Why Auto Stocks Are So Cheap

In this week’s energy and industrials edition of Industry Focus, Sean O’Reilly and John Rosevear take a closer look at these two iconic American companies.

We look at the prospects for the American new-car market, the likely risks and potential upside of an investment in either -- and how both companies are positioning themselves to head off the coming wave of “disruption” from Silicon Valley and beyond.

A full transcript follows the video. 

This podcast was recorded on June 16, 2016.

Sean O'Reilly: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at quickenloans.com/fool.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, June 16, 2016, so we're talking about energy and industrials. I am joined today by Motley Fool senior auto specialist John Rosevear. John, thank you so much for joining me on the show today.

John Rosevear: Thank you very much for having me, as always.

O'Reilly: We don't get to talk verbally enough. I'm always editing your stuff.

Rosevear: I'm always sending you snarky notes over Slack.

O'Reilly: Ain't that the truth? Today, first thing I wanted to talk about was the fact that you're our senior auto specialist. I joke, I was like, "Yeah, he knows like eight different former presidents of Ford. He just knows all these people." I really wanted to get some time with you and talk to you about the valuations on these auto stocks. On the show, we usually talk about energy because that's what's been going on with oil prices and everything. It started with Tesla (TSLA 0.78%), because that's a big deal. But you look at the valuations on Ford and GM, and you're just like, "What is going on here?" The multiple on the market's 18 or 20 and you've got Ford with a P/E of 6? Why are these so cheap by any reasonable measure?

Rosevear: There are a few explanations. First of all is these are big, old-school, cyclical industrial stocks. It's not an uncommon pattern if you look way back in history that they cruise around a price-to-earnings ratio of 10. But then, profits start to rise as the auto market moves toward a peak and the P/E shrinks. The reason they shrink is because investors start to say, "Wait a minute -- if the market is peaking, that means profits are going to start to shrink in time." That's just how they've always behaved.

There's a certain amount of that going on right now, but these are really low. GM's P/E right now, trailing-12-month basis, is 4.3 or something. It's really low. It's nowhere near 10. You look at the Wall Street estimates for earnings, and they're good. They'll be up this year. They'll be up more next year if the estimates follow through. They had a good year last year, earned just over $5 a share, which is very good for GM, well over $10 billion before taxes.

There's strong businesses. We're way past bankruptcy. We're way past the economic crisis. Both companies have very strong management teams. Ford especially, you can say this company is battle-tested. These guys all went through the near-death experience. They all worked closely with Alan Mulally. Mark Fields, CEO, was Alan Mulally's right-hand guy for several years. He was really the architect of the turnaround. Ford is trading at about 6 times earnings. With this crack management team, with very good sales in the U.S., with promising things going on overseas, what is the story? I think a certain amount of the story is just the cycle.

The market for new light vehicles -- "light vehicles" is our technical term for cars, pickup trucks and SUVs, thrown together. Basically, things people buy to own and drive in their garage, versus big trucks. We have a chart. I don't know if the readers will be able to see it. We have a chart that Sean and I have been looking at today.

O'Reilly: If you want the chart, we'll email it to you. Email us at [email protected]. All right, sorry, John.

US Light Vehicle Sales data by YCharts

Rosevear: Briefly, we can tell you what the summary of the chart is. The pace of auto sales, which is measured with a monthly number, is very close to the all-time highs that were set last decade during the great SUV boom, 2005-2006, when --

O'Reilly: Everybody had an Escalade. Say it.

Rosevear: Everybody had an Escalade. The margins on these things were fat. Toyota was trying to figure out how to make SUVs, and all these things. Then of course, as we know, the market turned. Gas prices went up. SUV sales stalled. The economic crisis happens. GM and Chrysler crashed in a bankruptcy court and all that. But before that, the pace of auto sales in the U.S. was extremely strong. We're close now to that pace. That makes analysts think, "Huh, maybe there's not a lot of growth left here." Profits may not drop for a while. They could cruise at this level for a few years. But growth may be hard to come by. Of course, as investors, we want growth.

