Why 2017 Is the Year to Invest in Retail Stocks

The retail sector is a tough one to invest in, due to intense competition, fickle consumer tastes, and a disruptive shift from brick-and-mortar retailers to e-tailers. The Dow Jones U.S. Retail Index advanced less than 1% in 2016, underperforming the Dow's 7% growth and the S&P 500's 5% gain. But looking ahead, 2017 could be a brighter year for retail stocks for five simple reasons.

Image source: Getty Images.

1. Shrinking brick and mortar footprints

Many retailers struggled over the past few years because they opened too many brick-and-mortar stores. As more people shopped online, traffic at those stores fell and comparable store sales growth crumbled.

In response, many are reducing their brick-and-mortar footprints to cut costs. Macy's (NYSE: M), for example, willclose 15% of its stores (about 100 locations) by early 2017. Other retailers -- including Wal-Mart (NYSE: WMT), Target, and JCPenney -- have also shuttered hundreds of stores and laid off thousands of workers.

Those closings sound grim, but they could strengthen these companies' long-term earnings growth. Macy's earnings are expected to fall 13% this year, but rebound 9% andgrow at an average annual rate of 12% over the next five years.

2. Smarter investments in e-commerce and training

In the past, many retailers tried to grow their top lines by opening more stores. However, that strategy often backfired the following year when sales didn't grow year-over-year. As retailers slim down their brick-and-mortar footprints, they're also investing more wisely in e-commerce and employee training.

For example, Wal-Mart raised eyebrows when it invested billions in strengthening its e-commerce presence, raising employee wages, and improving employee training. But those investments paid off -- Wal-Mart is now countering Amazon on multiple fronts, analysts arepraising its cleaner and more organized stores, and shoppers are finally returning. Smart moves like these might make 2017 a turnaround year for some major retailers.

3. The emergence of "best in breed" apparel brands

2016 was a brutal year for the retail apparel industry. Aeropostale filed for bankruptcy, American Apparel filed for bankruptcy for a second time, and major retailers like Gap (NYSE: GPS), Guess, and Abercrombie & Fitchall posted quarter upon quarter of negative comps growth.

The reasons were almost always the same -- tough competition from "cheap chic" retailers like Zara and H&M, weak e-commerce growth, over-extended brick-and-mortar footprints, and unfavorable weather conditions. But amid all those excuses, several "best in breed" retailers kept posting positive comps growth.

Notable examples include Urban Outfitters (NASDAQ: URBN) and American Eagle Outfitters (NYSE: AEO), which respectively reported 1% and2% compsgrowth in their most recent quarters. Urban's comps were supported by its 5.2% growth at its namesake brand, which offset declines at its Free People and Anthropologie brands. American Eagle's comps were supported by 21% comps growth at its Aerie lingerie and activewear brand, which offset its namesake brand's anemic 0.4% comps growth. Identifying standout brands like these makes it easier to separate the winners from the losers.

Aerie. Image source: Aerie.

4. Low valuations and high yields

As investors abandoned retail stocks, valuations fell and dividend yields rose. That created some high-yielding stocks with below-industry average valuations and above-average yields with sustainable payout ratios.

Data source: Yahoo Finance, Dec. 1.

These retail stocks now look like decent dividend investments, especially since the multiples of many other income stocks have climbed above industry averages as low interest rates sent investors scrambling toward classic dividend stocks.

5. High consumer confidence levels

Last but not least, American consumer confidence levels remain strong. The Consumer Confidence Index hit 107.1 in November, compared to 98.6 in October, according to data from The Conference Board. That marks its highest level since July 2007. Economists had only expected the index -- which measures confidence toward business conditions, personal finances, and jobs -- to reach 101.2 in November.

This means that if consumer confidence levels remain high next year, the aforementioned improvements across the industry could lift sales and profits at many retailers, which face easy year-over-year comparisons to this year's tepid growth. Investing in the retail sector could still be tough in 2017, but there are still solid turnaround plays if you know where to look.

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Leo Sun owns shares of Amazon.com and American Eagle Outfitters. The Motley Fool owns shares of and recommends Amazon.com. The Motley Fool recommends Guess?. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.