“The intelligent investor is a realist who sells to optimists and buys from pessimists” - Benjamin Graham
There are certainly plenty of pessimists about AutoNation Inc. (AN, Financial), as shares have sold off the past year from $65 to about $48 today. Are the pessimists correct and is the drop justified? Or is this an opportunity for a realist to buy from those pessimists and benefit later when sentiment changes?
For that matter, guru Mario Gabelli (Trades, Portfolio) recently added AutoNation to his portfolio, and Edward Lampert and Bill Gates (Trades, Portfolio) are among other gurus who own the stock. How might a realist analyze AutoNation? I suggest three key steps to get started:
1. Understand reasons for the sell-off.
2. Identify key company initiatives going forward.
3. Review the price to valuation relationship at current levels.
Why the sell-off? What do the pessimists see?
Why has AutoNation sold off so steadily? Higher interest rates (even if only modest increases) have a rather large impact on the demand for AutoNation's products because naturally people need to make larger payments with higher rates. Second is the slowdown in China and other key customer nations, which puts a damper on demand.
This challenging operating environment has forced the company to use aggressive incentive programs and discounting to move product and inventory levels are rising. Naturally earnings are negatively impacted.
Key company initiatives
During the past year, the company has been active with mergers and acquisitions to increase coverage and market share growth opportunities. Perhaps more importantly, the company has been implementing a significant national branding strategy that includes an enhanced digital marketing strategy. The idea is to drive more customers into showrooms across the nation and use the web to drive efficiencies. There has been some early success and results look promising over the longer term.
Is AutoNation on sale now? What is the price to valuation relationship?
When valuing a company, I follow the school of thought to pay close attention to that company’s own historical valuation as measured by its own P/E ratio, and then take action when the price is reasonable relative to earnings. Here’s where my F.A.S.T. Graphs subscription is helpful to get a visual of the relationship between price and value.
First, let’s note that AutoNation’s average P/E ratio over the past 10 years has been 15.8X earnings.
Interestingly, over the past decade the P/E has dipped to 10X to 12X earnings several times; for patient investors each time, the P/E then rose to peaks around 18X earnings.
At today’s market price the forward P/E for AutoNation is 10.1X, below the average P/E and close to those previous low buying points.
Sometimes a picture is worth a thousand words. To see this data visually, in the chart below the orange line represents earnings history and what could be considered "fair valuation" at a price/earnings multiple of 15X. The blue line represents an historic normalized average P/E. Finally, the black line is the market price.
Historical Graph - Copyright 2016, F.A.S.T. Graphs - All Rights Reserved
Note how the market price is well below the historical valuation. In my opinion, this data realistically demonstrates that given its own historical long-term valuation, at current levels AutoNation is cheap relative to its earnings.
What might be a target price?
It’s often instructive to calculate a realistic target price as part of the overall study of a company to craft an investment plan. In this case, assuming AN is successful with its efforts and that earnings projections hold, a return to normalized P/E levels suggests a potential 24- month target price of around $65.
Recap
Benjamin Graham probably had it right: “The intelligent investor is a realist who sells to optimists and buys from pessimists.” In my view, a realistic review of AutoNation suggests that this may be the time to buy from the pessimists and hold out for a chance to sell to the optimists later.
Also check out:
