used cars

2 Picks in the Booming Used Car Industry

This morning’s release of Consumer Price Index (CPI) data for September confirmed an interesting trend in America. The data as a whole were uneventful, with most of the headline numbers being at or very close to their anticipated levels. There were, however, some interesting numbers in the more detailed breakdown of pricing that the report contains.

The most noticeable of those was a massive 6.7% Month-on-Month surge in used car and truck prices, resulting in an annual increase in prices there of 10.3%. That confirms and adds to what we have seen for a few months now after July and August data indicated increases of 2.3% and 5.4% respectively.

So why are used car prices soaring, and how can investors cash in?

The increase is most likely the result of a couple of things, both related to Covid-19. The pandemic is pushing more people to buy cars as they reconsider their use of public transportation while, at the same time, it is restricting the availability of new vehicles. On the other side of the supply/demand equation, there is no used car factory that can ramp up production. A strong, two-pronged increase in demand and an inherently limited supply is bound to push prices higher.

That is obviously great news for stocks in the sector, but the benefits won’t be distributed evenly. It means higher prices achieved for current inventory and therefore higher margins, but it also means that replacing that inventory is becoming much more expensive. In that situation, one of the most important things to consider in a stock in the industry is free cash flow (FCF), as buying power matters more than ever.

Still, there are other things to consider, too. As I said, this is confirmation of an existing trend, so some buying of stocks in the space has already taken place, making value as hard to find in used car stocks as it often seems to be in used cars themselves.

If we screen stocks based on those two criteria, good free cash flow and relatively good value indicators such as P/E and PEG ratios, two clear winners emerge, while some stocks that you might otherwise consider miss in one way or another. Carvana (CVNA), for example, may have impressive revenue growth, but limited cash on hand and FCF of -$762 million, they could easily be squeezed if prices continue higher. Another big name, CarMax (KMX), is much better situated in cash terms, but looks like anything but value in a traditionally low-multiple industry, with trailing and forward P/Es that are both around 23 and a PEG of 2.29. (A PEG of 1.0 or below is considered to indicate value).

Those numbers look even worse when you compare them to something like Sonic Automotive (SAH). They don’t have the positive revenue growth that some others have shown despite the Covid-related downturn, but they do look like much better value with P/Es of around 8 and 10 and a PEG of 0.42. Add in FCF of $612 million, and SAH looks well placed to take advantage of these unusual times.

SAH chart

My other pick would be AutoNation (AN). Value metrics there are a little higher, with P/Es of 18 and 10.5, but a PEG of 1.08 indicates that that is justified by expected growth. Where AN really scores, though, is in how much cash they can plow into inventory in a rising market given their FCF of over $1.7 billion.

AN chart

As you can see above, neither of these two stocks look like screaming value based on a simplistic chart reading alone. They do, however, fit the profile of companies that can benefit from current conditions and, given that so far on this run up from the lows, momentum investing has worked much better than any other style they could both easily have a lot further to go.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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