The automotive market is facing inflation-driven headwinds, but one sector of car retail looks good right now.
The stock market has gotten off to a sizzling start in 2024. Both the S&P 500 and Nasdaq Composite have gained roughly 11% on the backdrop of strong tailwinds in the technology and energy sectors in particular.
Despite a strong stock market, there are some challenges in the macroeconomy that are tough to ignore. Namely, inflation has remained stubborn and unusually high compared to historical levels. This can make assessing investment opportunities quite difficult.
One way to potentially gain an edge in the market is to look at what companies and themes institutional investors are exploring. Dan Loeb is a well-respected hedge fund manager, and the CEO of investment firm Third Point. After closely looking at his latest 13F filing, one move in particular really stuck out to me.
Loeb scooped up 1.5 million shares of Advanced Auto Parts (AAP 0.22%). Considering the current economic environment, buying an automotive stock might seem like a bad idea.
However, I think this move is genius. Let’s break down what’s going on in the auto industry right now, and assess why Advanced Auto Parts looks like a lucrative opportunity — especially in an inflationary environment.
The car market is facing some difficult headwinds
Over the last 18 months, the Federal Reserve has raised interest rates 11 times in an effort to curb inflation. As a result, car manufacturers, as well as resellers like Carvana or CarMax, have faced some headwinds.
In other words, rising interest rates have caused consumers to scale back spending, causing inventory levels to rise at automotive retailers. This dynamic has led to a backlog of excess inventory and slowing sales for car businesses.
Image source: Getty Images.
Advanced Auto Parts is in a unique position
While consumer discretionary spending is strained right now, there are some areas that are seen as inflation proof. One example of consumer spend that is more immune to inflationary headwinds are found in businesses that have pricing power.
Generally speaking, companies have pricing power when their products and services are in high demand — regardless of the state of the economy. This means that even during tough economic periods, certain businesses still witness strong demand.
Within the broader car market, companies that sell automotive parts, equipment, and maintenance services are viewed as inflation proof. The reason? Well, as discussed, consumers aren’t exactly racing to buy new cars during times of high inflation or rising interest rates. Therefore, people often choose to hold on to existing vehicles for longer.
Advanced Auto Parts benefits from this dynamic. Even during times of high inflation, car owners still need to upgrade certain aspects of their vehicles and get inspections.
Given that Advanced Auto Parts doesn’t have much competition from other types of car retailers right now, the company is in a unique position in that it still sees demand and has leverage over the consumer as it pertains to pricing.
Is Advanced Auto Parts a good stock to buy right now?
The chart below benchmarks Advanced Auto Parts against some peers in the auto equipment market on a price-to-sales (P/S) basis. At a P/S multiple of just 0.4, Advanced Auto Parts is trading at a noticeable discount to its peers. While this might give the appearance of an undervalued opportunity, there are some important items to further discuss.
AAP PS Ratio data by YCharts
The chart below illustrates quarterly revenue and gross profit trends at Advanced Auto Parts over the last several years. It’s pretty obvious that its business isn’t exactly linear. Nevertheless, I still see the stock as a compelling buy for a few years.
AAP Revenue (Quarterly) data by YCharts
First, the disparity among valuation multiples compared to the competition is tough to overlook. While this alone doesn’t necessarily make it a value play, I’m encouraged by Loeb’s validation of Advanced Auto Parts over alternatives.
Second, while the business itself has demonstrated some volatility, I actually think there’s some steady growth on the horizon. While the Federal Reserve has hinted at lowering interest rates this year, investors still do not know when or if that will happen, and to what degree.
For those reasons, I think equipment retailers like Advanced Auto Parts will continue to see outsize demand compared to other car businesses. In theory, this should lead to some sustained accelerated growth.
Lastly, while inflation has cooled off, the current rate of 3.4% is still much higher than the Fed’s long-term target of 2%. As long as inflation remains stubborn, I see a business such as Advanced Auto Parts as well-positioned among broader opportunities in the automotive market.