The outlook for cyclical stocks is somewhat uncertain as Brexit means the prospects for the UK economy over the medium term are difficult to forecast. While in the long run, Brexit could lead to less red tape and bureaucracy, in the short run it could cause reduced confidence and a slowdown in consumer spending. Despite this, a cyclical company with a wide margin of safety could still be worth buying. Here is one example of that, with the company in question having 35%-plus potential upside in 2017.
Impressive performance
Today’s results from the UK’s largest automotive online retailer, Pendragon (LSE: PDG), show that it is making strong progress with its current strategy. In the 2016 financial year its operating profit increased by 2% on a like-for-like (LFL) basis, with underlying pre-tax profit 7.6% higher. This was driven by initiatives such as Sell Your Car and its after-sales progress update portal. Furthermore, visits to the Evanshalshaw.com and Stratstone.com websites have developed further. They have risen by 14.4%, with 66% of visitors from self-generated, rather than paid, sources.
Looking ahead, the company believes it can deliver double-digit growth in used vehicle revenue in 2017. It plans to double used vehicle revenue within five years and is on target to do so following an investment in inventory and marketing initiatives. In the current year, its earnings are expected to fall by 1%, but then recover to grow by 8% next year. As such, it remains a relatively solid business given the uncertain future facing the UK economy.
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Margin of safety
Pendragon’s valuation indicates that there is significant upside potential on offer. It currently trades on a price-to-earnings (P/E) ratio of 8.7. In the last four years, its P/E ratio has averaged 11.7. Assuming it meets its forecasts over the next two years and its rating rises to the historic average, the company’s shares could be trading as much as 42% higher. Given the uncertainty which the UK faces within that time though, a price rise target of 35% may be more realistic in order to provide a margin of safety against the prospect of earnings downgrades.
Within the same sector, Auto Trader (LSE: AUTO) is another stock with significant upside potential. Its outlook is superior to that of Pendragon, with its earnings due to rise by 20% this year and 14% in each of the next two years. Its P/E ratio of 26.2 appears to offer good value for money as, when it is combined with the company’s forecasts, it equates to a price-to-earnings growth (PEG) ratio of 1.5.
Since Auto Trader has only been listed for a couple of years, using its historic P/E ratio is perhaps less relevant than is the case for Pendragon. However, for investors who are seeking a fast-growing business, Auto Trader seems to be a sound buy. Meanwhile, for value investors, Pendragon may be the superior option. Both stocks face an uncertain future thanks to Brexit, but their potential rewards could be above and beyond those of the wider index in the next two years.
