The Other Auto Story

Everyone talks about

For the last several years, the members of the traditional auto sector--

However, the good times may be nearing an end. As Tesla's sales soared, the overall industry saw vehicle sales decline by 4.7% in April year-over-year. Morningstar expects a continued falloff in sales for the year: analysts Daivd Whiston and Richard Hilgert call for a 2.5% decline in auto sales in 2017.

That falloff in sales has led to a falloff in stock market performance. The industry index is down by about 8% year to date as of this writing. Several of the big car companies have also suffered stock price declines this year, including GM and Ford, which have seen their share prices fall 3.7% and 13%, respectively. As of this writing, automakers such as GM and Fiat Chrysler are trading in Morningstar's 4-star range, which suggests they're undervalued.

So, is now the time to shift into high gear with auto stocks or to tap the brakes? The answer depends on where you think auto sales--and the economy--are headed.

Wait for Another Recession? As was evident in 2008, when the economy goes south, so too do automobile sales. Cars are pricey, and if people are feeling the financial pinch, they'll hang on to their vehicles longer than they might otherwise. One of the reasons for the pullback in auto stocks and their valuations this year is, after years of rising returns and an improving economy, the market is starting to anticipate a setback. Or, at the very least, investors think a downturn would do the sector good, says Whiston.

"The market loves to hate auto stocks," he says. "It's a highly cyclical, capital intensive industry, and there's a powerful negative sentiment that maybe it has to go through a recession. People don't think they should pay up for these stocks at the top of a cycle."

Part of the problem is that many investors don't believe auto companies are any better off than they were during the recession, even though they're generating massive profits and have either turned themselves around or, in GM and Ford's cases, are in the midst of a turnaround. Some still think that next recession won't be different, and that auto companies will once again find themselves on the brink of extinction.

"The turnaround has been taking longer to play out--and it is playing out--but some people are still skeptical," says Whiston.

Joel Grant, an analyst with T. Rowe Price, is of the view that these stocks are too expensive today, and that current valuations aren't accurately reflecting the appropriate multiples on normalized earnings. He expects these stocks to fall further when there's a drop in consumer confidence. Maybe the postelection rally finally comes to a halt, or a new policy or action spooks Americans enough that the economy steps back.

"Stocks of automakers may not drop to 2008 levels, but typically, when there's a mild recession, these companies (fall) and then start looking more attractive from a price perspective," he says.

Much Better Businesses

Of course, the economy may not slow down, and markets may continue to rise--and if that's the case, then there could be an opportunity here. After all, auto companies are in better financial shape than they have been in years, and while there will likely be some softening in sales regardless of what happens to the economy--around 16 million vehicles sold is more typical for annual sales--companies can withstand a modest decline, says David Segal, co-manager of

A lot has changed since 2008, he says, including the regulatory environment, which has helped keep these companies in line. Auto financing, which nearly dried up during the financial crisis, is also working as it should today, so most people aren't having trouble getting a loan.

Companies have plenty of cash on hand to tap into if need be, too. GM has more than $20 billion in cash, for instance, says Segal, while some of the European automakers have even more cash on hand. Balance sheets are generally in good shape, and European and Chinese sales, which are both growing, may make up for a decline on this side of the ocean.

Add to that a growing economy and falling unemployment, and demand for autos should remain robust, says Segal.

"I don't see anything on the horizon that leads me to believe the world is coming to an end," he says. "Investors think a cyclical slowdown will always look like 2009 and 2010, and that makes people avoid the sector."

Still High Uncertainty With investors having conflicting views on where the auto market may be headed, it's no wonder Morningstar assigns most auto companies high Uncertainty Ratings. (Morningstar's Uncertainty Ratings represent the predictability of the company's future cash flows--and, therefore, the level of certainty Morningstar has in its fair value estimate of a particular company.)

Although Whiston isn't modeling a severe downturn into his analysis, he's not counting on continued growth, either. Earnings could see modest expansion of about 3% per year, he says.

Automakers are also no-moat businesses, according to Morningstar, which means they don't have entrenched competitive advantages. Whiston and Hilgert note in their Automotive Observer report that the industry is a highly competitive, capital-intensive business that can experience big swings in economic profitability on relatively moderate changes in demand.

"(The industry) experiences cyclicality that can destroy economic value for years at a time," they write. "Even though the automobile is a modern-day technological marvel that requires enormous engineering talent, complex software coding, and immense organizational skill to design, develop, and bring to market, substantial global industry overcapacity reflects the paucity of barriers to entry."

There are also threats to the sector's long-term future, with autonomous cars and companies like Tesla eking out more market share. However, despite Tesla's strong quarterly performance, David Herro, manager of the Gold-rated

Opportunities Even with the uncertainty, there are opportunities in this market, says Whiston. Fiat Chrysler and GM are favorites at Morningstar.

Fiat Chrysler, says Whiston, is trading at a 31% discount to the company's fair value estimate in part because investors don't think it will reach the many objectives it had hoped to achieve--like higher sales and profit margins--when it laid out its five-year plan in 2014.

While Morningstar's forecast is predicting lower sales and margins than what's in management's five-year plan, it's still more optimistic than the market. Whiston has come up with an intrinsic value that's about double the consensus price target, he says.

It's a similar story for GM, with investors skeptical about its turnaround plan. However, Whiston and Hilgert write in their report that the company is "far more efficient and global than it has ever been, and we think additional improvement is coming via further cost-cutting and platform reductions."

GM is a margin expansion story, says Whiston--it's improving its manufacturing efficiency and increasing economies of scale--but it's also repurchasing about $14 billion of its own stock. It's currently trading at $34, well below Morningstar's $51 fair value estimate.

If it does take a while for these stocks to rise again--and even if they fall in the short-term--nice dividends for most of these companies should keep investors satisfied. With GM, Ford, and Nissan offering yields of 4.5%, 5.5%, and 4.6%, respectively, investors can get paid to be patient.

As cheap as these stocks are, though, you'll have to decide whether they're cheap enough.

"It's a tough one because we are at the top of the cycle," says Whiston. "It depends on your risk tolerance and how long you’re willing to wait."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.