Most investors fall into what’s called “Indicator purgatory,” where they rely heavily on indicators and chart patterns to tell them where to start buying and selling in the market. However, there comes a point in the economic cycle, such as today, when those strategies become too crowded, and most participants collectively look at the same set of indicators all at once.
This is when professional money managers and traders start to zoom out to generate the best ideas, the ones that earn them the big bucks, so to speak. One simple way they achieve this is by considering economic data as a whole, such as the recently released retail sales data, which, despite a contraction, still shows investors a massive opportunity to adjust their portfolios.
While there are dozens of ideas to be had within this report, today’s focus is on the automotive sector. Particularly, why investors should consider selling or avoiding names like O’Reilly Automotive Inc. (NASDAQ: ORLY) and AutoZone Inc. (NYSE: AZO) while also looking to buy the heavy discounts in Advance Auto Parts Inc. (NYSE: AAP) as fantastic risk-to-reward setup based on fundamentals.
Not a Great Month in Auto Parts
[content-module:CompanyOverview|NASDAQ: ORLY]Looking at the latest release in retail sales data can shine a brighter light on the reality of the market (and the economy) today. While auto parts are still leading the way with a 6.4% annual growth rate, zooming in could show a potential downside to some of the overextended stocks in the space.
This stems from the fact that auto parts sales contracted up to 2.8% over the past month, showing a potential slowdown and retreat from their bullish momentum. However, it is still too early for investors to decide whether this will become a long-term theme.
Especially now that new car prices and financing rates are not the most favorable for buyers, this could lead them to the used car market or to simply maintain the car they currently have. Of course, this could create a strong tailwind for auto parts demand, but there’s a risk that it won’t be as aggressive as some think.
[content-module:CompanyOverview|NYSE: AZO]Cutting O’Reilly and AutoZone out of a portfolio might be beneficial from a risk management perspective, despite what Wall Street analyst ratings might suggest. O’Reilly and AutoZone trade within 95% of their 52-week highs, while Advance Auto Parts only trades at 54%.
Additionally, macroeconomic headwinds such as persistent inflation and weakening consumer sentiment could put further pressure on discretionary spending, even for vehicle maintenance.
If sales continue to soften, valuations for these stocks could come under scrutiny, making it even more critical for investors to assess their exposure in the sector.
Better Reward, Lower Risk in Advance Auto Parts
More than that, investors can look to the valuation multiples inherent in these stocks, such as the forward price-to-earnings (P/E) ratio, which also favors Advance Auto Parts from a risk-to-reward perspective. By trading at only 15.6x forward P/E, Advance Auto Parts offers a steep discount to O’Reilly’s 26.2x and AutoZone’s 20.0x.
[content-module:CompanyOverview|NYSE: AAP]That’s not all. The thesis behind the market shifting to bulk orders to maintain or trade used cars favors Advance Auto Parts and its business model the most, even as it falls out of favor from Wall Street ratings due to bearish momentum. This could be why contrarian analysts have landed on a much more optimistic outlook when it comes to the company’s underlying earnings power.
Investors can see that through the forecast for up to $0.96 in earnings per share (EPS) for Advance Auto Parts in the next 12 months, a massive jump from today’s net loss of $0.04 per share. With this in mind, it becomes clear that Advance Auto Parts is superior to the flattish forecasts in O’Reilly or the single-digit percentage increase in AutoZone.
Investors need to remember that analysts will guard their jobs and reputations when rating these stocks, which is why they might have leaned on boosting AutoZone and O’Reilly rather than Advance Auto Parts when it comes to price targets, but that doesn’t truly reflect the underlying momentum in these names.
With this in mind, and knowing that EPS growth typically drives a stock’s price higher, investors can see that Advance Auto Parts offers a much better setup than its competitors, where the downside is relatively already priced in.
This simple setup also explains why up to $550 million in institutional capital made its way into Advance Auto Parts stock over the past quarter alone, led by those at the Vanguard Group and Price T Rowe Associates, each with a stake of $314.2 and $316.2 million, respectively.
On the other hand, up to $4.04 billion in institutional capital was sold over the past quarter, a potential sign of investors realizing that the stock might be overextended today. For AutoZone, those from the Manufacturers Life Insurance Company decided to unload up to 1.4% of their holdings in AutoZone stock as of February, another sign of lost confidence in these extended names, adding to the optimism in Advance Auto Parts stock.
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