Costco Wholesale (NASDAQ: COST) has been one of the best-performing stocks in the retail sector.
Shares of the membership-based warehouse chain have jumped more than 600% over the last decade, and the company continues to expand both through new stores in the U.S., and by growing same-store sales and expanding its e-commerce business.
However, despite that success, there’s a good argument that Costco is now overvalued. The stock trades at a price-to-earnings(P/E) ratio of 56, about twice that of the S&P 500 index.
You don’t have to take my opinion on the valuation. Top billionaire investors have been selling the stock in the second quarter. That includes Ray Dalio’s Bridgewater Associates, which sold 94,000 shares of Costco in the second quarter, worth nearly $80 million at the time.
Meanwhile, Ken Griffin’s Citadel Capital dumped 124,000 shares, or roughly $100 million. Though Costco’s business looks strong, it’s likely those two hedge funds concluded that its valuation was getting stretched.
If you’re thinking of following them out of Costco, here are two retail stocks worth rotating into.
1. Home Depot
Home Depot (NYSE: HD) is the nation’s largest home improvement retailer.
While Costco stock has continued to climb since the pandemic, Home Depot has struggled with the slowdown in the housing market, and the stock is still trading below its all-time high from 2021.
However, Home Depot looks well positioned to move higher from here. First, the Federal Reserve has begun its rate-cutting cycle, cutting the benchmark federal funds rate by 50 basis points last week.
Falling interest rates should help reignite the housing market, lowering mortgage rates and monthly payments, and mitigating the lock-in effect from low mortgage rates. It will also lower rates for home equity loans and home equity lines of credit (HELOC), encouraging renovations and other home improvement projects.
Home Depot is also poised to capitalize on the recovery thanks to its acquisition earlier this year of SRS Distribution, a leading building materials distributor. That deal helps vertically integrate Home Depot further downstream, closer to its professional customers, and expands its addressable market by an estimated $50 billion.
Home Depot stock now trades at a P/E ratio of 27. That might seem expensive, but its earnings growth should rebound as the housing market bounces back.
2. Target
Target (NYSE: TGT) has also struggled of late, but for different reasons than Home Depot.
As primarily a discretionary retailer, Target has been hit with the slowdown in consumer spending as well as internal problems like theft, but the company now seems to be overcoming those, and the business is moving in the right direction.
Meanwhile, inflation now seems to be under control, and falling interest rates should also encourage consumer spending.
Target’s recent challenges have also set it up for a sharp rebound in profits, as its second-quarter results show. Gross margin jumped from 27% in the quarter a year ago to 28.9% due to cost improvements, a favorable category mix, and other factors.
That improvement in gross margin flowed through to make a significant difference on the bottom line as operating margin improved from 4.8% to 6.4%. In other words, if the company can continue making significant improvements in gross margin, profits could jump from here.
Like Costco, Target is continuing to open new stores, and the company enjoys a number of competitive advantages, including its multicategory business model, store-based fulfillment of online orders, and curbside pickup program.
Target is a stronger business than its recent performance has indicated, and it looks like a good buy at a P/E ratio of 16. Analysts also expect similar earnings growth next year from Target and Costco, showing that Target looks like a steal compared to the much more expensive Costco.
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Jeremy Bowman has positions in Target. The Motley Fool has positions in and recommends Costco Wholesale, Home Depot, and Target. The Motley Fool has a disclosure policy.
Billionaires Are Selling Costco. These 2 Retail Stocks Are Better Buys. was originally published by The Motley Fool
