How to Invest in Apparel Stocks

Few corners of the retail industry carry as much weight in the stock market as the apparel sector. Last year, clothing stores in the U.S. tallied $275.2 billion in retail sales, according to the Census Bureau, and that doesn't include billions in apparel sold at general merchandise stores like Walmart and Target and department stores like Macy's. Globally, Euromonitor estimated that apparel and footwear sales reached $1.7 trillion in 2017.

It's no surprise, then, that investors would look to the apparel sector for opportunity. Not only is the industry huge, but it also encompasses dozens of stocks and a wide range of product categories, including sportswear and athleisure, lingerie and undergarments, business clothes, footwear, fast fashion, casual, off-price, and others. While individual apparel retailers generally compete with those in their own segment, they are all subject to similar market forces, which in the U.S. include rising minimum wages and a tight labor market, seasonality that drives a sales surge in the holiday season as clothes make popular gifts, and high consumer confidence that's boosted discretionary spending as the economy has been strong and unemployment is low.

Before diving into individual apparel stocks, let's take a step back and define the industry, examine the risks and opportunities, and discuss what investors are best suited to the sector.

What is the apparel industry?

Simply stated, apparel is defined as clothing, footwear, and accessories, and the apparel industry is made up of the wholesalers and retailers that sell them. Today, the apparel industry includes both online and offline apparel retailers, and while the industry represents hundreds of billions of dollars in annual sales, it's growing slowly. Clothing is not a new industry, after all, and there is relatively little opportunity for breakthrough products that expand the market the way there is in industries like electronics or technology. Through the first four months of 2019, sales at U.S. clothing stores have risen just 0.6%, and Euromonitor sees global sales increasing just 2% by 2022. Because of manufacturing being outsourced to places like China and other cost-saving innovations, apparel prices have remained flat on average over the last 20 years, meaning apparel companies have not benefited from inflation. For consumers, clothes have gotten cheaper.

The different types of apparel businesses

Apparel companies operate through a broad range of business models as this is a huge, age-old industry that has evolved into different channels over the years. The chart below shows some of the most common ways of forming an apparel business.

Opportunities in apparel stocks

Though overall growth in the apparel industry has been sluggish, there are still opportunities within the sector, and a number of areas are growing quickly.

Athleisure has arguably captivated apparel investors more than any other trend over the last decade, generating significant returns for Lululemon and at times driving growth at companies like Nike and Under Armour. Other retailers have taken notice as Gap, for example, launched the chain Athleta several years ago, and other competitors have rolled out their own athleisure lines.

Off-price chains like T.J. Maxx parent TJX Companies have also outperformed over the years, because these companies have benefited from being insulated from e-commerce. The off-price model, which is based on quickly turning over discounted inventory, is hard to replicate online, where retailers often have to pay for shipping and returns and photograph pieces of clothing to post online. Known for value, the off-price sector has proven to be a winner with consumers.

Finally, the personal styling and e-commerce trends in apparel come together in Stitch Fix (NASDAQ: SFIX), the only pure-play online styling service stock. Stitch Fix is one of the most disruptive apparel stocks on the market, as it offers a clear alternative to the traditional way of clothes shopping. Rather than select clothes in a store or from a website, Stitch Fix customers fill out a profile on the site with information including their fit, style, and budget, and then a Stitch Fix stylist sends them a box of clothes. They keep what they like and return the rest. The company is the leader in its industry, and competes against Nordstrom's Trunk Club, among other privately held styling services like Bombfell and Le Tote.

Fashion is fickle, as they say, and that presents both risks and opportunities for investors. Savvy in-the-know investors and shoppers may be able to spot the next big trend in fashion and capitalize on it, much like what's happened with athleisure and fast fashion over the last decade.

Risks in apparel stocks

Like any other industry, there are a number of potential pitfalls in apparel that investors should be aware of.

The biggest risk in the apparel industry these days is the threat from e-commerce, in particular Amazon.com, which may already be the country's biggest apparel retailer. With the rise of e-commerce, it's become clear that many of the country's biggest apparel retailers, including department stores and mall-based retailers like Victoria's Secret parent L Brands and Gap, simply have too many stores. That's prompted thousands of store closings and a number of bankruptcies in recent years including Sears and Toys R Us as that process continues to play out.