We should back up a second and say the U.S. market is really, really important here. Ford and GM are both global companies. If you go to Shanghai, you'll see Fords and Buicks and Chevys on the street. Likewise in Latin America, likewise in Europe, all over the world. But the U.S., from a profit perspective, is of outsize importance.

For Ford, North America accounted for 61% of their total global revenue last year, and 86% of its pre-tax profits.

O'Reilly: Correct me if I'm wrong. That's because Ford, the real moneymaker is trucks. There's nothing Americans love more than a Ford F-150.

Rosevear: F-series, you got it. F-series, that's what we call it. F-series is F-150 and the Super Duties. The F-250, F-350, and so forth, we track them as a group. Ford reports results for them as a group. Ford's most important product in the whole world. They sell a ton of Focuses and so forth in China. They sell all sorts of cars in Europe. Pickup trucks, it really comes down to pickup trucks.

The margins on those things are huge. With gas prices moderate, as you've been discussing on the podcast for a long time now, truck sales have been terrific. That's also true at GM. GM sells almost as many pickups as Ford. Sometimes more in some months if you add together the Chevys and the GMCs. GM also sells, they really dominate what's left of the big SUV market. Escalade-style SUVs, the industry --

O'Reilly: Was it the other one, the Sierra something, or--

Rosevear: The Sierra is the pickup. This is the Chevy Tahoe and Suburban. The GMC Yukon and the Cadillac Escalade, these are big truck-based SUVs. A lot of companies used to make them. A lot of companies used to sell a lot of them. Most of that business has gone away for most of those companies. GM has like three-quarters of the market that's left. Which is so many that they're expanding their factory in Texas that builds these things, because they can't crank out enough right now, believe it or not.

O'Reilly: Did all those sales go to crossovers, would you say?

Rosevear: Yeah, it's been a big movement. This is a global trend, an industrywide trend. People going to crossovers. A crossover is basically, simply put, it's a cross between a car and an SUV. It's an SUV-shaped vehicle that's built on a car architecture instead of built on a heavier pickup truck frame. This makes them lighter. This makes them handle more like cars. This makes them ride more like cars, and it makes them more fuel efficient.

A trend that's going on separately, and this is also driving big profits for GM and Ford in North America, is people are giving up cars for crossovers. People are trading in the Ford Fusion on a Ford Escape or an Explorer or an Edge. Likewise at GM, likewise at really all of the automakers, this has caught some by surprise.

You have companies like Honda, which, for years, the bread-and-butter has been the Accord and the Civic, the smaller sedan and the bigger sedan. The CR-V, their compact crossover, is setting sales records. Meanwhile, it's like the car sales have stalled because people are migrating. This is a global trend. It's happening in China. It's happening in Europe even now, too. The twin to the Buick Encore is a small Opel called the Opel Mokka, which GM sells in Europe -- booming sales, booming sales. This is a small premium crossover. Just everywhere, crossover sales are booming. That has also helped profit margins everywhere, because generally speaking, you make a little more money on an SUV-shaped vehicle than you do on a sedan-shaped vehicle, especially now when demand is hot.

This has also helped -- there are some questions as to whether, "Oh, gas prices will go up and they'll shift back," but this trend was happening when gas was over $3 a gallon. It was already in place by 2012-2013. I think this is a long-term shift, which might mean more competition squeezes margins over time. Right now, everybody is making good money on crossovers. Ford and GM have among the best line-ups of crossovers in the business. That's boosting them right now, too.

But again, generally, even crossovers are going to be a cyclical business. Sales will rise and fall with the economic cycles. Because it costs so much to set up a car factory, to run a car factory, to staff a car factory, the fixed costs in the business are so high, whether your factory makes 100 vehicles a day or 600 vehicles a day, a lot of those costs don't change. The higher the market, the fatter the profits. As the market contracts, profits get squeezed.

To back up, why are Ford and GM cheap? One reason is because people are concerned that squeeze is coming, because the market appears to have plateaued.

O'Reilly: That's just the question, is it possible that -- I hate to say this time is different -- but is it possible this time is different? Because, as you've mentioned, Ford and GM, they have footholds in, let's take China, for example. Their middle class is the size of the United States population. It's over 300 million people. They see our lifestyle and they're like, "Oh, we need a car." You look at these valuations; you can't buy the whole company. If I buy all of Ford and I get all my money back in six years, what is going on here?

