1 Reason to Tread Carefully in This Sector

1 Reason to Tread Carefully in This Sector

Stocks tied to consumer spending have been huge winners lately. Thanks to elevated consumer confidence, folks are feeling optimistic and starting to open their wallets. But this news has investors wondering if good stock buys still exist in the consumer goods space.

Dissecting the sector
Just last month, The Conference Board reported that the Consumer Confidence Index hit a five-year high. The real estate recovery is under way, and the job market is slowly rebounding. Despite a payroll tax increase that took effect at the beginning of the year, consumers are loosening the purse strings and feeling good these days. In fact, consumer spending rose at the fastest pace in two years during the first quarter of this year.

Consumer discretionary stocks, which span industries like autos, apparel, leisure, and media, enjoy more upside during a robust economy and typically outperform the overall market when the economy is purring. For example, from the March 2009 market doldrums to present, the consumer discretionary sector returned 282% versus 175% for S&P 500. So far this year, it's been the best-performing sector, returning nearly 26% versus the S&P 500's 20%.

Yet investors are getting cautious. Last week, retail sales came in weaker than expected. Also, some of the biggest winners in the consumer discretionary sector are trading at rich valuations. Take Tesla , a stock that's surged an incredible 262% year to date. Many investors feel its current forward price-to-earnings ratio of 136 is both frothy and completely unjustifiable.

Last week, my Foolish colleague Sean Williams both extolled the virtues of CEO Elon Musk's genius and broke down Tesla's crazy valuation. Without a doubt, Tesla has a lot going for it. Musk's commitment is unquestionable, Tesla's technology is game-changing, and the company recently posted a profit. But big competitors are gaining ground in the electric vehicle market. And the infrastructure needed to make electric vehicles a viable and prolific means of transportation is not only lacking, but also years from becoming reality.

Rev up or downshift in this sector?
With huge stock run-ups like Tesla's, some investors feel the gains in the sector are behind them. So should you stay out of the sector completely? In a word: no. Good buys still exist, though it might require a bit more work to find them.

For example, Disney appears to be a good buy. Its stock price is up a more modest 29% so far for the year, yet it boasts an enticing forward price-to-earnings ratio of 16. Disney enjoys a diversified stream of revenues and an ability to produce seemingly endless billion-dollar movie franchises. Its Pixar, Marvel, and Lucasfilm acquisitions are proving successful and generating assets that'll create value for decades to come. In addition, Disney's lucrative cable networks bring in roughly 45% of revenues and two-thirds of annual operating profit.

Foolish takeaway
By developing a diversified strategy for adding all sectors to your portfolio, a portion of your portfolio will prevail regardless of what happens in the market. But when a specific sector is on a tear, it increases the importance of doing your homework to find high-quality companies with enticing growth prospects whose stocks trade at good values.

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The article 1 Reason to Tread Carefully in This Sector originally appeared on Fool.com.

Fool contributor Nicole Seghetti has no position in any stocks mentioned. Follow her on Twitter @NicoleSeghetti. The Motley Fool recommends Tesla Motors and Walt Disney. The Motley Fool owns shares of Tesla Motors and Walt Disney. 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.

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