Despite Gains in 3Q, Consumer Cyclical Still Offers Compelling Opportunities

The consumer cyclical sector recouped prior 2022 losses in the third quarter by garnering roughly a 5% return, outperforming the U.S. equity market’s 3% decline, as of Sept. 27. Still, the consumer cyclical sector trades at a 25% discount to our fair value estimates, with 72% of stocks in our sector coverage trading in 4- or 5-star territory. We surmise the lingering pessimism stems in part from near-term concerns over consumer willingness to spend, given persistent inflation, rising interest rates, and plunging personal savings rates. However, we think this is more than baked into the shares, rendering travel and leisure and apparel retail as two of the more undervalued spaces, at 35% and 33% discounts to our intrinsic valuation, respectively.

To buoy our stance, improving U.S. hotel occupancy levels quantitatively suggest travel volume remains resilient. Particularly, average daily rates, which more than fully recovered in the second quarter of 2022, reaching 114% of 2019 levels, showcase hotel operators’ stout pricing power thanks to the pent-up desire to travel, wallet share shift to service consumption, and incremental trips from remote work flexibility. While heated inflation could further pinch consumer pocketbooks and curb discretionary spending (including on travel), we do not expect to see softening travel demand in aggregate over the near term. Rather, a recovery in business and international trips that have been lagging the rebound in leisure trips should invigorate the travel industry ahead, in our view.

Consumer Cyclical Stocks Chalked Up Robust Gains in the Quarter

Source: Morningstar Equity Research, Data as of Sept. 27, 2022.

However, Each Consumer Cyclical Subsector Still Offers Opportunities

Source: Morningstar Equity Research, Data as of Sept. 27, 2022

Despite Sector Gains in Q3, Consumer Cyclical Still Offers Compelling Opportunities

As for apparel retail, the amalgamation of shifting consumer purchasing decisions and supply chain disruption that led to bare shelves during the last holiday season left retailers with a conundrum of estimating appropriate inventory positions. Specifically, early ordering to cope with supply chain constraints coupled with sales declines in some categories amid inflation resulted in elevated inventory levels. However, as retailers act to curtail inventories at the shelf ahead of the upcoming holiday season (through aggressive markdowns, order cancellations, and assortment changes), we expect inventory levels to improve over the next few months, positioning apparel retailers for a better 2023.

Demand for travel persists even amid macro challenges.

Clothing retailers’ inventories pilling up, but firms not sitting still.

Sources: Smith Travel Research. Company filings. Morningstar. Data as of Sept. 22, 2022

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