Rosevear: I know. Ford and GM, unlike the last time the market went south, Ford and GM have very strong balance sheets. They're in good shape. They say they will break -- their breakeven point is a pace of sales around 10.5 million a year.

O'Reilly: They're doing 50% more than that, right?

Rosevear: Yeah. It's up around 16, 17 million and has been for a while. That's the trough of the deep recession. Even during the economic crisis, it was only below that for a few months. But of course, their costs were much higher back then, which is why they got into trouble, but they've shaped up.

Mary Barra and her predecessor have done a tremendous job cleaning up GM into what they call the fortress balance sheet, with a little help from the bankruptcy court, of course. Ford has done much the same with a lot of help from the huge loans that Alan Mulally had the foresight to take way back in 2006, when he came in.

O'Reilly: I still remember reading a case study about that. They took out those loans, they went all-in on making a great line-up of cars, and the rest is history.

Rosevear: That's it in a nutshell. I covered a lot of that at that time for the Fool, especially as they got into the economic crisis.

O'Reilly: Did you think it was a brilliant move?

Rosevear: Yes. Having met and spent some time with Alan Mulally, he is as advertised; he is really amazing. He just came in and asked the right questions. He said, "Let us do these eminently sensible things that Detroit, as a group of companies, has invented reasons not to do for decades. Let us have one product line that we sell all over the world rather than developing completely different sedans for the U.S. and Europe. Let us have one brand of cars. Let's get rid of -- we've been dabbling with Jaguar. We've been dabbling with Volvo. Let's knock that off. It's a distraction. It's a diversion. Let's sell Fords. Let's sell the same line-up of Fords all over the world, with some regional variations, but all based off the same architectures. That's key.

You can change the sheet metal and change the features and so forth, but if you have six different vehicles created on the same architecture, you can theoretically build them all on the same assembly line, given that a new auto factory is a billion dollars or more.

O'Reilly: It's low-stress for sure. These guys are cheap. This time it might be different; who's to say? Hopefully we can conclude that. Why else should investors be concerned right now? -- because that seems to be the crux of the issue in leaning one way or the other toward whether these stocks are buys or not.

Rosevear: The U.S. market is one concern. There's a lesser concern about stalling growth in China. Both Ford and GM are very well-positioned there. GM in particular is a market leader in China. It's funny how many Americans don't know that, that if you go to Shanghai, you're going to see a ton of Buicks on the street.

O'Reilly: Isn't that because Mao used to drive a Buick?

Rosevear: Yes. Buick has had a tiny presence in China for decades. The last Chinese emperor famously drove a Buick. A Buick was the first car in the Forbidden City, ever. There's the sentimental attachment, but there's also just enduring loyalty. The small number of Chinese families that had cars years ago, maybe they were Buicks. They've just had a presence there a long time. GM has managed it really well, and managed it for growth and profitability; they have done a good job there.

China might be a little bit of a concern. But also, one of the things we talk about a great deal, and I know you talk about on this show, is disruption, the big word.

O'Reilly: This is The Motley Fool, after all.

Rosevear: This The Motley Fool, after all, and it's what we investors love, if we can get on the right side of it, which is a challenge.

O'Reilly: That is the trick.

Rosevear: That's one of the questions, actually. Is an investment in Ford and GM being on the wrong side of the disruption that is probably coming to the auto business?

O'Reilly: Big changes are clearly coming to the auto business. The biggest of all these appears to be the advent of driverless cars and ride hailing.

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John, getting over to the word of the day, which is disruption, is this the reason that you think the market's anticipating these stocks might be cheap?

Rosevear: I think it's part of the reason. A lot of institutional-sized investors are holding their breath. We've got things that are seen as threats to the old way of doing business. Cars have been sold basically the same way for a century now. The advent... there are more dealers, there are more financing options, leasing is more prevalent than it was 40 or 50 years ago, when it was very much unknown. It's the same thing. You go to the franchise dealer, you make a deal, you buy a car, you bring it home. You finance it maybe, or maybe you pay cash. You have insurance. You park it in the garage. You need parking if you drive it to work, all these kinds of things. This has not changed. Guess what? There are people looking to change it. A lot of these people are in Silicon Valley.

