The markets have been very optimistic about the consumer discretionary sector and its equity components, and for good reason. You see, the United States GDP pushed a 4.9% expansion in the past quarter, which was above many economists' expectations; however, the main driver behind the expansion is what will matter to you today.
The American consumer has attributed a good chunk of this growth. Wall Street's behavior is a testament to the reality under the economy's hood. By looking at the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA: XLY), you will note a massive outperformance of 12.0% year-to-date against the S&P 500.
However, some bears are starting to point out that the effects of rising interest rates and stubborn inflation will eventually catch up to the consumer, hurting retail sales in the process. Because stocks like ULTA Beauty (NASDAQ: ULTA) operate in a recession-proof consumer niche, they make excellent investments today.
Do you want to know the secret behind the undeniable track record behind Warren Buffett's stratospheric wealth rise? Well, it can be boiled down to two things: First, find businesses that generate high returns on capital without leverage; second, buy them at a reasonable price and let them grow.
With ULTA, you get these two requirements checked off the list and a third extremely important factor that will help you give up uncertainty and stress, making this a multi-decade hold the easiest decision you have ever made for your portfolio.
You see, stocks like ULTA are what can be termed 'eight to eighty' businesses, where target audiences range from eight-year-olds all the way to eighty-year-olds. More than that, the beauty products space will keep on selling through economic booms and busts.
Another example of a stock with such a social moat is Starbucks (NASDAQ: SBUX), where younger consumers can opt for sweeter drinks and snacks.
At the same time, older audiences can get a classic coffee with a pastry on the side. Moreover, the coffee business - just like beauty products - is not going anywhere soon, and it's doubtful that a recession would slow down its sales either.
So look, these qualities are nice and all, but what about the financials? Isn't that where Buffett starts to generate his ideas? Well, after having established that ULTA holds a moat, it is time to translate it into numbers.
Beginning with ROIC (return on invested capital), a five-year average of roughly 25.0% will place ULTA at the top of its peer list. ROIC is key to building wealth since it speaks to management's ability to manage and invest capital correctly; plus, a stock's annual performance begins to mirror ROIC over the long term.
To pay or not to pay
Understanding that ULTA's financials are solid, with its brand moat showing through an industry-leading 43.0% gross margin and 12.0% net income margin, the question needs to be whether today's price is right for a potential purchase.
You could say that ULTA's closest competitor in the miscellaneous retail space is DICK's Sporting Goods (NYSE: DKS). You can add Starbucks to this comparable list on a brand moat - plus recession-proof products.
DICK's analysts are placing a price target of $144.1 a share on the stock, which would imply an 18.7% upside from today's prices in order to meet it. Though decent, the real juice comes from seeing where markets value this business relative to the industry.
With an average forward price-to-earnings ratio of 14.5x, DICK's 9.6x is showing a discount of 33.5% to the industry. While you could argue that a discounted valuation makes this stock more attractive, think about this first.
The forward P/E is set to gauge the value and quality of the next twelve months of earnings in stock, and markets will not want to pay for earnings they deem lower quality or lower growth. You wouldn't mind paying a few extra bucks to ensure you got the best doctor in town would you?
In this sense, ULTA's 15.2x forward P/E is not only 58.2% higher than DICK's but also 5.2% over the industry average. There must be a reasonable explanation for this, and there is.
ULTA analysts expect earnings growth to come in at 7.1% over the next twelve months, which is nearly double DICK's expected 4.4%. Add the product and audience moat to this growth, and you can justify paying a premium price for this stock.
Price targets reflect this view, as a consensus of $529.7 will imply a net upside of 27.8% in ULTA stock. And guess what? If the bears are right and there is a slowdown in consumer strength, ULTA will be at the top of the list of defensive growth stocks to be picked.