Wal-Mart earnings signals a buy in discount cereal | Fundamental Analysis

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Wal-Mart earnings signals a buy in discount cereal

Thursday, 14 August 2008 15:07

Have you found yourself spending more time looking at the bottom of the cereal isle in the grocery story or the top of the shelf? According to Wal-Mart (WMT) today, consumers are spending more on store brands as they try to squeeze more buying power out of their funds. Store brands are usually found at the bottom of the isle where shelf space is cheaper compared to the upper shelves which are closer to eye level. This is not entirely unexpected and offering lower cost goods has been part of a strategy that is working for Wal-Mart right now. However this article is not really about WMT’s strategy, instead it is about looking for opportunities within an earnings announcement rather than just the company the release is reporting on.

The US economy is in contraction and therefore equities are struggling which leaves investors looking for defensive stocks. A stock that is likely to perform better than its peers in a contraction is something we would consider defensive. When WMT disclosed an increasing trend of consumers moving towards store brands it made me think about one of these defensive stocks that has been appearing in the news recently. Looking inside the news to find these kinds of trading ideas to add to a diversified portfolio will always be more effective than a computer search.

Specifically, the news today made me think about Ralcorp Holdings, Inc. (RAH) the owner of Ralston and Post cereal products among several other “store brands.” They are a real leader from a fundamental perspective in that industry and despite the squeeze in commodity prices are uniquely positioned to outperform their competitors as stores continue to execute on the Wal-Mart strategy of advertising and delivering lower retail prices.

In the chart below, RAH outperformed during the last market drawdown (2000-2003) and has been reasonably defensive during the current market downturn. I would expect the same pattern to continue in the near term.

Alternatively, a trader could spread a stock like RAH against a short position in another lower performer in its industry as a pairs trade. That could create profits even if RAH declines, as long as it continues to outperform its paired stock on a relative basis.

If you would like to learn more about pairs trading – click here.