The great Warren Buffett once said, "Diversification is protection against ignorance. It makes little sense if you know what you are doing." Buffett's statement is the complete opposite of what fund managers do these days with their very diverse portfolios. But you know what, those fund managers usually fail miserably.
I'm with Buffett on this one, and in my portfolio I've swung for the fences: 40% of my portfolio belongs to positions in Ford (NYSE: F ) and General Motors (NYSE: GM ) . Right now I'm sitting on a healthy gain and I'm not taking profit just yet. Here's why Ford and GM will both remain a huge chunk of my portfolio for years to come.
I cover the two companies pretty thoroughly for The Motley Fool, and know that one downside to owning stock in Ford and GM is that macroeconomic concerns often lead to severe sell-offs in auto stocks. This happens regardless of how well either company does on its top-line revenues and bottom-line profits. For most investors, it's a continuing headache; for savvy investors, its a consistent opportunity to buy on dips.
Right now North America is a primary source of growth for auto sales, and there's reason for optimism in the short term. Here's a representation of the auto industry's recent seasonally adjusted annual rate of sales, or SAAR:
April was a minor speed bump – the overall trend is improving and is still far ahead of levels seen after the great recession. Here are some reasons to expect SAAR numbers to remain strong this year and improve in 2014.
The fleet of vehicles in the U.S. is still old, credit is still easily available, and gas prices are reasonably stable. We're seeing proof that housing recovery is taking hold, giving consumers some of their wealth back and stoking more confidence in the improving economy.
Detroit automakers must agree, as Ford announced it was reducing by half the length of its typical summer shutdown for 20 of its North American plants to meet increased demand. Chrysler is following Ford's lead and leaving three plants open all summer, and reducing many plant shutdowns to only one week. In addition to that Ford plans to increase its third-quarter production by 10% compared to last year.
As construction and the housing sector continue to improve, it's sending a surge to the most profitable auto segment – full-size pickups. Ford and GM estimate that they get over half of their profits from this segment, and are in the perfect position to capitalize with fresh products. We're on the eve of seeing GM's 2014 Silverado launch, and Ford's redesigned F-150 hits the market next year.
Down the road
In summary, things look good for the short term. The long-term view is even more appealing when looking at catalysts that can boost stock prices significantly.
Ford expects to lose about $2 billion in profit as the dim outlook in Europe continues. The situation is similar to what we saw in the U.S. during the great recession, but management has learned from that experience and is exporting a turnaround plan to Europe – expecting to break even by 2015. Simply breaking even would directly boost Ford and GM's bottom-line profit significantly.
North America generates most of Detroit's auto profits, but there is immense potential for growth in China as the decade progresses. Consider that China's automotive market will grow so quickly through 2020 that it will create sales growth comparable to the size of Europe's entire market at today's level – about 12 million vehicles.
GM is far ahead of Ford in China and is already a dominant market player. Ford is determined to catch up and has plans to double its market share by launching 15 new models by mid-decade. Both companies look to significantly grow revenues through China because their models are very popular with the Chinese consumer, who typically avoids domestic brands due to poor quality and design.
Both companies are also in position to take advantage of an idea that could revolutionize the automotive industry. Developing connected vehicles could bring in an entirely new stream of reoccurring revenue that has the potential to boost margins to heights not seen in the auto industry.
Ford also offers a dividend of $0.40 annually that I believe will be increased around mid-decade. As the U.S. Treasury continues to sell off its shares of GM, it will present an opportunity for GM to initiate a dividend that could attract a new type of investor – income investors.
Issues to watch
Although the next few years look to tell a great story for investments in Ford and GM, there are some issues that both must watch out for. As profits continue to improve, union contract negotiations are likely to heat up in 2015. It will be up to management to create a valuable, yet affordable, offer and convince the workers that it's in both parties' best interests – a tough objective, to be sure.
Another issue to watch for both Ford and GM is pension obligations. Ford plans to pay in billions more than required in order to take hold of the issue as soon as possible; when interest rates begin to rise, it will drastically reduce the billions in pension obligations.
At the end of the day, both Ford and GM are completely different and drastically improved companies than they were a decade ago. For the first time in nearly 20 years every Detroit automaker gained market share in the first quarter. This isn't a fluke; the automakers are producing valuable and popular vehicles that are attracting and helping to retain more consumers.
In addition to better products, the automakers have drastically reduced their break-even point. It's estimated that Detroit automakers can break even in the U.S. at a SAAR level of about 10 million vehicles – a night and day improvement from even five years ago. The future looks bright; I swung for the fences with Ford and GM and plan to enjoy the hit.
My bet is on Ford and GM, but are they truly the best two auto investments? A recent Motley Fool report, "2 Automakers to Buy for a Surging Chinese Market", names two global giants poised to reap big gains that could drive big rewards for investors. You can read this report right now for free – just click here for instant access.