Some traditional retailers have built successful e-commerce businesses that now make up a significant percentage of their sales. However, even those companies have often found that online sales tend to generate lower gross margins than in-store sales, since they need to deal with shipping and returns and managing a separate sales channel online.

Slow growth also presents a risk for investors in the apparel industry especially because price growth has been stymied over the years by outsourcing and competition from fast-fashion retailers like Zara, H&M, and Uniqlo, which are structured to refresh new styles quickly and sell items for low prices with the expectation that consumers will shop there frequently. That model has pressured the traditional apparel leaders in the U.S. like department stores and casual clothiers like Gap.

Furthermore, the fact that both the industry itself and prices for clothes are barely growing means that companies are fighting each other for market share, rather than benefiting from a growing market. Therefore, investors should be tactical about their investments in apparel, because the overall industry is not going to deliver significant growth.

Finally, trade tensions also present a risk for investors, as tariffs on Chinese imports could potentially force retailers to hike prices on apparel. That would likely cause consumers to cut back on spending, harming both sales and profits for apparel retailers.

Who should invest in apparel stocks?

Given the slow growth in the apparel industry, the sector presents the most opportunity for value and dividend investors. Apparel retailers are often undervalued and trade at P/E ratios as low as the single digits, and these types of stocks also tend to pay generous dividends. Macy's, for example, pays a dividend yield above 6%, and some apparel retailers, including Walmart and Target, are even Dividend Aristocrats, meaning they've increased their dividend payouts every year for more than 25 years.

Value investors will want to focus on retailers that have been ignored or overlooked by the market. Again, Macy's presents an intriguing opportunity here, as the company has a lot of valuable real estate, including its flagship store in New York's Herald Square, which is worth an estimated $4 billion. At one point, its real estate holdings were estimated to be worth as much as $21 billion by Starboard Value, an activist investor. Macy's has begun selling some of its real estate and consolidating its store base, unlocking value for shareholders and adding a new revenue stream.

Children's Place provides another example. Its stock plummeted at the end of 2018 as rival Gymboree declared bankruptcy and prepared to liquidate all of its stores. Children's Place slashed its guidance for 2019 due to the short-term impact from the liquidation, but the exit of its closest rival should benefit the retailer over the long term, since 70% of its stores overlapped with a Gymboree location. In 2020, when those headwinds are gone, Children's Place's financial results should improve significantly from the prior year.

Though apparel stocks will mostly present opportunities for value investors, there are also some growth stocks available in the sector. Stitch Fix, for example is disrupting the industry by approaching clothes shopping through an algorithmic discovery process. Based on your preferences, past selections, and its general customer base, it chooses clothes for you that it thinks you will like. Lululemon has also put up impressive growth over the years; the high-end athleisure company has built a unique brand in apparel that continues to outperform the sector, even as it's inspired a slew of imitators. Sportswear in general has outgrown the overall apparel industry, as Nike continues to put up steady growth as well. Finally, Canada Goose has splashed onto the public markets recently with a trendy, high-end winter coat brand. By opening new stores and growing its direct-to-consumer channel, the company is driving impressive growth on the top and bottom lines.

Key metrics/factors to watch

Every investor should understand the financial numbers shaping the industry that they're looking at. The list below shows some of the most important numbers and intangibles to pay attention to in the apparel sector.

Comparable sales

This metric measure the sales growth or decline of an apparel retailer excluding the impact of new or closed stores. Comparable sales, which usually includes e-commerce sales, gives investors a clear window into the performance of a company and its brand as the overall revenue growth figure can be muddied by sales from new stores. Healthy retailers should see steady same-store sales growth, at least in the low single digits. Adding new stores is an easy way for retailers to grow revenue, but it's not always in their best interest as deriving sales growth from new stores rather than the current base is more expensive. By increasing comparable sales, they avoid the costs of building new stores.

