A Defensive Investment In The Auto Industry

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

There are several ways that one can invest in the auto industry. The most obvious is through one of the automakers, like General Motors (NYSE: GM). You could also buy shares of a company that sells parts and accessories for cars, like AutoZone (NYSE: AZO). A less obvious play, and one that I would like to explore today is a used vehicle retailer, CarMax (NYSE: KMX), which operates a network of about 120 used car superstores.

Why CarMax?

CarMax is a way to play the auto sector somewhat defensively. While automakers tend to do very well in good economic times, used car dealers tend to do well in both good and bad economies. In good economies, more customers are able to afford to buy a used car that wouldn’t have been able to in worse times. In bad economies, a lot of customers who would prefer to buy new cars are forced to cut back on their spending and buy used, more affordable cars.

A Little Bit about the Company

CarMax sells primarily used cars; however, the company has added new car sales at a few of their locations. They also provide their own financial services through CarMax Auto Finance.

The company made a name for itself with its “no-haggle” price model, which consumers who despise used-car shopping embraced. CarMax won customers with its promise that the price tag in the window was “the” price; there was no need to play the normal games associated with negotiating for a used car. 

<img alt="" src="http://g.fool.com/editorial/images/48094/kmx-revenue_large.png" />

As well as CarMax has done over the years, there is still room for growth, and the market seems to acknowledge this with its valuation of the company. Despite being the largest used auto retailer in the U.S., CarMax only accounts for about 2% of the total used vehicles sold by dealers, leaving plenty of room to take market share from the traditional dealers, who, lets face it, many prospective car buyers dread having to deal with.

CarMax trades at a relatively high valuation of 25 times TTM earnings; however, this actually seems quite reasonable considering the growth potential of the company. The consensus calls for earnings of $2.08 per share for the current fiscal year (2014), and this is expected to rise to $2.33 and $2.67 in 2015 and 2016, respectively, for a 3-year average annual earnings growth rate of 12.6%. Worth mentioning is that unlike most companies, if the economic recovery performs worse than expected, these numbers could actually be higher for the reasons given earlier.

General Motors: Cheap and Risky

General Motors became infamous a few years ago due to its bankruptcy and ensuing government bailout. The shares that trade now are of the “new GM” and the company still leaves a bad taste in some investors’ mouths. The truth is that bankruptcy may have been the best thing to happen to General Motors in a long time, and the company is more financially sound than they have been in decades, with a much lower cost structure and greatly reduced debt. 

While the company appears cheap at just 11.7 times TTM earnings and excellent growth is projected over the next three years, proceed with caution. General Motors still has a ways to go before the market will be convinced that its turnaround is for real. When a company that is projected to grow its earnings by more than 20% annually going forward trades for a valuation like GM’s, it’s usually for a reason. Don’t get me wrong, I think GM is a steal right now, but it is the riskiest of the three companies mentioned, by far.

AutoZone: The Stable Choice

AutoZone, on the other hand, may turn out to be the most stable. Despite how many new cars GM sells (or doesn't sell), or how many used cars CarMax sells, there will always be a market for parts and accessories. The largest auto parts and accessories retailer in the U.S., AutoZone has more than 5,000 stores, and has recently stepped up its international efforts, with their first store in Brazil now open.

AutoZone trades at a relatively low valuation of just over 15 times TTM earnings, which the consensus of analysts projects will rise at about 14% for the next few years. These numbers do look good, and with the aging American vehicle population, AutoZone should thrive for years to come.

What’s The Best Way to Play the Sector?

The best way to play the sector depends on your particular risk tolerance. For safety, AutoZone is probably the best, while GM has the best growth potential out of the three. For a good blend of growth and stability, and exposure to an aspect of the auto industry that works in both good times and bad, take a look at CarMax, which should thrive for the next several decades, no matter what the overall market or economy does. 

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends CarMax and General Motors. 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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