LKQ Corporation Stock: Why I Took Profits (NASDAQ:LKQ)
I last wrote about LKQ Corporation (LKQ) in my article LKQ Corporation Has Risks, But I’m A Buyer Here which was published on November 22, 2020, about 14 months ago. In this article, I explained my valuation process for LKQ and why I bought the stock. (If you are interested in this process, please click on the line above and read this article.) Since then, LKQ has worked very well.
LKQ returned around 56% and nearly doubled the performance of the S&P 500 over the same period. This week I took profits in LKQ, and in this article I will tell you why I did it.
My last two articles have also focused on stocks that I recently sold. The first article was about Dollar Tree (DLTR). I sold this stock for valuation reasons. The second article was about US Bancorp (USB), and I sold that stock because it had probably reached its cyclical peak (or at least the probability was high enough that the risk/reward over the next two years is biased downward). I sold LKQ for a different reason, but this is perhaps the most important reason investors need to be aware of today, as the same dynamic applies to many mega-cap tech stocks that dominate the stock indices these days.
I’ll get into the details in a moment, but the main reason I took profits in LKQ was the danger of what I call “boom/bust risk”. And boom/bust risk is a bit different than valuation risk or “normal” cyclicality risk that I try to avoid with Dollar Tree and US Bancorp.
Let’s start by looking at LKQ’s earnings history.
What share class is LKQ?
Before analyzing a stock, I always look at its earnings history and price history first to determine which type of analysis is best to use for the stock. For example, for Dollar Tree I used what I call “full cycle earnings analysis” and for US Bancorp I used what I call “deep cyclical” analysis. Determining which style of analysis to use was informed by earnings history.
One of the factors that drew me to LKQ in the first place was that it had a fantastic EPS growth record that was on par with any of the big tech stocks, yet it only traded around 14 -15 P/E when I bought this. It was a very good risk/reward ratio at the time. The end game of the process is to produce a 10-year expected CAGR for the stock based on EPS, earnings growth and price mean reversion. After going through this process, I estimated that a 10-year CAGR for LKQ was around +13.59% at the time. My base range for buying a “full cycle earnings” stock is that if the 10-year CAGR is above 12%, the stock is a “buy”, if it’s between 4% and 12% , it is a “hold”, and below 4% is a “sell”. LKQ was well above my 12% threshold in November 2020, which is why I bought the stock at the time.
What makes LKQ an interesting case study is that right now, LKQ’s 10-year CAGR is still quite high at +13.46%, indicating that it should still be a “ purchase”, but, instead of continuing to hold it, I sold. So what gives?
Identification of explosion/rupture hazard
Last year, LKQ had the biggest year for EPS in its history as a listed company. In the two years to 2021, EPS grew at a single digit rate, and over the next two years, analysts expect EPS to grow in the single digits as well. Compared to the 52% LKQ saw last year, the longer and more consistent earnings trend is about -80% slower than that. And that’s if analysts aren’t too optimistic about the near-term future. There are good reasons to think they might be. One-time government stimulus and supply chain issues, which are likely to decline in 2022 and disappear completely by 2023, mean that if EPS growth were to fall back in line with the previous trend leading to stimulus and supply chain issues supply, instead of the $4.35 per share that analysts are now expecting earnings in 2023, we would get $2.97 per share. Experience has taught me that the kind of disappointment in expectations tends to crater stock prices, and I want to avoid that, so a few weeks ago I put a trailing stop on the LKQ position, and it was triggered last week, so I took profit.
Sometimes when I write personal “sales” articles like this, readers struggle with their simplicity. Often they want a long, drawn out explanation of the business and details about long term goals and competition, management and a whole range of other issues that a person could write about if they wanted to. But, my view is that it is a bit dishonest for me to fill an article with this information when it has no bearing on why I actually took profits last week. There aren’t really any specifics on these companies that would likely have changed their minds when government stimulus, supply chain issues and COVID are the simplest explanations for the gigantic jump in EPS. from last year. That doesn’t mean I couldn’t end up being wrong. I could very well. But I think the odds are on my side.
Where I put my money LKQ
As a writer, I always feel a responsibility that when I write a bearish piece on a stock that I think is worth selling, I also include an idea of what to do with the product. With inflation quite high at the moment, cash is not too attractive. This year I decided to put what I call my “default” money, that is, the money that is waiting to find a home in a new individual stock, in a 60/40 balanced proxy iShares Core Growth Allocation ETF (AOR). This ETF tends to be less volatile than the broader market, and also leans towards more international exposure, which I think will make it more defensive since US mega-cap tech stock weightings are smaller in AOR . So far this year, my estimate has proven true.
Year-to-date, AOR has declined to about half the pace of SPY and 1/3 the pace of QQQ. And if the market were to reverse at some point and rise, the AOR should also capture a decent amount of upside potential.
A lot of what I do with stock investing is trying to find stocks that have similar upside potential to their peers or the market, but less downside potential. My experience has been that most investors have one of two difficulties, either they don’t see the potential upside reward of a stock or they don’t see the risk of a stock. During bull markets, most people don’t see the risks. During bear markets, most people fail to see the potential rewards. In November 2020, the potential rewards of LKQ seemed to me to outweigh the risks. Now that situation has reversed and the potential risks seem to me to outweigh the rewards when compared to the alternative AOR.
This article is the third installment of a four-part series that I am writing where I explain the reasons why I sell particular stocks. Whenever possible, I like to lead by example, so these are all the stocks I actually owned and wrote public articles about, that I’m now selling for different (albeit related) reasons. My next article will complete the series, and after that I plan to write more in-depth articles on the subject, but first I wanted to give detailed and specific examples of my thinking on the subject that are backed by real-deeds of life.
I did the same four years ago, in January 2018, when I shared that I was taking profits in the deep cyclical stock BorgWarner (BWA) after it nearly doubled. Soon after, I started warning investors in deep cyclical stocks that they should also consider taking profits. I called this series “How low could they fall?”. I hope that by leading by example, this time I will be more successful in convincing people of the potential downside of holding these volatile stocks for too long and in poor conditions.