Luxury brands: Beware the downside risk of upscale stocks

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Even if you can't invest like the rich, you can invest in them. Canada's pension funds sure are.

Institutional money has found a new preferred destination in U.S. luxury retail chains, representing a bet that the world's affluent consumers will rediscover their lavish side.

On Monday, the Canada Pension Plan Investment Board reached a deal in partnership with U.S. private equity firm Ares Management LLC to purchase Neiman Marcus Inc., the Dallas-based department store chain, for $6-billion (U.S.).

In July, Ontario Teachers' Pension Plan also invested in luxury U.S. retail, committing $500-million to support Hudson's Bay Co. in its proposed takeover of Saks Inc.

But ordinary investors looking at following in the footsteps of the big pension funds should realize this isn't a get-rich-quick strategy.

The pair of deals comes during a soft patch for most high-end chains. While luxury consumption has sustained the sector throughout the economic recovery, high-income Americans have become uncharacteristically frugal this year.

Executives at premier retailers would almost unanimously agree that the second quarter was one that should be forgotten. Saks, Ralph Lauren Corp., Coach Inc. and Nordstrom Inc. have all disappointed investors. "We have had a very strong last three years coming off the recession," Mike Koppel, chief financial officer at Nordstrom, told analysts last month. "There's been all kinds of stories out there in terms of all the different macro factors that may be affecting [more recent] consumer spending."

It could be sagging consumer confidence, fears about emerging market weakness, or a combination of worries. "That's something everybody is trying to get their arms around," said Dorothy Lakner, retail analyst at Topeka Capital Markets in New York.

The expectation that the U.S. Federal Reserve will start to slow the pace of its bond buying program could be weighing on the well-off. Quantitative easing is generally thought to have had an uplifting effect on equities, which has been good for those whose wealth and incomes are primarily tied to the markets. Since the pit of the recession, the S&P 500 has risen by 145 per cent, and almost 25 per cent since just November.

"If the stock market's doing well, usually luxury spending is pretty solid," said Brian Yarbrough, an Edward Jones analyst.

Higher taxes could help explain the reluctance to spend. This year, all U.S. earners were hit with payroll tax hikes, with the wealthiest bearing the largest increase to tax rates.

"It's caused some temporary sluggishness in spending patterns," said Liz Dunn, an analyst with Macquarie Securities. "In the near term I think they're just absorbing increased taxation."

A resilient stock market would help restore spending growth, as would a continuation of the U.S. housing recovery. Rising property values add to the wealth effect of U.S. homeowners.

"The affluent consumer is in pretty good shape," Ms. Lakner said. "It's hard to argue otherwise unless you just point to some sort of general world malaise."

Looking beyond the spending lull, Teachers and CPPIB have identified buying opportunities in luxury retail and so too might retail investors, particularly those with faith in the U.S. stock market and residential real estate market. "If you have a longer-term investing horizon, I think you could do pretty well," Mr. Yarbrough said.

Coach recently announced a leadership change and set out a plan of expansion both geographically and into product lines beyond handbags, Ms. Dunn said. She rates the stock one of two top picks in the category; the other is Ralph Lauren, which continues to move beyond apparel. Both stocks have fallen by 13 per cent off their year-to-date highs.

International expansion is crucial to the fortunes of the enduring luxury brands, Ms. Dunn said. As the major emerging market economies have risen in wealth and profile, high-income consumers have embraced Western luxuries. And the worst predictions for the Chinese economy have not yet come to pass. "The outlook for global luxury spending is even more robust outside of the U.S.," she said.

Although investors in Tiffany & Co. must also weigh the movements of precious metals prices, the jeweller is well-positioned to increase sales through its ongoing expansion into Europe and Asia Pacific, Ms. Lakner said. She has a "buy" recommendation on Tiffany with a price target of $95. Even if China falters, the company's presence there is small enough that the expansion could continue apace, she said, establishing "a catalyst for spending globally."