Brexit negotiations will soon begin and I believe companies with large economic moats and defensive characteristics will perform well. An economic moat will enable improved financial performance versus sector peers during what may prove to be a challenging period for consumers and the wider economy.
Defensive characteristics should help to further protect companies from the negative effects of rising inflation and the potential for an economic slowdown which may result from higher uncertainty.
One company which I believe offers both of these characteristics is Auto Trader (LON:AUTO). Apparently, it needs no introduction since over 88% of people recognise the brand as an online space to buy or sell cars. Similarly, the vast majority of readers will not have heard of any of its competitors, since the company is four times larger than its nearest rival based on consumer audience.
As well as a defensive profile and large economic moat, Auto Trader also offers good value for money, in my opinion. I feel its strategy will strengthen its competitive advantage and it could prove to be a sound long term investment.
Economic moat
Auto Trader benefits from a relatively wide economic moat, in my opinion. It has a large competitive advantage over its rivals in terms of its network effect. It has a constant stream of buyers who are unlikely to look elsewhere, while the vast majority of sellers use the site rather than a competitor. Buyers know Auto Trader has the largest supply of cars on a national basis, with 430,000 listings per day on average from over 80% of UK automotive retailers, and therefore keep coming back to visit the website. Similarly, sellers list on the site because of its popularity among consumers, with 250 million advert views per month on average.
Auto Trader’s economic moat provides it with efficient scale and significant pricing power, in my opinion. It also means it could survive a downturn in activity in the wider economy better than other consumer-focused stocks. They may not have the same level of economic moat or competitive advantage that Auto Trader does. Given the prospect of a slowdown in the UK economy and reduced consumer confidence as inflation rises to 4% or higher this year, Auto Trader could raise prices or use its efficient scale to its advantage in order to outperform the wider consumer goods industry.
Defensive growth stock
While new cars are often viewed as cyclical products, used cars may be much more defensive than investors realise. During periods where the rate of inflation surges higher than wage growth, consumers often turn to lower-priced alternatives. For example, used cars may become more popular than new cars, just as budget supermarkets take market share away from mid-price point operators. Therefore, Auto Trader’s sales could be more resilient than many of its wider consumer goods industry peers.
Auto Trader’s sales could be more resilient than many of its wider consumer goods industry peers.
Although there is no guarantee that inflation will exceed wage growth this year, forecasts of an inflation rate above 4% mean there is a relatively high probability that it will do so. In such a scenario, Auto Trader’s adaptability may allow it to survive better than many of its consumer goods industry peers. Conversely, if the UK economy continues to perform well and Brexit does not cause consumer confidence to wane, Auto Trader’s 100% digital offering and long-term growth potential should allow it to post an improving financial performance over the long run. Therefore, I feel it could significantly outperform the wider economy in a variety of macroeconomic conditions, thereby offering defensive growth potential.
Investment appeal
Auto Trader’s share price has risen over 50% since listing two years ago. Therefore, it is perhaps unsurprising that the company has a P/E of 31.3. While high, I believe its growth rate justifies such a high P/E, since it is forecast to register EPS growth of 16.6% on an annualised basis during the next three financial years. At a time when few UK-focused consumer stocks are able to offer even positive EPS growth, I believe Auto Trader’s outlook is rare and could be worth a scarcity premium.
In my view, Auto Trader has a sound strategy. It is aiming to add greater value to the customer experience through additional features to its website. For example, it now shows finance costs on a new or used vehicle and has a dealer rating system to improve trust and confidence among consumers. I also feel there is scope to leverage the data it collects to improve profitability for retailers using its platform. This focus on creating a better quality product for both retailers and consumers could allow Auto Trader to increase the size of its economic moat in the long run.
Outlook
Companies with large economic moats and defensive characteristics could be more appealing than ever in 2017. An economic slowdown caused by Brexit may mean their relatively resilient demand and competitive advantage allows them to outperform their industry rivals. With inflation forecast to move higher, a competitive advantage within the consumer goods industry could be highly advantageous.
In my view, Auto Trader has a large economic moat when compared to its consumer industry peers. I feel it is solidifying and strengthening its relative position through improvements to the customer experience and via additional features. I also believe it offers good value for money given its growth potential. If the UK economy experiences a slowdown in consumer spending, I think Auto Trader’s focus on used cars could mean it has better defensive characteristics than many investors realise. Therefore, it could be a worthwhile investment for the long term given the uncertain outlook ahead of Brexit negotiations.