O'Reilly: We've talked about them a little bit on Industry Focus, obviously, but for those who may not be aware, just to provide some context for what we're talking about here today, can we just run down really quick what, just for the layman, what Google, Tesla, and Uber have been up to in, like, a minute or less?

Rosevear: There are a lot of other companies in the categories with what they're doing. That's good. We'll just take these as the leader.

Google, of course, does many experimental, interesting, quirky things. One of the things they've been working on for years is self-driving cars. Autonomous-driving technology, the technology that allows the computer to drive the car safely for you. You don't have to touch the steering wheel. They've had the adorable little prototypes running around for a while. We've all seen them. I think they call them the Panda cars or something like that.

O'Reilly: They look like wind-up toys.

Rosevear: They do look like wind-up toys. Apparently, they don't ride very well, I've heard.

O'Reilly: Really? They're not comfortable?

Rosevear: They're just for test. They were made up for Google. They were built by a contractor in Michigan that works with the auto industry just as test cars for them to drive around their campus and so forth. Google is not going into the carmaking business. They have made that clear. They've hired an industry veteran to run the Google Cars unit. What they seem to want to do is either get into ride hailing with autonomous cars, or partner with one or more automakers to provide their self-driving technology to cars. Of course, automakers view this askance, because they saw what happened to the phone makers who partnered with Android. That's a concern. That they'll just be making the dumb cars, and the personality and the brains and all the data which everybody wants goes to Google. They're mindful of that. There has been some resistance to working with Google in the auto business.

Tesla, of course, is Tesla. People talk about Tesla disrupting the auto business. I have argued for a long time that what Tesla has really done is enter the auto business, and that's a hard thing. They deserve a huge amount of credit. Tesla is becoming an automaker. They're fast-growing. They're innovative. They're, of course, making electric cars. But Elon Musk, his famous secret plan boiled down to, "We're going to show the world that electric cars can be awesome and hopefully push the industry to follow us." He wasn't looking to destroy the industry. He was looking to lead the industry. Love or hate Tesla, that's what they're doing. The acceleration of battery electric vehicles has been greatly accelerated just because of Tesla's very visible success. A lot of companies are working on them. Some more than others. We'll get into how that plays out with Ford and GM in a bit.

The other company you wanted me to talk about was Uber. Uber, along with Lyft and Didi in China and several other big companies around the world, are pioneers of ride hailing, where you use an app to summon a car. The cars are crowd-sourced. Drivers sign up to drive for Uber. Passengers get the Uber app and hail one of these vehicles, Uber's system directs the nearest vehicle or whatever to you. The idea is that everybody makes some money out of this. The thought here is that in some places and times, services like Uber will lead people to say, "Hey, I don't really need to own a car anymore."

O'Reilly: Yeah. That would obviously decimate Detroit's business. How are GM and Ford positioning themselves to handle this? Because GM, they invested $500 million in Lyft. They're all looking at this. They're all trying to follow Tesla with the driverless technology. What else is being done in order to position themselves, because I don't think they want to go through bankruptcy court again.

Rosevear: No. To be clear, Ford never went into bankruptcy court. It's a close shave, but Ford refinanced itself before the market forced it to go into court and restructure. But anyway, the vision, the way Google and Tesla and Uber come together as the big disruption threat that we all see on the horizon, is a universe where you don't own a car; you hail a car with a software app whenever you need one. It just shows up. It's electric, it's self-driving, it's comfortable, and it's safe, because self-driving cars that talk to one another won't get into very many accidents. It's the thinking, and it seems to be very sound thinking if we can perfect the software.

That together is the threat. What some of us refer to as robot, the robot Uber world, where these self-driving cars... as a digression, personally, I think this is what Apple's car is really about. I think what they're aiming to be is the premium robot Uber, if they go into this business. That's my theory.

What are GM and Ford doing about this?

O'Reilly: I just found out the Chevy Bolt is apparently a big deal in this world.

