Looking for good buys: in an uncertain economy, it may be too early to bail out on retail stocks.

FEDERAL RESERVE CHAIRMAN BEN Bernanke kicked off the holiday season early by delivering a present to the nation's retailers, Cutting the fed funds rate by half a point in September breathed new life into Wall Street's outlook for the retail sector--because lower interest rates generally mean that consumers will have more money to spend, which will in turn spur economic growth. After edging downward over the summer, the S&P retail index spiked immediately following the announcement of the interest rate cut and closed up 4.6% the day of the announcement.

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But it will take time to see if lower interest rates will have their intended effect, so there's no guarantee the holiday shopping season will be a joyous one. The housing recession, a tougher borrowing climate, a declining dollar, and slowing job growth could all pinch consumer spending and pull down the profitability of retailers both large and small.

Some experts believe that there will be an overall slowdown in the sector. Morgan Stanley analyst Gregory Melich predicts that retail sales will grow by only 3% in 2008, the slowest rate in five years. But the good news is the retail sector is diverse. Yes, the subprime mortgage mess has hurt home improvement chains like Home Depot (HD), which saw earnings drop nearly 15% in the second quarter compared with those of a year earlier. Through early September, shares of Home Depot, a component of the Dow Jones industrial average, were down 13.3%, while the Dow was up 5.2%.

A possible good sign for luxury retailers: unabated spending by more affluent consumers boosted earnings of luxury accessories retailer Coach Inc. (COH) for the quarter ended June 30 by 43% over the same period a year earlier. "You're going to see pockets of retailers that are doing very well," says Scott Krugman, a vice president with the National Retail Federation.

Retail stocks can be gauged like those in other sectors, by looking at, for instance, their price-to-earnings ratios or cash flow. But stores also have a unique set of vital signs on which investors should focus. One key measurement is same-store sales, which tracks the year-over-year sales trends in stores that have been open for at least one year--thereby filtering out growth achieved by building new stores. An upward trend in same-store sales means that a chain's merchandise is popular and its brand is strong. As a result, it allows a given company the ability to increase revenue without the expense of building new stores. You'll also find same-store sales numbers in the earnings reports for restaurant stocks.

Yet despite the uncertain economic outlook, there still may be some buying opportunities in the retail sector.

DRUGSTORE CHAIN: WALGREEN CO. (WAG)

The Deerfield, Illinois-based drugstore chain is a strong defensive play, says Theodore Parrish, co-portfolio manager of the Henssler Equity Fund (HEQFX) at The Henssler Financial Group in Kennesaw, Georgia. "People are still going to buy their medicine," he says, even if consumer spending on discretionary items heads south.

That bodes well for all drugstores, including competitors such as Rite Aid (RAD) and CVS Caremark (CVS), but Parrish says Walgreen Co. is particularly strong. In its 2007 fiscal year, which ended Aug. 31, the company reported sales of $53.8 billion--a 13.4% climb over 2006--and same-store sales growth of 8.1%. Parrish says that sales of both drugs and front-end items, such as shampoo and paper towels, are experiencing strong growth.

What's more, Walgreen Co. has expanded into a nearly 6,000-store empire with virtually no debt--an unusual situation for a capital-intensive retailer. For years, the company's same-store sales have soared quarter after quarter, so there's naturally a question of how much longer that can last, Parrish says. But Walgreen's price/earnings-to-growth ratio--a measure of how much an investor is paying for earnings growth--is at a five-year low, meaning it is actually undervalued.

TEEN RETAILER: ABERCROMBIE & FITCH CO. (ANF)

The retailer of casual apparel for youth posted stronger than expected back-to-school sales, reporting a 6% increase in August same-store sales--beating analysts' predictions of 2.1%. Based in New Albany, Ohio, Abercrombie should register modest single-digit increases in same-store sales for its fiscal year ending Jan. 31, 2008, according to Marie Driscoll, director of the consumer discretionary retail group at Standard & Poor's Equity Research Services.

The company also owns the popular Hollister chain and continues to grow both in the U.S. and abroad. Its latest brand is RUEHL No. 925, which targets post-collegiate consumers. So far, the company has built 16 stores and another new brand is expected to be introduced early next year. Driscoll expects Abercrombie's expansion to help sales grow 15% for this fiscal year and 13% the following year.

Abercrombie shares are cheap, Driscoll says. The company's forward price-to-earnings ratio--the price of its shares compared with its projected earnings--recently stood at about 13, which was 15% below its peer group and 5% below the S&P 500.

DISCOUNT RETAILER: TARGET CORP. (TGT)

The Minneapolis-based chain is a good bet both for defensive investors and sizzle seekers, analysts say. Discretionary items--such as clothing--bring in healthy profit margins, says Chris Tuitt, an analyst with T. Rowe Price, the Baltimore-based mutual fund company. But if consumers grow conservative, the company can always fall back on consumer staples, such as laundry detergent and other household products. "So if things turn out not so great, they're not going to fall off a cliff," says Tuitt, adding that the company has averaged 5% annual increases in same-store sales for a decade. "I think Target should be a great investment over the next year or so."

But what makes Target a better investment than other discount stores? The company has better merchandise and stronger customer loyalty, and on average sells a greater number of expensive items than its rivals, says Parrish. "People want to shop at Target because of what they sell and how they sell it," he says. In August, Target posted second-quarter earnings growth of 14%, and same-store sales growth of 4.9%. CEO Bob Ulrich says that projected earnings of $3.60 per share "remains within the range of likely outcomes," for 2007, evidently not yet feeling the sting of a possible slowdown in consumer spending.

In the end, fears about consumers closing their wallets may not pan out. So while investors would do well to get a little more conservative in picking retail stocks, Parrish says, "that's not to say that you shouldn't have any growth in your portfolio."

Abercrombie & Fitch (ANF)

Price 9/19/07       $82.35
2009 Est. EPS        $5.98
Forward P/E Ratio    13.8

Target (TGT)

Price 9/19/07       $66.18
2009 Est. EPS        $4.10
Forward P/E Ratio    16.1

Walgreen (WAG)

Price 9/19/07       $46.05
2008 Est. EPS        $2.37
Forward P/E Ratio    19.4

Note: Table made from line graph.