Stock picking for smart shoppers

NEW YORK (Money) -- This week leading up to Christmas figures to be a boom time for retailers. So far, however, business has been only so-so and price competition has been fierce.

As a result, shares of leading retailers have lagged much of the rest of the market. Part of the reason is uncertainty about the outlook for 2007.

Declining real estate prices and the chance of an economic slump could lead to earnings disappointments for retailing stocks during the coming year. On the other hand, low unemployment and the possibility of interest-rate reductions by the Fed should support consumer spending.

All things considered, it's nearly impossible to make a useful prediction about retailing trends in 2007. But what's much more important is that several top retailing stocks in the Sivy 70 are cheap relative to their long-term growth potential.

Four weeks ago, I outlined the case for Wal-Mart. The stock is notably cheap, having actually declined over the past 12 months. Domestic business is hurting - same store sales were actually down in November, compared with a year earlier.

But looked at from a longer distance, Wal-Mart (Charts) looks like a bargain, a fundamentally attractive stock close to a low. The international business is strong and the company is branching out into new businesses with a lot of potential, particularly generic drugs.

The company's compound earnings growth is projected at more than 11 percent annually, and the shares yield 1.4 percent. That's an attractive return for a stock that trades at less than 15 times estimated earnings for 2007.

Target (Charts) is not quite as cheap, with a price/earnings ratio of 16.3, but the chain has been performing better than Wal-Mart. Same-store sales were actually up almost 6 percent in November.

Target has been more successful than Wal-Mart at fine-tuning its product mix to attract a slightly more affluent shopper. And Target is following Wal-Mart into the generic-drug business. Overall earnings growth is projected at a 13 percent compound annual rate over the next five years, a bit higher than Wal-Mart's.

Electronics retailer Best Buy (Charts) has an even higher projected growth rate of about 14 percent annually. And the share price has gained more than 13 percent over the past year, compared with 8.5 percent for Target.

But investors were disappointed last week when Best Buy reported earnings that were several cents a share below expectations. Fierce price competition from Wal-Mart and other chains have greatly eroded the profit margins on popular consumer electronics, such as flat-panel televisions.

Analysts are cautious about the fourth-quarter retailing outlook, and it's hard to know what 2007 will hold. But the giant chains still have a formula that could work for a number of years.

They get a certain amount of growth simply by opening new stores. And in a better economic environment, increases in same-store sales plus small price increases to keep up with inflation would get earnings close to their targets.

Adding such stocks to your portfolio when they're cheap, as the retailers are now, is the key to successful long-term investing. A few years later, such stocks usually look like great bargains in retrospect.

Of course, if you want the best bargain of all, first pay off whatever credit-card debt you take on during your holiday shopping. Avoiding interest on your balances not only gives you the equivalent of a high return -- but the benefits are also a sure thing.

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