As the credit crunch has deepened to give way to a financial crisis, consumers are confronted with a myriad of economic hardships, including rising unemployment, elevated energy prices and tighter credit. With consumers tightening their spending habits, retailers are expected to face one of the most grim holiday seasons in years.

Today’s retail sales report serves as a precursor to what the holiday season may bring. Retail sales for the month of September plunged nearly double what economists projected, marking the largest decline since August 2005 as consumers reined in spending.

To see how lackluster this holiday sales season will be, as well as to get a look into retailers’ strategies and overarching trends this holiday season, SmallCapInvestor.com interviewed six retail experts. Our panel of experts includes Mercedes Gonzalez, CEO of Global Purchasing Group; Peter Collins, chief financial officer of True Religion Apparel, Inc.; Jim Reed, lead portfolio manager for the UMB Scout Stock Fund; Jeff Van Sinderen, senior equity analyst at B. Riley & Co.; Eric Beder, senior retail analyst at Brean Murray, Carret & Co.; and Wendy Liebmann, founder and president of WSL Strategic Retail.

According to our panel, this slowdown will be broad-based, from low-end to luxury. Retailers will focus on discounts and tighter inventory management to move merchandise and shore up bottom-lines. Those that offer value and unique items will weather this holiday best. Discounters will be the sweet spot.

Here’s what our experts had to say:

What is your sales outlook for the holiday shopping season? Will we see a repeat of last year or will things be worse and why?

Reed: “It will be worse than it was last year. We’re expecting essentially a 1% increase versus a 3% increase last year. We’re taking our lead from the back-to-school sales, which were kind of punk due to high gasoline prices, which remain high and are still taking a bite out of customers — although it’s not extreme as it once was. Then there are job losses. The September jobs report saw 40,000 jobs . . .

Given soft consumer demand, how much of an emphasis will retailers place on cost management and inventory management compared with prior year cycles?

Reed: “They’re going to watch inventory as much as they can. You’re going to see a lot less inventory this year. But, it looks to me they’re moving beyond inventories and just straight out job cuts.”

Collins: “We’re taking a conservative posture as it relates to building inventories. We want to avoid excessive inventory, so we are being more prudent with our production plans.”

Van Sinderen: “What you saw happen a few months ago is different than what you’re seeing happen today. So, I think it’s ongoing management that you’re constantly modifying. Fall has been surprising for retailers. Even though they’ve been planning inventory fairly conservatively, some have been surprised by how soft business has been. If you were planning your business one way a few months ago, you’re probably planning it even tighter now.”

Gonzalez: “They're going to adjust their inventories too late in the game because they’re such a big machine that can't stop mid-season and change gears. So they're going to cut back on inventory that's going to be reflected in the spring, which is when they're going to do their sales.

“What happens now is that department stores plan their spring buys based on this season's forecasts. If they feel like they're overbought, especially with the . . .

Are you seeing or do you expect to see sales erosion from the upper echelon?

Reed: “I don’t expect to see a tremendous amount of erosion. I do think your affluent area will be impacted, but people will be looking for last year’s styles and I think you’ll also see outlet malls and folks who have off-priced brands do very well. So the affluent will spend money, but they’ll spend it more carefully. Now that the dollar has rebounded, foreigners who have been propping up Northeastern retailers are going to see a slowing in sales.”

Van Sinderen: “Absolutely. I think it will be across the board. Luxury is not immune to this slowdown. Think about the impact of the financial markets on the people who have a lot of money in the market. They’re hurting as well. We’ve already seen that reflected in Nordstroms’ and Neiman’s numbers.”

Gonzalez: “Absolutely, except for the savvy luxury brands. Take Louis Vuitton, for example. With the price of the euro, they know what the luxury tax coming in is, the price of the euro, the weak dollar. They’re committing luxury suicide. So, they started manufacturing their opening price points domestically, manufacturing in the United States.”

Liebmann: “Though the affluent shopper probably has the money, he/she is now feeling the pain of this economic situation, and is probably in the mind set of 1) I don’t know what the next few months will look like, 2) I don’t know what my bonuses will look like, and 3) and I’m going to pull my head in for a while. I really don’t need anything else and maybe I’ll stick to the necessities or maybe I’ll shop cheaper. We expect them to potentially pull back from the department or specialty store channels and do more necessity shopping in some of the more value-oriented . . .

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“Increasing cash flow remains the single best measure to separate the haves from the have-nots. If a firm’s cash flows aren’t increasing, be wary. We look for strong top and bottom-line growth of 25% or greater on a quarterly and annual basis, a build up of cash on the balance sheet, a trend of successive upside earnings surprises and upwardly revised estimates. The company should operate in a favorable industry and markets that contain extraordinary growth potential.

“In the current environment we wouldn’t expect to find as many companies with 25% revenue and earnings growth, so in that sense, yes my expectations have been lowered. We pay closer attention to guidance in this environment, as the probability for downgraded outlooks is more likely.”

What are your favorite small-cap stocks with market caps of under $1 billion for the year and why?

