The Retail Sector’s Q1 Earnings Scorecard from Zacks has this to say about the sector: “Total Q1 earnings for the Retail sector are up +1.4% from the same period last year on +2.9% higher revenues, with 63.3% beating EPS estimates and 53.3% beating revenue estimates. The sector’s Q1 results are tracking below what we have been seeing in other recent periods and are also among the weakest this reporting cycle.”

So What Are the Challenges?

From the point of view of consumers, cost of living is rising, which is impacting discretionary spending, so people aren’t willing or able to eat out that often.

Moreover, according to the Bureau of Labor Statistics’ consumer price index summary, cost of food at home declined through the last few months of 2016, flattening in January, before rising through the next few months and moderating in April. Food away from home rose throughout the period. This resulted in a net trailing twelve months decline of -0.8% for food at home and a net trailing twelve months increase of 2.3% in cost of food away from home.

As far as restauranteurs’ challenges are concerned, the National Restaurant Association’s (NRA) 2017 outlook says it all: While estimating a 4.3% increase in industry revenues this year to $798.7 billion, the NRA highlights several factors that will challenge the industry:

Foremost among these is “rising labor costs and a complex legislative and regulatory landscape on federal, state and local levels” that will add pressure on business performance and bottom lines. Additionally, the rising competition and improving employment levels mean that the cost of attracting and retaining talent will remain the foremost challenge.

Second, while the declining grocery costs (index for meats, poultry, fish and eggs fell 0.6% in April, the cereals and bakery products index fell 0.3%, the index for nonalcoholic beverages fell 0.3%, the dairy index fell 0.2%, while the index for other food at home rose 0.1%) mean lower input cost for restaurants, it also means that some customers will take advantage by eating at home, thus lowering footfall and impacting same-store sales. Two things will result from this:

Restaurants may have to step up marketing costs, using a mix of traditional and online (social media) channels. They can attract customers using the food quality, nutrient density, responsible sourcing, good service or price focus, or say that they offer all these. But ensuring these will further raise costs.

Or, perhaps they have to pass on the cost benefit to consumers in the form or discounts and deals, which will squeeze their margins.

Finally, investment in technology, including the more common online ordering, kiosks and mobile payment facility will continue.

How to Pick a Restaurant Stock

Note that despite these negatives, the restaurant sector still has a few things going for it, such as a stronger economy and rising employment levels. But are these factors good enough reason to invest in the sector?

Let’s take a look at the Zacks Industry Score, which for Retail-Restaurants, is 102 (top 40% of 256 industries ranked by Zacks), indicating that there are likely some opportunities. These are likely to be in the casual and QSR segments, the first because of the increasing focus on quality and sourcing, and the second because of those who can’t afford the standard they’re used to will likely look at cheaper alternatives initially.

The Zacks Rank and Style Score system are also important tools that help you pick winners during these times. Here are five stocks you can bank on based on this tried and tested method:

Diversified Restaurant Holdings

Diversified Restaurant Holdings is the creator, developer, operator and franchisor of ultra-casual restaurants and bars. The company operates two complementary concepts: Bagger Dave's Legendary Burger Tavern and Buffalo Wild Wings. It operates primarily in Michigan, Florida, Illinois, Indiana and Missouri.

Zacks Rank #1 (Strong Buy) You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here

Value: B, Growth: A, VGM: A

Last Earnings Surprise 50.00%, last 4-quarter average surprise is 45.83%, 2017 earnings estimate is up 125% in the last three months.

Papa Murphy’s Holdings (FRSH Quick QuoteFRSH - Free Report)

Papa Murphy's Holdings operates as a franchisor and operator of the U.S. pizza chain Take 'N' Bake. The company operates in three segments: Domestic Company Stores, Domestic Franchise and International. In addition to pizzas, the company offers a growing menu of grab 'n' go items, including salads, sides and desserts.

Zacks Rank #1

Value: B, Momentum: A, VGM: B

Last earnings surprise 155.56%%, last 4-quarter average surprise is 203.89%, 2017 earnings estimate is up 64% in the last three months.

Red Robin Gourmet Burgers (RRGB Quick QuoteRRGB - Free Report)

Red Robin Gourmet is a casual dining restaurant chain focused on serving an imaginative selection of high quality gourmet burgers in a family-friendly atmosphere. They currently own and operate in 12 states, and have additional restaurants operating under franchise or license agreements in 18 states and Canada. Their signature product is the gourmet burger, which they make from beef, chicken, vegetables, fish, turkey and pot roast.

Zacks Rank #1

Value: B, Growth: B, VGM: A

2017 estimated revenue growth of 6.48% is above the average growth estimate for restaurant stocks according to the NRA.

Last earnings surprise 53.45%, last 4-quarter average surprise is 17.27%, earnings estimates have risen in the last two months by 4.8%.

Del Taco Restaurants

Del Taco is the second largest Mexican-American QSR chain by units in the United States, serving more than three million guests each week. At Del Taco, menu items are made to order with fresh ingredients, including Cheddar cheese grated from 40-pound blocks, handmade pico de gallo salsa, lard-free beans slow-cooked from scratch, and marinated chicken grilled in the restaurant. The menu includes classic Mexican dishes such as tacos, burritos, quesadillas and nachos as well as American favorites including hamburgers, crinkle-cut fries and shakes.

Zacks Rank #2 (Buy)

Value: B, Growth: B, VGM: B

2017 estimated revenue growth of 4.06% is almost consistent with the average growth estimate for restaurant stocks according to the NRA.

Last earnings surprise 11.11%, last 4-quarter average surprise is 5.69%, earnings estimates have risen in the last two months by 4.8%.

The Habit Restaurants

The Habit Restaurants, operator of The Habit Burger Grill, is a burger-centric fast casual restaurant company. It is engaged in preparing char-grilled burgers, sandwiches and salads. The company offers tri-tip steak, grilled chicken and sushi-grade albacore tuna cooked over an open flame; prepared salads and a selection of sides, shakes and malts. It has operations in California, including the Bay area, Central California, Greater LA, Inland Empire, Orange County, Sacramento, San Diego; Arizona; Utah and New Jersey.

Zacks Rank #2

Growth: B

2017 estimated revenue growth of 19.64% is significantly higher than the average growth estimate for restaurant stocks according to the NRA.

Last earnings surprise 12.50%.

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