view. If XRT was roaring higher, than I would suggest this isn’t that great of a backdrop and to be cautious. But with the fund down 20% in a year, I see stable retail sales as a reason to be opportunistic.
Sentiment Remains Steady
Digging deeper in to the consumer mindset, monitoring monthly sentiment figures can give us some insight in to how spending might hold up in the months ahead. In particular, the University of Michigan publishes an index of consumer expectations that demonstrates how consumers view prospects for their own finances and the economy as a whole in both the near and long-term. When we look at this index, we see that sentiment has dropped in March but not back to levels we saw last year:
This is another “mixed bag” metric. Sentiment has dropped since February, so that is worrying. But even with the drop it sits at an elevated level compared to the last calendar year. Similarly, the drop in sentiment has likely been part of the reason for XRT’s recent weakness. So, again, while the current investment environment may not seem great for a retail fund, the current share price reflects these challenges. That is central to why I see value in buying a position at the moment.
The Opportunity In Apparel
I will now shift to the underlying holdings of XRT. This is important for investing in the fund because “retail” can mean many things. In the case of this ETF it is quite diversified, which is why I favor it over other “consumer discretionary” themed ETFs that tend to be top-heavy with the likes of Amazon (AMZN), Tesla (TSLA), Alibaba (BABA), and a few others.
By contrast, XRT’s top holdings still clock in at under 2% of total fund assets. Further, the sector breakdown shows investors will get diverse exposure:
What stands out here is the “apparel” weighting – the largest in the fund at 24%. There is some risk here, as inflation and higher interest rates are going to pressure discretionary spend. That means apparel purchases may be a place consumers and households cut back to make ends meet during challenging times.
I say that because I don’t want to suggest this is a risk-free sector. But it is one I do favor despite these risks. One key reason is that it continues to be a post-Covid play. After a year (or two) of hunkering down, life in America is basically back to normal. Pretty much every state and city is wide open and mask-wearing and lockdown are almost a thing of the past. This is good for both public well-being and a sense of community, but also for apparel companies. The reason being, people didn’t need to “look good” when they were just sitting home watching television. Whether it is going back out to the office or for entertainment, a return to normal lifestyles means a return to fashion and dressing up. This is good news for stores that sell clothes.
Of course, this is not “new”, as we have had about a year or normalcy in many parts of the country. But it is a trend that is continuing and I believe XRT will benefit from it. Beyond that, a second reason to be bullish on the apparel sector is the amount of M&A that is ongoing. Consolidation in the industry can reduce overhead costs, help navigate challenging supply-chains, limit competition, and improve margins. Simply, there can be a lot of benefits for investors.
Why am I bringing this up? Because the sector has indeed been seeing quite a bit of M&A in the short-term. The following graphic gives a snapshot in to some of the biggest deals since Q4 through today:
As an investor, I welcome this consolidation and am also encouraged by the fact market insiders see value amongst their peers. That bodes well for broader market confidence as well as an improvement in the retail space. This says to me that investors are making moves while valuations are down, and that is a buy signal to me as well.
Q1 Distribution Saw Strong Growth
My last looks at the fund’s dividend. This is relevant because myself and other investors just received the Q1 distribution last week. So looking at how it stacks up to 2022’s Q1 payout is timely.
In this regard, there is a lot to be happy about. While retail is not going to be a high income area, getting a reasonable yield always helps with a buy case. What I like in particular about the last payout is that it is
|Q1 Distribution – 2022||Q1 Distribution – 2023||YOY Growth|
Source: State Street
The simple takeaway here is this is a bullish sign. Strong dividend growth is always something I will welcome and seeing it in an unlikely place like XRT helps convince me this is a good way to play the space.
XRT is not having the best start to 2023. After an initial surge, it is struggling, and its longer term story isn’t pretty either. The fund is suffering from tepid consumer confidence, persistent inflation, and a higher interest rate environment that is clouding the outlook for discretionary spend. None of this sounds like a backdrop investors want to see, but the “good” news is that share prices reflect this. The fund is in bear market territory and that means these challenges are being factored in to the fund’s market price.
This doesn’t mean XRT does not have further to fall, but I like the idea of buying in on recent weakness because I see trends that could help it reverse. We are out of lockdowns, improving the market for apparel and other discretionary items. The fund’s dividend has grown handsomely on a year-over-year basis. Finally, household debt is manageable for U.S. households so I do not believe consumer is going to be weak in the remainder of the year. Therefore, I am a buyer of XRT here, and encourage readers to give the idea some thought at this time.
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