How I Predicted O'Reilly Automotive's Drop 2 Months Ago

Jun.27.12 | About: O'Reilly Automotive, (ORLY)

A couple of months ago, I wrote an article about why O'Reilly Automotive's (NASDAQ:ORLY) shareholders should be nervous. In that article, based on macroeconomic trends and valuation, I argued that O'Reilly was too richly valued and would bring terrible returns over the next year or two.

At that moment, most readers didn't believe me because O'Reilly had such a beautiful bullish run over the past several years.

Here are two comments I believe largely reflected the market sentiment at the time:

Is Your optimism on the general economic outlook based on bogus government advertised indicators?(lies by omission)

84 Months ago Auto zone was trading for $69 a share.

78 People sold 139 shares of stock...
The "insider trading" You cite, is it not mostly lower level employees selling their stock? After seeing it more than double in price over such a short period, the average employee at O'Reilly, making less than $24K/YR probably just needs the cash.

I think I'll dump 200 shares of Autozone and let the "safer", "better managed" O"Reilly Auto Parts have it for a while.

Total hogwash. Stock is a little pricey, but it has also been very good at making their numbers. Management is excellent, investors like the consistency in earnings growth and the company is understandable unlike the tech sector.

Both comments turned out to be totally wrong about the stock. Reflecting on the history of O'Reilly and similar companies, several lessons can be learned:

  1. Valuation is dynamic. When a stock is going higher, people tend to forget the most important thing in valuing a company: its valuation, reflected as the P/E ratio, or the Price/Cash Flow ratio, is going higher as well. For this simple reason, when growth stops, the stock tanks really badly because its P/E ratio also collapses. We have seen this play for many stocks before, such as Crocs (NASDAQ:CROX), Netflix (NASDAQ:NFLX), and Green Mountain Coffee (NASDAQ:GMCR). Now it has happened to O'Reilly.
  2. Macroeconomic trends are unstoppable. No company can single handedly stop macroeconomic trends. In most cases, even the United States government is not able to do it. In the event of an economic recovery, the ball game changes. People start to buy new cars, instead of staying with their used ones, which require a lot more maintenance. By the same token, AutoZone (NYSE:AZO) is already at risk (which I also wrote about two months ago in a Seeking Alpha article). Similarly, stocks such as AutoNation (NYSE:AN) and Pep Boys (NYSE:PBY) are in trouble as well.
  3. Do not fall in love with the company you invest in. Even a well-managed company can be overvalued. Its stock could do very badly in the market for things that the company cannot control. For example, newspaper companies such as New York Times (NYSE:NYT) have been doing pretty badly, not because its journalism quality is decaying, but because the world is moving towards fast-food-style online news. The same can be said about textile companies in the 1970s and 1980s. Even the almighty Warren Buffett couldn't make Berkshire Hathaway's original textile business work (NYSE:BRK.A) and (NYSE:BRK.B). So no matter how long one stays with a company, when the time has come to sell the stock, sell.

By summarizing this event, I hope these lessons are useful to both you and me in our future stock market endeavors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.