Is Costco Stock Suitable for Your IRA or Roth IRA?

Is Costco Stock Suitable for Your IRA or Roth IRA?  

Shares of Costco (NASDAQ: COST) are suitable for a traditional individual retirement account (IRA), but they are not an optimal choice for a Roth IRA. Costco's financial ratios paint it as a company primed for modest growth in the coming years. It is a safe, low-risk investment, but investors should not expect aggressive returns from Costco stock.

Shares of lower-risk, lower-growth companies are more suitable for traditional IRAs than Roth IRAs because of the tax treatment of each investment vehicle. Traditional IRAs allow modest gains to compound more quickly because qualifying contributions and dividend income are not taxed; however, withdrawals at retirement are taxed as ordinary income, which eats into large gains. Roth IRA investors pay income taxes on contributions but not on qualifying withdrawals at retirement. Big gains from high-growth investments are more fully realized in a Roth IRA.

Costco: A Brief Snapshot

Costco has a market capitalization of $69.7 billion and pays a modest dividend yield of 1.1%. Its stock has performed admirably from 2005 to 2015. It weathered the Great Recession well, ebbing only briefly from late 2008 to mid-2009, and then rebounding spectacularly. As of December 2015, Costco shares trade for more than double their pre-recession highs.

While growth outlook is moderate, some portentous signs loom for the company, including declining same-store sales, low oil and gas prices, and the effects of a strengthening dollar on international sales. From the fourth quarter of Costco's fiscal year in 2014 to the same quarter in 2015, same-store sales declined by 1%. The company reported that the drop was entirely attributed to lower oil and a higher dollar. Gas sales are a huge revenue source for the company, and including gas stations at its supercenters has helped Costco attract and retain members. When gas prices drop in concert with oil prices, consumers have less incentive to avail themselves of Costco's discount gas. Nearly one-third of Costco's locations are outside the United States. A strengthening dollar throughout 2015 resulted in weaker overseas sales once exchange rates were applied.

Company Outlook

Costco is a dominant mass-merchant retailer in the United States, trailing only Wal-Mart in market share, albeit by a large margin. As of 2015, Wal-Mart controls 57.4% of the mass-merchant retail market, compared to 17.6% for Costco. Costco is the nation's largest membership-only warehouse club and second-largest retailer (behind Wal-Mart). Costco has a fiercely loyal customer base, a highly diverse product offering, geographical diversity and an international presence. Its corporate reputation is much better than that of Wal-Mart, which seems to find itself embroiled in one public relations nightmare after another. All of this points to long-term stability for the retailer and its share prices.

Costco has 474 locations in the United States and 674 locations internationally, including warehouses in Canada, the United Kingdom, Mexico and Japan. Its 2014 revenue was over $112 billion, which is 15% higher than Amazon's revenue for the same year. As of 2015, Costco is in a growth mode, aggressively pursuing new locations and products.

The company's impressive revenues and imposing industry presence are tempered by several external factors. The continued meteoric rise of e-commerce, led by Amazon, cannot be ignored. Amazon has made big strides with Amazon Prime, a membership club that confers discounts, fringe benefits and free shipping. For years, instant gratification has been the one advantage maintained by brick-and-mortar retailers over their online rivals. A Costco customer can drive home with his merchandise rather than waiting for an Amazon order to arrive. However, Amazon is launching same-day shipping in certain markets and testing drone delivery technology. How these developments affect retailers such as Costco remains to be seen.

Financial Analysis

If you adjust for the effects of oil prices and currency valuations, Costco's same-store sales, rather than declining from fourth-quarter 2014 to 2015, actually increase by 7%. The company's gross margin, which was 13% over the past 12 months, has crept up slightly over the last decade. The story is the same for its operating margin of 3.1%. These numbers are low compared to industry peers, such as Walmart, but this is more a reflection of the company's business model than an exposition of any weakness. Regardless of the reason, however, narrow margins rarely coincide with aggressive growth, underscoring Costco's place as a stable, long-term investment and not a high-yield investment.

Costco's price-to-earnings (P/E) ratio is 29.39. This number indicates how valuable investors perceive the stock relative to its current earnings. Costco's price/earnings to growth (PEG) ratio, which factors expected growth into the P/E ratio, is 5.64. Both values are high compared to the company's peers. This indicates perceived value in Costco shares, but the ratios are nowhere near the level typically seen in high-yield investments.

Costco's dividend yield is 1.1%, which is modest but provides investors with steady income in periods of low or no growth.

Costco looks to be an excellent choice for investors seeking stability, long-term growth and principal protection.

Traditional IRA Suitability

Traditional IRAs are best for conservative investments, particularly those that pay dividends. Qualifying contributions are tax-deferred, as is dividend income, which can be reinvested into the IRA with no tax. This is ideal for slow-growth investments, since they compound more quickly without taxes being removed. However, income from traditional IRAs is taxed at ordinary income rates when withdrawals are made at retirement. For this reason, high-growth investments are not ideal, since investors lose a large chunk of their gains upon withdrawal.

Costco is a mature, stable company that pays a modest dividend. Investors should not expect large returns, but they should expect stability and a low probability of principal erosion in a downturn. Because of slow-growth expectations and dividend income, Costco shares are suitable for a traditional IRA.

Roth IRA Suitability

Roth IRAs are best for high-growth stocks. There are no tax benefits for contributions, but investors can make qualifying withdrawals at retirement tax-free. This means they keep 100% of their gains, which is a boon to high-yield investors, who, based on 2015 tax rates, would stand to lose as much as 39.6% of their gains if taxed as ordinary income.

Most of Costco's aggressive growth appears to be in the rear-view mirror. The company is an industry leader with a major international presence; its product offering is extraordinarily diverse. Unlike a startup, which can trigger massive growth by unveiling a new product or expanding into new markets, Costco is already there. Aggressive growth is unlikely, but stability is practically assured. Therefore, Costco shares are better invested in a traditional IRA than a Roth IRA.