This week I’ve spent focused heavily on retail stocks because I believe the bottom is basically in. One reader (who I regard as very astute) told me that I’m “dead wrong” given that we are heading into a recession and consumer spending is going to be down over the next 6 to 12 months, by his estimates. I’m in agreement with his reasoning, but not his conclusion – namely because I believe that pretty much every institution has already been in front of the spending downshift, and thus that is already priced into retail stocks and then some. What I tried to highlight yesterday with the upgrades in the retail sector from UBS was the idea that retail stocks will respond positively before the actual economic recovery is at hand.

Today’s idea is very similar to that: look at a sector that is exposed to slowing economic growth, has taken a big hit from sellers of late, and now sits at a very low valuation. The group? Refiners.

Right now I don’t believe the refiners are an investment-worthy bunch, as there are too many issues – near-term, declining margins due to distillate prices lagging crude, and long-term, with the desire to bring new capacity on by the upstream companies that have tens of billions in cash floating around. I would have to see some very high evidence that high refining margins are here to stay before I constructed any long-term thesis, and I simply don’t see that right now. Still, the names here – Valero (VLO), Frontier (FTO), Western (WNR), Tesoro (TSO), and Holly (HOC) – are very tradable, and it’s worth assessing if now is a good time to get long.

I see two potential catalysts to play on the long side. First is the contrarian bet that the earnings estimates have come down far too much, which has led the stocks to being oversold. The following charts show the EPS estimate trends for the five refiner stocks, with the leftmost point being the current number, and the data points moving right going back 7, 30, 60, and 90 days.

[You may need to scroll down to see the charts below]

The numbers these companies are going against for this quarter and next have come down across the board. The full year numbers have come down as well, although not as dramatically – is this because margins are expected to revert to higher levels after Q1 2008, or because those future quarters need to come down as well and the full years are still too high as well?

[You may need to scroll down to see the chart below]

This negative shift in earnings sentiment has led to fairly large sell-offs in these stocks, even when viewed relative to what has been going on in the broader markets. All of these stocks are down double-digits in the last month, and all but one (HOC) is off 20% or more. The momentum indicators look to be bottoming and starting to turn up, something that typically leads to a tradable bounce off oversold levels.

The other potential catalyst here is the seasonal component of demand (more driving in summer months), although for the first time in a long time this can hardly be considered a lock given that lethargic consumer spending could translate to reduced discretionary gasoline demand. Again, there is some risk here, but the risk/reward looks favorable considering that VLO and TSO, in particular, are trading at low (1.5x book) multiples. HOC and FTO, while more expensive on a book multiple basis (3.5x), have strong earnings power in their own right as well.
Of course, the earnings question is central here: is a slowing economy and consumer going to be enough to seriously cut back on oil demand - even enough to offset the growth in emerging markets? I doubt that, and the lack of new capacity coming online both upstream and downstream due to long lead times means that the refiners should continue to do well. I’d look for sentiment surrounding these stocks to become more favorable over the next two quarters as it becomes clear that the downturn will not impact distillate demand, and thus I’d be long-biased with this group.

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