June 13, 2010 in Business

Home Depot and Lowe’s look better, but use some caution when investing

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Though Home Depot’s (NYSE: HD) and Lowe’s (NYSE: LOW) latest quarterly results suggest that investors are feeling more at home with home-improvement companies, think twice before rolling out the welcome mat just yet.

Home Depot increased first-quarter net income by 41 percent to $725million. Revenue increased 4.3percent to $16.9 billion, and same-store sales (for stores open a year or more) increased 4.8 percent. Management upped its projections, now expecting fiscal 2010 sales to increase 3.5 percent and earnings to increase 21 percent.

Lowe’s tidings weren’t quite so heartwarming. Its first-quarter net income increased 2.7 percent to $489million. Revenue increased 4.7percent to $12.4 billion, and same-store sales jumped 2.4 percent. Lowe’s management said 2010 will be a “year of transition” for its industry.

Investors should remain highly discriminating when buying retail stocks. Economic optimism has buoyed many such investments, but folks caught up in the euphoria seem to ignore the influence of high unemployment and a still-stagnant housing market.

Home-improvement retailers rely on the housing industry and consumer confidence for growth. Until one or both of those factors brighten, home-improvement stores will remain haunted by risk. (Home Depot and Lowe’s are “Motley Fool Inside Value” recommendations.)

Ask the Fool

Q: Are the best companies the ones with lots of cash and no debt? – R.D., Palmdale, Calif.

A: Not necessarily. Companies with piles of cash do have flexibility to act quickly when various opportunities arise.

But many successful companies manage their cash balances down to near zero. They use the money to buy back shares, pay dividends and acquire other companies, among other things. If they suddenly need cash, they draw on their lines of credit.

Debt can be OK, as long as a company is able to manage it, and too much cash can be unproductive.

Q: I expect to come into a few thousand dollars soon. Is it better to use it to pay off my car loan or invest it in the stock market? – J.W., Sioux City, Iowa

A: It all comes down to interest rates and growth rates. First, if you have any credit card debt, use the money to pay that off. Credit card rates are typically very steep and debilitating.

Next, compare your car debt with your alternatives. Let’s say your interest rate is 7 percent. If you invest in the stock market, the average annual gain in stocks over many decades is about 10 percent, but that’s just an average and far from certain.

So you need to decide whether you’d rather save a definite 7 percent or hope for a 10 percent gain. Consider your risk tolerance, and remember to consider the effect of taxes, too.

It can be worth paying a little in interest in order to earn more through stock appreciation. Just make sure you’re investing for the long haul. Short-term stock returns are unpredictable and can be volatile.

My dumbest investment

My first stock was eToys. I didn’t invest in the market for another five years! It more than doubled before it died – but I never sold. – R., Singapore

The Fool responds: Anyone investing in stocks needs to be prepared for occasional losses – and, of course, the less you know about investing, the more losses there will likely be. The shares of eToys had a short life, debuting in 1999 to much excitement, as investors had dollar signs in their eyes when viewing online businesses. The shares quickly zoomed from $20 to more than $80 in just a few months, and the company was out of business in about two years. Its assets were sold off, and today Toys “R” Us owns the eToys site.

The main lesson to learn here is to be careful with initial public offerings (IPOs), as they’re often tied to companies that haven’t yet proven themselves. EToys had actually posted losses instead of profits before going public, and investors still jumped in. It’s smarter to look for a track record of growing revenue and earnings, along with competitive advantages and financial health.

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