These Stocks Might Have Another Gear

Dan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

These three companies have been performing exceptionally well over the past several years. Better yet, there have been no signs of a slowdown. However, that does not mean the coast is clear. Risks exist, and these risks should be considered in order to avoid taking a large hit to your portfolio.

A focus on quality

CarMax (NYSE: KMX) is primarily a used vehicle retailer, but it also sells new cars and offers auto services as well as financing. In regards to quality, CarMax prides itself on:

Honest and transparent financing (you see offers the same time a salesman does)

Quality certification (125-point inspection)

Fixed commissions

Full service history report

Five-day money-back guarantee

30 top brands in one location

95% of customers would recommend the company to a friend

CarMax currently has over 100 locations, and it continues to grow. Locations were recently added in Colorado, Florida, Texas, Virginia, and Georgia. CarMax plans on opening 13 stores in 2013, as well as 10 to 15 stores in 2015 and 2016. As long as the economy holds, this looks like a realistic growth rate.

Though CarMax is a well-run operation with an exceptional business model, there are challenges. Competitors are offering many promotions, which has the potential to lead to market share losses. Higher inventory has also led to lower pricing. New vehicle sales have especially slowed. Fortunately, used vehicle sales have held up, but margins are lower on used vehicles.

Looking at the big picture, CarMax has seen consistent revenue improvements over the past four years, and its net margin of 3.90% is solid for the industry. However, the stock is trading at 25 times earnings, making it expensive relative to peers. CarMax also does not pay a dividend, and its debt-to-equity ratio of 2.18 is high.

Strategic expansion

AutoNation (NYSE: AN) holds a market cap of $6 billion, and it is currently trading at 18 times earnings. The company’s net margin of 2.03% is respectable for the industry, and buybacks are commonplace. However, AutoNation does not pay a dividend, and the company’s debt-to-equity ratio of 2.49 could be better. The short position on this stock is also relatively high at 7.10%.

AutoNation has seen revenue improve over the past three years, and earnings have improved over the past four.

You might be wondering why the short position is high. Put simply, AutoNation, and its peers, have been performing well as a result of low interest rates. The good news for longs is that Federal Reserve Chairman Ben Bernanke hinted that even with the taper, interest rates are expected to remain low for a long time to come. The bad news is that when interest rates increase, it is likely to impact companies like AutoNation.

AutoNation is attempting to diversify its operations as much as possible, and it is looking to expand its high-margin services segment. AutoNation also aims to expand its reach by opening new stores in places like Mexico and Brazil.

Betting on luxury

As stocks and real estate appreciate, the rich get richer. Or, the former rich recapture their wealth. Regardless, with many people seeing increases in discretionary income, more luxury cars are being sold. Penske Automotive Group (NYSE: PAG) second-quarter results provide the proof.

Revenue increased 11.6%, earnings jumped 26.8%, and same-store sales increased by 11.5%. New vehicle revenue and used vehicle revenue were both impressive, with gains of 12.7% and 15.5%, respectively. Additionally, Services and Parts revenue increased 8.1%, and Finance and Insurance revenue improved by 17.9%. The only negative was in Fleet and Wholesale, which saw revenue decline 10.5%.

As you can see, Penske has various revenue streams, which is one of the reasons it is appealing to many investors. It also offers 40 luxury brands, 25,000 cars, and 30 collision repair centers. Apparently, that was not enough for Penske.

It recently acquired Western Star Trucks Australia, a commercial vehicle distributor, which give it strong exposure to New Zealand and Southeast Asia. Penske expects this acquisition to add $420 million to $460 million in revenue and $0.10 to $0.14 to earnings annually.

Like its peers, Penske has seen consistent earnings improvements over the past four years.

Conclusion

As long as interest rates remain at record lows, all three companies have significant upside potential. When interest rates eventually increase, or perhaps earlier depending on the broader market’s reaction to Federal Reserve tapering of its $85 billion per month bond-buying program, all three stocks are expected to fall. At that time, thanks to strong diversification, Penske would likely be the most resilient of the three.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends CarMax. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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