Rosevear: It's funny. I was actually about 20 feet away when Mary Barra first unveiled the Chevy Bolt about a year and a half ago in Detroit. It was a big surprise. They were showing off the new Chevy Volt, with a "V," which is of course their innovative plug-in hybrid, essentially, that has great owner loyalty. They just rolled this thing out. It looks like a little crossover in person. It's not sexy and fast like a Tesla, and everybody is like, "Huh? What's that about?"

O'Reilly: Does it have the body of the Volt?

Rosevear: It's built on, it's very loosely related, as I understand it, to one of GM's small car platforms. But it's a new architecture that they created.

O'Reilly: This looks like the Ford Focus. I'm looking at it now.

Rosevear: The Bolt is very interesting. I spent some time talking to the folks who worked on the program at GM in Detroit, at the auto show in January. They're not interested in Tesla. This car was designed from the ground up with ride hailing in mind. They went on and on about all these features. It's got this special rearview mirror they've got that has so far only been used on top-line Cadillacs, that combines cameras to give you a seamless view around the car and the rearview mirror, without the window pillars or things like that in the way, because the cameras fill in the gaps.

It's got floors that are flat, rear doors that open wide, the seat is configured in the back seat to make it roomy for passengers. Even though the Bolt isn't a particularly big vehicle, it is very roomy in the back seat. It's easy to slide in and out of. It turns on a very tight radius. It's very maneuverable. There are cameras and sensors that help you pull right up to the curb. It's got all of this, the smart technology in it for tracking and so forth. It's like, "Huh?" They're telling me all this and it's, like, tailor-made for Uber or, more specifically, Lyft.

Now we're seeing, a few months later, GM is testing self-driving versions. GM acquired a little company in San Francisco called Cruise Automation. It was, like, a 40-employee company that had been working on a self-driving system that could retrofit to certain Audis. It was like this little niche thing. GM took them out for a rumored $1 billion. They have not yet fully explained this purchase, but the hints that have been coming out of GM were that they needed one particular thing to make their self-driving software system work and Cruise had the thing. It was the missing piece of their puzzle.

O'Reilly: They paid a billion dollars for this --

Rosevear: If they paid a billion dollars and they get self-driving cars to market two years ahead, is that a bad investment?

O'Reilly: No. I will not argue that.

Rosevear: We don't know for sure yet. But it's certainly a bet that GM can make. Now, they've already got... the Bolt doesn't even arrive at dealers for normal customers to buy until the end of the year. But there are already self-driving Bolts testing on the streets of San Francisco. Lyft has said -- you mentioned that GM put half a billion dollars into Lyft in January. It appears they've been working with Lyft for a while before that was announced. Maybe even as they were working up for the specs for what became the Bolt and so forth. Lyft has said that they're going to test a self-driving taxi service in a U.S. city to be named, within a year, and that the cars will be self-driving Chevy Bolts.

O'Reilly: That is just amazing to me.

Rosevear: This isn't the future. This is in the product plan. It's coming. It's right there. If you ask a GM product employee who works on the electric cars or the self-driving stuff, "What are you doing to catch Tesla?" They give you this look. They're like, "Catch Tesla?" Tesla just released their beta system early. They're like, "We got Tesla's range. We've got a self-driving system. We're not catching Tesla." They don't quite say it that way. They are much more gracious than I am making them sound. Props to GM for biting their tongue there. They feel like they're right there. They really have something to show for that.

O'Reilly: To help the Bolt case, then, bring it around to the valuations and everything. I'm trying to be unbiased here. I've read an interesting analysis of... everybody on planet Earth, or just the United States, even, want the driverless cars, obviously. Nobody would be buying a new Ford or GM car, and we wouldn't own it, we just hail them, quick two-minute trip and all that stuff. The number of miles that these cars that are presumably circling our cities are going to drive in a year will be astronomical. Does that not imply that there's going to be a high replacement rate and the automakers will technically be fine?

