Autos About to Floor It

 | Dec 12, 2012 | 2:30 PM EST  | Comments
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Stock quotes in this article:

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sup

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azo

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mnro

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pby

It's back to investment basics again, and the basics are no clearer than they are in the auto industry, specifically when it comes to new-car sales. The auto industry is in the midst of a multiyear cyclical turnaround that should deliver exceptional returns for investors who are patient and rational enough to take the ride. The thesis behind this future payoff, moreover, is extraordinarily simple. For those who think it takes a complex thesis to yield above-average returns, give your brain a rest and consider Albert Einstein's remark: "Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius -- and a lot of courage -- to move in the opposite direction."

The thesis go like this. Back before the economy when over the cliff, in 2005 and 2006, new-car sales were at 16 million units. After the Great Recession, these sales collapsed to somewhere around 11 million. As a result, the average age of a U.S. vehicle is now around 11 years, making the active U.S. auto fleet the oldest we've seen for decades.

For a while it made sense to continue repairing used vehicles. That's why, during the recession and thereafter, auto-parts retailers like AutoZone (AZO) delivered exceptional results. While I still remain a fan of this business model, the sector has begun to experience slower rates of growth. So have automotive-repair shops -- shares in Monro Muffler (MNRO) and Pep Boys (PBY), for instance, are both trading near 52-week lows. (Again, I have a contrarian viewpoint on the future of these businesses, but that's another topic altogether.)

The reason for the slow growth is that, at some point, the cost of repairing an old vehicle becomes too expensive relative to the value of the car. I believe we have reached that point in the U.S., and the results seem to confirm that. New-vehicle sales in the U.S. have been growing for the past couple of years, and for 2012 the numbers are set to eclipse the level of 14 million to 15 million units. Over the next couple of years, as more vehicles enter the too-expensive-to-replace category, new-vehicle sales will continue to accelerate.

Moreover, auto financing is accessible again, and today's super low interest rates make new cars very attractive compared with gently used vehicles. It's far easier to lend someone $25,000 for a car than it is to lend $250,000 for a house. Delinquency rates in auto loans are very low -- believe it or not, more people will walk away from a mortgage payment than they will an auto payment. Plus, a repossessed vehicle can be resold rather quickly. That's not the case with housing. As a result, lenders are vastly more willing to lend for a car than they are for a home.

In fact, this exact thesis has played out in my own household. After spotting transmission oil leaks in my wife's eight-year-old car, we began to consider getting her a replacement. The Jeep was worth $4,000 to $5,000, and if we had to fix the transmission, we could end up spending between $2,000 and $3000.

My initial plan for her was to get her three-to-four-year-old gently used vehicle. I ended up getting her a 2012 Jeep Grand Cherokee instead -- a good-as-new car with 8,000 miles on it, costing about 30% less than a brand-new one. What sealed the deal was that we could finance the car at zero interest for 36 months; instead of paying $30,000 for the 2012 Jeep, we borrowed the money for free. I can probably earn 5% on that money, which warms my heart as an investor. Consider the economics here for most folks -- you can borrow at 4% to get a used vehicle, or borrow at 0% and get a new one with years of warranty service, as well as probably six to eight years of use.

The investment play is simple: Own shares in the automakers. The most favored among many professionals is General Motors (GM). Warren Buffett's Berkshire Hathaway (BRK.A) owns a nice chunk of GM, and so does billionaire investor David Einhorn. Ford (F) is also a quality choice -- through a combination of managerial skill and good timing, this company required no government loans during the recession. Or you might consider side shoots like small-cap Superior Industries (SUP) which makes aluminum wheels for the automakers. Superior shares currently pay a dividend of 3.4% and trade for 8x trailing earnings.

The proof is in the pudding. Cars are getting very old and too costly to repair, and that will send consumers looking for replacements. Interest rates are low, and auto financing is readily available for most. In short, the tailwinds are there for new-car sales to remain robust for the next several years.

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