Gross margin

Gross margin is the percentage of revenue that apparel retailers keep after accounting for cost of goods sold, which includes merchandise, labor, and occupancy costs. Gross margin gives the best picture of how efficiently a retailer is turning over its inventory. If comparable sales rose but that was largely because of markdowns, then gross margin will likely fall, showing that the increase in sales did not lead to rising profits. Like comparable sales, rising gross margin is preferable, though a dip isn't necessarily a warning sign as retailers can be contending with issues out of their control like rising minimum wages or higher merchandise costs due to tariffs on China.

E-commerce growth

This figure in the key e-commerce channel shows how fast retailers are growing their online sales and what percentage of their sales come from the online channel. Not all companies report this, and the ones that don't are likely struggling to grow online sales. However, a number of apparel retailers are seeing e-commerce growth of 20% or better and some derive nearly half of their sales from their online channel. The share of apparel sold online grows every year and most apparel retailers will have to eventually build profitable and growing e-commerce businesses, especially as brick-and-mortar traffic is falling in places like malls. Apparel retailers with strong e-commerce growth are most likely to have a bright future ahead of them as technology is only going to make e-commerce easier. Some companies refer to this category as digital sales.

Brands

An intangible but highly valued asset in apparel, brands are often the biggest source of competitive advantage since apparel retailers tend to compete in terms of quality, style, or brand rather than price as price competition is more common in other retail sectors. Like fashion in general, brand perception can change over time. To learn more about a company's brand and its perception, pay attention to things like marketing, buzz in the general public and in the media, and even what influencers are wearing a given brand or saying about it. Apparel brands often carefully cultivate such images and their ability to positively control their brand's perception is a good determinant of their future growth and opportunity.

Key players and stocks to watch in apparel

The apparel industry is highly competitive with low barriers to entry, and investors have a number of choices on the stock market. To help you narrow down your options, the chart below shows several stocks in different businesses in the apparel industry to give investors a better sense of the opportunities available.

Let's take a closer look at few of these companies and see what they have to offer.

Nike

Nike is the world's most valuable apparel company, and synonymous around the globe with sports. For nearly 50 years, the company has been cultivating top athletes to build and support its brand, counting the likes of Michael Jordan, Tiger Woods, Serena Williams, Cristiano Ronaldo, and LeBron James among its sponsors.

The growing popularity of sports around the world and Nike's masterful marketing has delivered steady growth for the company over the years. Nike's revenue has doubled over the last decade to $36.4 billion in 2018. In 2015, it set a goal of hitting $50 billion in revenue by 2020, though later it said that it would take longer to reach that milestone. Nike's brand and well-known Swoosh logo is worth an estimated $28 billion as of 2018, far more than any other American fashion brand.

Withstanding challenges from rivals like Under Armour and Adidas, Nike has revamped its business to speed up innovation, bring product to market faster, and focus on its direct-to-consumer segment through e-commerce and experiential stores.

Nike has an advantage over other apparel companies because nearly two-thirds of its revenue comes from footwear, which has proven to be a much faster-growing category than apparel, especially as sneakers have become more fashionable in recent years. Euromonitor, for instance, predicts that sports footwear will grow by 20% by 2023, compared to just 10% for the general footwear category, and low single digits for apparel.

Brand power also carries more weight in footwear than in apparel. For example, Nike, including its Jordan brand, has a dominant share of the performance (high-end) basketball shoe with more than 80%, according to research firm NPD, and that superior market share as well as its cast of sponsors create a halo effect on the rest of the brand.

For apparel investors looking to capitalize on the power of brand, Nike presents an appealing option.

TJX Companies

The parent of T.J. Maxx, Marshall's, and HomeGoods, TJX is one of the biggest U.S. retailers. In fact, it's the largest American apparel retailer by market value. TJX's tried-and-true off-price formula has delivered consistent results for investors, and other off-price chains have also found success including Ross Stores and Burlington Stores, a testament to the strength of the model in today's retail industry.

The company gives customers discounts of 20%-60% compared to full-price retailers by taking advantage of excess inventory from manufacturers, department store cancellations, or closeout sales when vendors want to clear merchandise. That strategy not only helps the company deliver low prices and value for customers, but also ensures an ever-rotating selection of merchandise, keeping customers visiting its stores often.