Rosevear: Even if they are self-driving electric cars, making cars is hard. When I say that, what I mean is making cars profitably to global standards of quality that we've all come to expect. Making a fragile, high-performance exotic and selling it for half a million dollars is relatively easy. Making a Toyota Corolla or a Chevy Cruise is very difficult to that level of quality and perfection, time after time and making a good profit on it.

If we're all going by robot Uber, those cars are going to get used up quickly. Somebody's got to make them. Obviously, GM is angling to be one of those companies that's going to be making them. Then, at the same time, this may become the standard in cities. Maybe it'll replace buses and subways in cities that have buses and subways. I don't know. There's also a good argument that 30 years from now, come whatever happens with technology, Ford and GM are still going to be selling a ton of pickup trucks in Texas.

O'Reilly: Yeah, amen.

Rosevear: Maybe those pickup trucks are electric, and maybe it just takes the right combination of product features and affordability to make these loyal pickup truck customers who order the V8 pickup every five years or seven years say, "Whoa! Wait a minute. Maybe there's something to this electric thing." A dual-motor Ford Super Duty with monster torque and monster trailer towing capacity, I think that would get a close look from a lot of people, even if it did not have a V8 roar or a big diesel sound. I think in time they will be able to, as the costs make sense for people, sell electric pickups, but I don't think they're going to stop selling pickups for a long time. Maybe not 200 years from now, but certainly 30 years from now.

O'Reilly: John, before we sign off, are you a buyer these days of Ford, GM, any of the automakers?

Rosevear: I own Ford and GM. Frankly, I own enough Ford and GM. That's not a reflection of what I think of their investment desirability. Both of them are making, if we set aside this disruption factor for a moment -- I know that's a big factor to set aside -- both of them have excellent management teams, good balance sheets, and they're making good moves to boost their profitability over time by building on the turnarounds they've done in the U.S. to improve their operations in places like Europe as well. That's happening. Those profits are going up. Ford and GM are going to be profitable in Europe this year. That's new. They lost money there for years, because Europe went through a very big recession...

China is going to continue to expand and they're both players there. They're making good margins there. South America is troubled now, but that won't always be true. Both companies have been able to minimize the damage while Brazil works through whatever it has to work through. They're streamlining product portfolios to increase their cost advantage, their ability to take advantage of their economies of scale, by streamlining and simplifying what they do under the skin of the cars, the things that aren't visible to customers when you're just riding around and driving. There's more commonality there. That's the way the whole industry is going, but Ford and GM are certainly in the midst of that. They're in the midst of developing future technologies that will keep them competitive as fuel economy standards tighten and so forth. They're all doing the right things.

GM expects its margins are going to be squeezed on pickups, says it has to go to more fuel-efficient things. It's offsetting that by greatly boosting its Cadillac brand, because luxury cars make big profit margins. Cadillac's catching on in China. At some point, they're going to try and go into Europe with Cadillac. The cars are almost good enough to do that, to go compete with the Germans on their home turf. We'll see how that goes. There are a lot of these efforts going on to boost margins. They should unfold over the next six or seven years with, again, setting aside the cycle of the economy and any massive disruption that might happen, relatively steadily over time, we may take a dip in the U.S., but then we'll come back up, and meanwhile, the cycles will run overseas. But if we get back to a situation like this in seven years, Ford and GM should both be considerably more profitable than they are now, absent any disruption.

Meanwhile, you're collecting dividends in the 5% range or close to it on both of these stocks. I think if you're looking for the moonshot, you're definitely not in the right place. But if you want a company to put away and reinvest the dividends and see where you are in a decade and expect to have a nice, handsome return that you don't have to lie awake at night worrying about, I think these are both intriguing candidates.

I might lean toward GM right now, just because if you look back to 2008-2009, Ford has come further already than GM has. GM still has more room to optimize overseas and so forth than Ford does. I won't argue against somebody who says, "I'm going to go buy Ford today." I would say, "Good." It might not outperform for a few years, but if you sleep on it for seven years, you may be very happy.

O'Reilly: Awesome, Mr. Rosevear, thanks for your time. Thanks for joining me today.

Rosevear: Thanks, as always.

O'Reilly: That is it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people in this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For John Rosevear, I'm Sean O'Reilly. Thanks for listening, and Fool on!