Here's Lookers at you, kid

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One of my key stock-picking themes is alertness to where market expectations are out of synch with economic reality, to identify mispricing. This needs adapting as circumstances change: for example at the end of last year and early this, I was attracted to shares in the more 'cyclical' companies being trashed by the market to very low earnings multiples and fat yields, as 'defensive' shares and corporate bonds became preferred.

Such a contrarian approach has worked well: the market's biggest risers this year have tended to be cyclicals bouncing back.
 
But with mixed messages on the UK economy (just recently, declining GDP versus rising consumer confidence) cyclical need treating with care. Various may now have recovered from low single figure PE ratios, say to about 10 times, but unless there is a worthwhile yield that is satisfactorily covered by robust earnings prospects then nervy investors who were sensitive enough to buy in may figure it best to turn a profit. Shares like this need 'follow through' in terms of trading updates, to sustain recovery.
 
Lookers (LOOK), a UK-oriented motor dealer listed in the FTSE SmallCap index, is a useful example. Its shares have started this week edging down from about 60p to 57p despite a strong Interim management statement last Friday, which cited progress 'significantly ahead of both budget and the prior year.' How indicative is this of the UK economy in general and how should you regard cyclicals such as Lookers right now and for the longer term?
 
'Motors' shares were sold viciously in the late 2008/early 2009 bear market, amid fears that consumers and businesses would defer spending. Showing how markets are liable to over-extend rather than find equilibrium for long-run pricing, Lookers had peaked above 180p in 2007, on a price-earnings multiple over 20 times, then fell as low as 15p as the bear market bottomed out last March.

The smart recovery to 60p shows how you do not necessarily need 'good news' for sentiment to improve from a severe low. UK car sales have fallen by 15% year on year in the nine months to end-September - perhaps not as worse as feared, but it shows how confidence tends to stabilise with clarity. It is primeval fear of the dark unknown that sends markets into a tailspin.
 
Lookers says the government's car scrapping scheme, whereby old cars generate a grant to buy new, has helped limit downside in the new car market. Group progress needs interpreting carefully, however, when management says it has achieved like for like new car sales '11% ahead' of a market that is down 15%.

Likewise when corporate sales have also helped the group 'outperform' the market. Used car sales and margins have held at high levels and revenue from after-sales rose by 3% as Lookers gained share also in a declining market.

The after-sales parts division however continues to deliver record results, with all three divisions of this business significantly ahead of last year. So despite the 'one-off' aspect the government car scrapping scheme, overall this is a pretty good achievement in a tough sector.
 
With UK consumer confidence now said to be the highest since January 2008, in principle this sets a context for Lookers to build on this performance; in practice it is worth bearing in mind, unemployment is liable to trend higher as a recession continues and fears of job security are likely to weigh on big commitments such as new cars.

Possibly the re-rating of VAT from 15% to 17.5% will mean a minor fillip then weigh on demand. Overall it is understandable why Lookers anticipates an ongoing 'challenging' new car market.
 
Since the interim dividend was cancelled to focus on debt reduction, earning power is the main focus for valuing the shares. In particular, what multiple of earnings is justified? This is the key to the shares' support level.
 
Panmure Gordon, one independent broker, has an 85p target for the shares - representing about 40% upside. Lookers' downside risk ought to be fairly limited now it has shown it can trade respectably in a very nervous period, so this target is interesting.
 
Company REFS cites Panmure (PMR) looking for about £26.0 million pre-tax profit this year, rising to £28.7 million next year, for earnings per share of 6.9p and 5.3p respectively. Peel Hunt, the company's broker, has just edged up its 2009 pre-tax profit forecast from £26.0 million (made 5 October, according to REFS) to £26.5 million implying earnings per share of about 7p. Also the 2010 forecast has risen from £28.7 million to £31.5 million but earnings per share are targeted at 5.8p.

This 'fall' is due to a higher number of shares in issue but I wonder if these brokers have fully factored in the aspect of dilution. Just over 200 million shares were issued at 40p last summer, raising about £80 million to reduce borrowings, taking the total in issue to 384 million.
 
If we assume about 6p per share then the prospective multiple is 10 times hence Panmure's target implies it can expand to about 14. This is indeed possible in the longer run, but in the next few months? REFS shows that Lookers' PE ratio multiple averaged over 20 times in 2006 and the mid-teens in 2007. However, these were boom years aided by unsustainable credit.
 
Lookers and other motors shares are still worth following because in the long run, the risk/reward profile favours upside. But I think another significant re-rating will need improved trading statements over the next 6-12 months, it is no surprise the shares are consolidating. The same applies to plenty other cyclicals; you need to read updates carefully. Each will provide insight into various strands of the UK economy.
 
Further reasons to keep Lookers on your list are its strengthened balance sheet which lends ability to take advantage of development opportunities - for example, low-priced acquisitions during the recession. There is also a new chief executive, an internal candidate who has been managing director of the motor division - with the CEO of 8 years retiring from the board having also worked for Lookers for 23 years. It will be interesting to see how he intends to make his mark.
 
You can learn more via www.lookers.co.uk