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Invest In What You Know, Unless Maybe That Is Autos

By Jacob Meredith - Feb 21, 2014 at 9:10AM

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Use products you are familiar with to find rational investment ideas, but be very careful.

Some of the greatest investment minds in the world, one being Warren Buffett's, have told us we should invest in companies that we know and understand. However, using this strategy blindly and investing in a company just because you purchase their products can lead to disastrous results. The automobile industry is a perfect example of how this strategy can hurt you, but if you dig deeper you may be able to find great investment potential.

Apply the brakes
Like myself, you may be very fond of your Chevrolet Silverado made by General Motors (GM 1.66%) or you may love the sleek new Ford Fusion by Ford (F 1.84%), but please, I'm begging you not to go buy these stocks based on your love of the vehicles. These companies both make excellent vehicles, we all know this, but there are certain issues with the industry as a whole that long-term investors should be well aware of and scared of.

Now slam the brakes
Automobile manufacturers live in the world of intense price competition. As said earlier, we may love a particular brand, but as rational consumers we would also probably consider a different make if the price is right. This kind of situation leads to lower and lower margins for every company involved; Ford has sported profit margins averaging around 1.5% over the last 10 years, and after you read through the novels that are the General Motors 10-K filings (due to bankruptcy in 2009), you find profit margins averaging -3.4% over the last 10 years (for this measure I have excluded fiscal year 2009 in which restructuring gains gave General Motors an unreasonably high accounting gain).

Another large problem with this industry, which stems from the first problem mentioned, is that automobile manufacturing is extremely capital intensive. Which means that these companies constantly need financing for new research and development or new manufacturing facilities or new equipment in those facilities. As you may know: companies can raise financing in the form of selling more equity or selling debt, neither of these is particularly great if you are already a shareholder.

Since the bankruptcy restructuring of 2009, General Motors has nearly quadrupled its long-term debt to $21 billion, which investors should not like to see when the company earned only $5.35 billion last fiscal year. Ford on the other hand has not added or eliminated any debt over the last 10 years, not too bad right? Well, Ford still has debt in the ballpark of $115 billion. Now for the icing on the cake, Ford has nearly doubled its shares outstanding over the last 10 years as well, diluting investor interest in the company by almost half.

Low margins and high debt loads are a tag team for disaster in the business world. The fact that these companies sell big-ticket items makes cycles in the economy dangerous for them and their investors. The companies become completely unreliable when it comes to sales, earnings, and interest coverage, making them truly fragile.

If you know autos, keep thinking
I'm sorry for bumming out you automobile enthusiasts out there, but automobile makers just aren't what we are looking for in long-term investments. However, we can still find reasonable investments in your realm of expertise.

Think about your last purchase involving automobiles; it most likely wasn't the actual vehicle, but rather something for your vehicle. Throughout the lifespan of your vehicle you have, or at least I hope you have, purchased plenty of oil or other fluids, replacement wiper blades, new hoses, and the list goes on. You may have even purchased these products from a NAPA Auto Parts store. These stores are owned by Genuine Parts Company (GPC 0.52%) and this is a company long-term investors can learn to love. An immediate investment in the company may not be warranted due to the current stock price, but it is an excellent company to have on our investment radars.

Genuinely great numbers
Beyond automotive parts this company, through different brands, sells industrial replacement parts, office products, and electronic materials. Who loves diversity under one roof? Informed investors do.

Genuine Parts has had return on equity of over 18% on average throughout the last 10 years and profit margins averaging around 4.5% and growing during the same time frame. Though 4.5% is not a particularly high margin, it is stable and about in line with competitors'. Also, the company has managed to raise its dividend each year over the last 10 years, even during the recession that swamped the automobile industry. Management appears very capable of delivering the results investors like to see. 

In contrast to the auto manufacturers above, Genuine Parts is conservatively financed. The company's long-term debt has hovered around $500 million for the last 10 years, and accounted for about 15% of the company's equity value at the end of 2013. On 2013 earnings of $685 million, that $500 million is not overly scary.

The big picture
Invest in what you know, but please use caution. General Motors and Ford, though the largest auto manufacturers in the United States, don't have good business economics in their favor and can easily hurt us as investors.

There are great companies you could buy a part of with your automotive knowledge; General Parts may become one of them. General Parts announced better than expected earnings as well as a dividend raise on Feb. 18, and the stock rose quickly on the news. The market is currently pricing General Parts at almost 20 times earnings, which is slightly higher than its five-year average of around 18, and also higher than the auto parts wholesaler industry average of 15.7 times earnings. Beware of the valuation, but if the market gives you an opportunity, this is a high-performing company that would be an excellent addition to a long-term portfolio.

Jacob Meredith and clients of Appalachian Capital Group, LLC have no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Genuine Parts Company Stock Quote
Genuine Parts Company
$155.77 (0.52%) $0.81
Ford Motor Company Stock Quote
Ford Motor Company
$15.79 (1.84%) $0.29
General Motors Company Stock Quote
General Motors Company
$38.58 (1.66%) $0.63

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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