The coming holiday season promises to be a rough one for big retailers. Companies like Wal-Mart, Kohl’s, and Macy’s have recently lowered their earnings guidance owing to a host of factors, including declining mall traffic, weak consumer confidence, and unseasonably warm weather. In response, retailers have been slashing prices to lure shoppers into their stores: UBS retail analyst Roxanne Meyer says that 80% of the retailers she covers are doing more promotions today than a year ago. Under the right circumstances, such discounting can boost market share and increase revenues. But when managed poorly, it can permanently damage a company’s bottom line — and should be a red flag for investors.
Consider an analysis of large retailers — including J.C. Penney, Target, and Wal-Mart — conducted by Simon-Kucher & Partners, a marketing consulting firm. The firm found that for each 10% decrease in selling price, the retailers would, on average, need to increase the number of units sold by about 50% to break even. “That math will never work out,” says Susan Lee, a Simon-Kucher partner. “The hope is to drive traffic into the store and make money on other items.”
To avoid being slammed by the discounting trap, investors should focus on retailers with significant nonprice advantages over their competitors. One such example is high-end department store operator Nordstrom, whose more affluent customer base tends to care more about fashion than prices. Goldman Sachs analyst Stephen Grambling, who has a buy rating on the stock, estimates that Nordstrom will generate $513 in sales per square foot in 2014, far above the average of $293 for all discretionary retailers. Grambling also notes that the company “is head and shoulders above the competition” when it comes to e-commerce.
In a similar vein, Dick’s Sporting Goods has grown earnings by selling high-performance brands such as Nike, Under Armour, and Callaway. The company’s strong relationships with vendors also allow it to minimize overlap with competitors’ products. Piper Jaffray analyst Sean Naughton, who has an overweight rating on the stock, notes that during the past year, 23% of company revenue came from brand-name products available exclusively at Dick’s — a percentage he expects to increase.
Having a built-in cost advantage vs. competitors may also help in times of severe pricing pressure. That’s true for TJX Cos., the parent company of T.J. Maxx and Marshalls. As the largest global off-price clothes retailer, TJX uses its bargaining power with suppliers to acquire brand-name merchandise at a steeply reduced price, and then sells it at 20% to 60% below what traditional chains charge. In October, TJX became one of the few retailers of late to increase its profit projections, saying that it expects to grow earnings per share by 10% to 13% annually over the next three years. That is the kind of discounter investors should want to own.
A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the November 18, 2013 issue of Fortune.