The Morningstar US Consumer Cyclical Index rose in the third quarter, outpacing the broader market. Around 40% of our sector coverage holds a 4- or 5-star rating, with the median stock trading at a 4% discount to our fair value estimates as Tesla pulls the average higher.
We view the apparel manufacturing industry as particularly attractive, as 75% of our coverage sits in undervalued territory. We surmise the market’s concerns are rooted in uncertainty around the degree to which tariffs and the weakening economic landscape will hinder consumers’ discretionary spending.
One byproduct of this uncertain economic landscape has been a shift in consumer spending patterns. Since November 2024, the growth in goods consumption has outpaced that of services, with goods growth averaging around 3% over the past three months, compared with less than 2% growth for services. This has manifested in slower spending growth at restaurants and in the travel industry, which are more discretionary enclaves. We expect cautious consumer spending to persistently affect demand for discretionary services as long as this uncertainty remains. While value-driven options are likely more in favor now, particularly in the apparel industry, we surmise that stout investments in innovation and marketing will facilitate an enhanced share position for leading brands (which often sell premium merchandise) in time as consumer spending normalizes.
The challenges facing restaurants have been compounded by the need to raise prices over the past few years to offset pronounced inflationary headwinds stemming from stepped-up raw material, labor, and transportation costs. Despite the near-term traffic pressure that has ensued, operators investing in enhanced technology, capabilities, and menu offerings should ultimately realize improved visit trends and margins that trend back to pre-pandemic levels over time.
Top Consumer Cyclical Sector Picks
Caesars Entertainment
We believe no-moat Caesars CZR is an attractive investment opportunity, trading around a 60% discount to our $61 per share fair value estimate. Although tariff policies could negatively impact travel and gaming demand in the near term, we forecast Caesars to capture a high-single-digit revenue share of the $72 billion domestic commercial casino gaming market. High financing costs have raised concerns about Caesars’ elevated debt level. However, management has a record of generating cash flows from strategic tie-ups to pay down debt rather than boosting shareholder returns via dividends or share repurchases. And we think it will continue to employ the same tactics; we forecast debt/adjusted EBITDA will fall to around 4 times (from our forecast of 6.4 times in 2025) over the next few years.
Bath & Body Works
Bath & Body Works BBWI trades 60% below our $62 per share fair value estimate, rendering shares a bargain. We believe cost inflation and consumer uncertainty will normalize over time, which should buoy long-term category growth. Further, we posit that the firm’s efforts to unlock cost savings, while also implementing new pricing mechanisms, should lead to operating margin improvement. As such, we expect Bath & Body Works to realize 3% sales growth on average over the next decade, driven by 2.8% growth from its stores, 3.4% digital growth, and 6% international growth, against an approximate 170 basis point expansion in operating margins to 18%.
Gildan Activewear
Narrow-moat Gildan GIL shares trade at roughly a 40% discount to our fair value estimate. We believe the market undervalues the benefits of the acquisition of narrow-moat Hanesbrands to Gildan. We anticipate the deal will greatly improve Gildan’s flailing consumer operations while strengthening its leading position on printwear basics in North America. In addition, Gildan anticipates opportunities to improve manufacturing efficiency in acquired factories and cut costs.