That model is relatively difficult to implement online, and though TJX sells clothes on its website, the vast majority of its sales come from its stores. While many of its peers are closing stores, the company is rapidly expanding its store base. It finished 2018 with 3,143 stores across all of its brands in the U.S. and expects to grow to 4,400 over the long term. Globally, it sees room for more than 6,000 stores.

TJX's recent results speak for themselves. In 2018, the company delivered 6% comparable-store sales growth, much better than most apparel retailers, and overall revenue increased 9% to $53 billion. Net income jumped 17% to $3.1 billion with the help of lower tax rate. Those figures show the company thriving in an environment that has challenged many of its competitors and suppliers.

With its off-price model, TJX should weather recessions better than most apparel companies, and it's shown it can gain market share even in strong economies when shoppers have plenty of discretionary income. Combine the strength of that position with the company's commitment to raising its dividend and TJX looks like a strong, all-around stock pick for apparel investors.

Nordstrom

For value investors, Nordstrom may be one of the best apparel stocks available today. Shares are trading near a five-year low, yet the company has a number of promising initiatives on the horizon, and its core business remains strong.

Nordstrom is best known as a high-end department store and its full-price channel, which also includes Nordstrom.com and a number of smaller business, contributes about two-thirds of its revenue, but the company also has a healthy off-price business made up of its Nordstrom Rack and complementary websites. Nordstrom Rack and the off-price business benefits from the same competitive advantages that TJX does, but it also derives an additional advantage from the way it dovetails with the full-line Nordstrom stores. Rack stores act as outlets for clearance merchandise from the full-price channel, and also use many of the same vendors.

Nordstrom was also ahead of the curve in investing in e-commerce, and it's built up an impressive omnichannel business. As of 2019, sales originating online made up 31% of the company's total revenue.

Nordstrom is being strategic about its store openings, closing some locations while expanding where it sees opportunity like in the Canadian market and in Manhattan with a new flagship Nordstrom store, which could generate $300 million-$400 million in annual revenue. It's also experimenting with omnichannel concepts like Nordstorm Local, small-footprint locations without merchandise that act as styling-focused service hubs. At Nordstrom Local stores, customers can have styling consultations, get alterations, and pick up online orders, among other things. The stores also extend the company's high-end brand in a new form and reinforce its reputation for customer service.

In 2014, the company also acquired Trunk Club, a Stitch Fix competitor that delivered 35% revenue growth in 2018, giving it a stake in the online personal styling market and also showing its willingness to tinker with new concepts.

Though the bulk of Nordstrom's business will continue to come from the full-line channel for the foreseeable future, Nordstrom's off-price chain, strong e-commerce sales, and experiments with Nordstrom Local and Trunk Club make it much more nimble than other department store chains and give it an upside potential that the market seems to be ignoring. Even the founding family thinks the stock is undervalued. In 2018, the Nordstroms offered to take their namesake company private at $50 a share, but the board of directors rejected their offer.

What's next in apparel

While the apparel sector may be more stable than other industries, the competitive nature of it as well as shifting fashion tastes means there is always an opportunity for an upstart company to emerge. Though the categories of products for sale remain largely the same, it's a mistake to think there isn't innovation in the industry. Technical fabrics, like the ones Lululemon has pioneered, have influenced other brands and categories like denim, and fast fashion has also caused other competitors to speed up their turnaround times and try to adopt current runway styles.

As in other retail sectors, convenience is king. E-commerce is growing as consumers spend more time shopping for clothes online, and we're likely to see more brick-and-mortar apparel retailers close stores in the coming years.

Still, the components of a successful apparel business will remain the same as investors will benefit from seeking out strong brands, companies known for high quality or value, and those that can deliver comparable sales growth and healthy gross margins. Whether you're on the hunt for value or growth, keep those factors in mind as you explore the market for apparel stocks.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Amazon, Nike, Nordstrom, Stitch Fix, Target, The Children's Place, and Under Armour (A Shares). The Motley Fool owns shares of and recommends Amazon, Lululemon Athletica, Nike, Stitch Fix, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool owns shares of G-III Apparel Group. The Motley Fool recommends Canada Goose Holdings, Nordstrom, and The TJX Companies. The Motley Fool has a disclosure policy.