“T-3 Energy Services (Nasdaq:TTES), Life Sciences Research (NYSE:LSR), Cano Petroleum (AMEX:CFW) and Merit Medical Systems (Nasdaq:MMSI) because of the specific niches they operate in.

“T-3 Energy manufactures and repairs equipment used in the drilling and completion of new and existing oil and gas wells, and for the production and transportation of oil and gas. The company has three product lines: pressure and flow control, wellhead and pipeline. Since April 2003, T-3 Energy has introduced 43 new products. As of March 9, the company had 18 manufacturing facilities located throughout North America.

“Equipment failure in the energy industry is not an option and as such T-3 Energy’s customers — namely many of the big exploration and pipeline companies . . .

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“We are extremely valuation disciplined and look for low P/E, low price-to-cash flow, low price-to-book, low price-to-sales, a low multiple of enterprise value-to-EBITDA, discounted cash flow analysis, private market equity value and peer group analysis.

“We like to find companies that are trading at depressed valuations relative to where they traded before in the past. We find assets that are undervalued relative to what buyers are willing to pay for comparable assets based on what we call private market equity value, which is what a strategic buyer would pay for a set of assets. We do an extensive amount of valuation work. We’re bottoms-up stock pickers here at Heartland, so a lot of what we do is bottoms up and then we marry it together with our top-down view of the world. 

“In this environment, you’ve got to be extremely religious in terms of your valuation work and make sure you are tracking a value company that has good growth opportunities. You need strong management teams and we’re focused on companies where insiders are buying stock, not selling it.”

What are your three favorite small-cap stocks with market caps of under $1 billion for the year and why?

“A company called Asset Acceptance (Nasdaq:AACC) is very timely here. Asset Acceptance is a $283 million buyer of charge off consumer receivables, primarily eligible credit card issuers. Asset Acceptance likes to buy bad debt. The underlying thesis is that part of this credit cycle will include delinquency trends . . .

What do you think about alternative energy? Do you think that energy prices need to remain inflated for the alternative energy space to remain profitable? 

Oberweis: “No, the key for alternative energy is the subsidies, quite frankly. The real danger to buying solar stocks right now is there’s some momentum in the Spanish and German markets, which are the two of the large consumers and drivers of the adoption of solar energy, to reduce or remove the subsidies that are making the technologies economical and affordable. That’s probably a much bigger and more important driver of the success of solar companies than the actual price of oil.”

O’Halloran: “Alternative energy is an industry where we have very strong forces helping the companies. We have three holdings in solar energy: SunPower Corp. (Nasdaq:SPWR), Energy Conversion Devices, Inc. (Nasdaq:ENER) and JA Solar Holdings Co., Ltd. (Nasdaq:JASO). This year we have more wind energy companies in the portfolio because wind energy is just starting to ramp up aggressively like solar did over the past couple of years. 

“American Superconductor (Nasdaq:AMSC) and Woodward Governor Company (Nasdaq:WGOV) — whose equipment is used to adjust turbine-generated power for conveyance to electrical grids — are a couple. There are also companies such as RBC Bearings Inc. (Nasdaq:ROLL) and Kaydon Corp. (NYSE:KDN), which make bearings for the wind turbines. Another is ITC Holdings Corp. (NYSE:ITC), which is in the process of rebuilding electrical transmission lines as part of a federal government initiative. These upgrade lines will help take energy from [wind farms], put it on to the electrical grid and get it into homes. Fuel cells and their technology and ethanol are either too early or not profitable enough for us to be involved with . . .

Riley serves on the board of directors of Aldila, Inc., Alliance Semiconductor Corp., DDi Corp. and Silicon Storage Technology Inc. He has served as advisor on a variety of M&A engagements, including the sale of Mossimo Inc. to Iconix Brand Group. In February 2007, Riley and a group of investors acquired Oregon-based Country Coach, Inc. from Perris-based National RV Holdings.

Prior to 1997, Riley held a variety of positions in the brokerage industry, primarily as an institutional salesman and trader, including co-head of equity at Los Angeles-based brokerage firm Dabney-Resnick and was a co-founder of Huberman-Riley, a Texas-based brokerage firm. Mr. Riley graduated from Lehigh University in 1989 with a B.S. in finance.

Riley is our tech expert on our small cap round table. He launched his third version of the Cash Rich Tech Stock Index (CRTS) in January. Year-to-date the index is down 2.44%, while the tech laden Nasdaq is down 12.89% and the Russell 2000 is down 7.27%. The first index was launched after the implosion of the tech bubble in 2002 and returned a jaw dropping 326% in just 19 months. It was closed down after that as stocks within the index reached fair value. The second was launched in May 2005 and returned 18.6% in a little under a year. Naturally, to gain some insight into investing in the tech and for some of his favorite names we turned to the mastermind himself, Bryant Riley.

What qualities do you look for specifically in a small-cap stock?  What criterion do you employ?

“We look for strong balance sheets, a product differential, recurring revenue stream or solidly installed base.”

Broadly speaking, what’s your formula for picking winners for these tech stock indices?

