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The auto sector has been a tug-of-war this year between the bulls and bears. Bulls contend that the sector is a haven for value opportunities, as shares of industry titans General Motors (NYSE: GM) and Ford Motor Co. (NYSE: F) trade for P/E ratios in the mid-single digits. These auto stocks could be too cheap, given that the auto makers enjoy the benefits of low gas prices and low interest rates.
On the other hand, bears point to weak auto sales in recent months as a sign that the U.S. consumer is tapped out. After a record year, and a nearly unimpeded run since the Great Recession, it seems inconceivable to think GM and Ford can keep this momentum going for much longer, especially if interest rates and gas prices are about to rise.
Which side has the upper hand?
Bears Feast on Weak Auto Sales
The two major U.S. auto makers have both performed poorly this year and the auto stocks reflect this. Shares of GM and Ford have lost 11% and 14% of their value year-to-date, respectively.
The sell-off accelerated recently, after weak July sales figures from both companies. Across the entire industry, auto sales inched up just 0.7% in July overall. The growth rate in auto sales has slowed, which has stoked fears that the cycle is near a peak. But GM posted a 1.9% decline in vehicle sales last month, and Ford’s sales were down 3%.
Indeed, rising interest rates and gas prices could compel U.S. consumers to buy fewer vehicles. The other factor that is hurting auto stocks is deep discounting practices. In an attempt to continue growing sales, auto makers are forced to offer incentives to attract buyers. This weighs on the profit margins for both GM and Ford.
Bears are seeing the potential for declines to accelerate, which could make these auto stocks value “traps.” This is the term that describes stocks that look cheap on the surface, but are actually set to decline because their earnings will fall.
There is no denying that auto sales could peak and trend downward moving forward. But it seems that the market understands that this is likely to happen, and has priced in the likely impacts on auto makers. This explains why the auto stocks are so cheap, and why they could be attractive value opportunities.
Why Buyers May Have the Last Laugh
At P/E ratios of around 6 on a forward basis, GM and Ford would have to experience a massive deterioration in earnings to make their stocks value traps at these levels. For example, even if GM and Ford suffer a 50% drop in profits next year, their shares would still be valued at about half the P/E of the S&P 500.
This just doesn’t seem likely. It is one thing to suggest auto makers will see a dip in sales and profit, which is to be expected after registering huge gains for several consecutive years. It is quite another thing to expect the kind of collapse that would make GM and Ford value traps.
Their recent earnings reports suggest GM and Ford are still doing well. GM’s revenue rose 11% last quarter and reached a company record. Meanwhile, Ford earned $3 billion in pre-tax profits last quarter, and 6% revenue growth year-over-year.
Investors in these auto stocks are getting another margin of safety in the form of 5% dividend yields offered by both GM and Ford. There could be enough margin of safety built into their current valuations to justify buying these auto stocks, even if the forward outlook is less than stellar.
Disclosure: The author is personally long F.
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