“We focus on things that everybody else hates and that people are selling because that’s how you get your best values. You take that and the segment, and find companies that have the best fundamentals. You’ve got to think contrarian . . .

What sectors do you favor for the second half of the year?

Lisanti: “If energy comes down in price, then consumers are going to go up. 

“Historically, after the Fed has stopped raising rates, the stocks that tend to do the best are tech, health care and energy. The sleeper is probably healthcare. The traditional growth sectors look to me like the sectors that make the most sense right now. They tend to have high intellectual properties, high profit margins, high barriers to entry and high returns on capital. Those are the kinds of attributes you want in this environment. 

“In energy, I would look at solar. Think of it as all along the energy spectrum. With [oil] at $140 it’s what we do to get more efficient. I’d put a little on the energy continuum. 

“Then there’s health care, which has been a really bad area. It hasn’t worked for two reasons. I don’t think health care outperformed until 2002, so, people have to believe that this is not going to be the quick rebound. As this plays out and after we get [a new president], it probably sets up 2009 as a much better year for health care. For the next 18 months health care will probably be a much better sector than it has been. My guess is it’s been starting to work a little better this past month, and I think that’ll continue.  

“I think we’ve probably bottomed in health care. [Some] health-care stocks are at a 10-year multiple lows. The last time we had 10-year multiple lows on anything, usually it’s a bottom. It was the case for retail in 2001 and 2002. Anytime you get that kind of a washout, usually it provides you with opportunities.

“I think materials and industrials will be more difficult areas as the rest of the world slows.” 

Oberweis: “Technology valuations continue to remain below average and, quite frankly, if you were a believer that the recent sell off in the first quarter . . .

O’Halloran has been in the investment business for 20 years. Prior to joining Lord Abbett, O’Halloran was an executive director and senior research analyst at Dillon Read/UBS Warburg from 1988 to 2001. Before beginning his career in the financial services industry, he was a trial lawyer from 1980 to 1986. O’Halloran earned an MBA from Columbia University, a JD from Boston College and an AB from Bowdoin College. He also is a holder of the Chartered Financial Analyst designation.

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“There are 3,000 stocks that we look at that we could own. We try to screen out 80% of those through growth hurdles and size parameters in terms of market cap, and financial strength in terms of debt-to-asset ratios. Then we look at the 600 or so, or 20%, of the names. The first inquiry is a two step process after that. First we identify the best businesses then we pick stocks based purely on their growth, not on takeover potential, turnaround potential or valuations. Organic growth is the best kind of growth, but if there’s a strategy of acquisitions that is multi year and sensible to supplement their organic growth, then that’s fine. We require 12% minimum top-line growth, and we want earnings to be growing at least as fast. Our portfolio on average is growing closer to 25%. 

“In terms of what represents a good business, we’re looking at four things: the first two at the microeconomic level, or inside the doors of the company, and three and four are considering the environment in which they function.

1) “When we saw Morningstar at $750 million on the IPO, we said, ‘This is like Moody’s. Moody’s is $20 billion. This is a jewel of a business.”  We saw Mercadolibre, Inc. (Nasdaq:MELI) at $1 billion and we said, “This is the eBay of South America. This is a great business.’  

2) “Is it a good business? Does it have a strong management team? Is the management competent and credible? It’s very important at the small-cap level to have good management. [In terms of] competency, we look at Mickey Drexler at J. Crew. He worked magic at The Gap. He redefined casual clothing in America. He’s a genius of a retailing executive and an example of a highly competent . . .

Our panel also explores the perils of inflation, stagflation, the beleaguered greenback and the presidential election’s effect on small cap equities. Lastly our experts take a look at possible share dilution and buybacks in an environment that’s shown varying degrees of illiquidity. (This is part three of a five part series.)

How are valuations on small caps now across the board?

Lisanti: “They’re cheap. When you look at the Russell 2000 growth, it’s selling at about one times its growth rate, which is very low. The Russell growth is selling at about 20-times its earnings and is supposed to grow at 19% going forward. Stuff in our portfolio is selling at about half its growth rate. We’re basically with companies that are growing about 45% and we’re paying about 22-times earnings for them. That’s really cheap. They have to overcome these economic headwinds and if they do, then the stocks will go up. But economic headwinds are not monolithic, sometimes they can prove to be positive. 

“My guess is they’re probably underweight small-cap growth and overweight small-cap value.” 

Oberweis: “Valuations are still substantially below what we typically see for high-growth equities. To be quantitative, we track the average P/E of companies that are growing in excess of 30% with a market capitalization of less than $1 billion. There are typically about 600 constituents in that group. It’s not a perfect statistical indicator, but it gives us a very good sample of where valuations have been and are going.

“Based on the standard forward estimates, the average P/E within that universe is about 23. Based on historical reported numbers, the average P/E within that universe is 33. To put it into perspective, the average historical over the last, say, five years based on forward is 30 and based on historical is 36. We’re well below average. The low we saw at the end of March was 21.7 based on forward. Based on . . .