2 Big Things You Need to Know About Auto Stocks

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Worldwide Invest Better Day 9/25/2012

For the past two decades, The Motley Fool has been working hard to help you invest better. This September, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.

In that spirit, I'd like to introduce you to the two key basics of investing in an industry that has captured investors' attention since the moment it came into existence: The business of making cars.

Why automakers are different
It has always been true: Many investors, particularly newer investors, are drawn to the automakers. Many are car enthusiasts who think that buying stock is a way to show support for the makers of their favorite rides. Others see an industry that seems easy to understand: Everyone knows which companies make good cars, right?


But here's the thing: Not all companies that "make good cars" are good investments, especially if they're coasting on their reputations. And even the automakers that are making great vehicles, and that have their financial houses in good order, might not be a good buy right now.

So what do you need to know to successfully invest in the auto companies? Well, for starters, the same things you'd want to know with any investment: Is it making money, and how? What is its business advantage? Who are its rivals, and how strong are they? Is the stock reasonably priced?

But with automakers, there are a few other factors to take into consideration. Here are two of the biggest:

Factor one: How's the economic outlook?
Some stocks, consumer-staples stocks like PepsiCo (NYS: PEP) , for instance, are great to hold no matter what the economy is doing. PepsiCo's line of products (not just soda, but also super-popular snacks like Gatorade and Doritos) ride a terrific distribution system to corner stores and supermarkets all around the world, where consumers snap them up in good times and bad.

PepsiCo has steady income from millions of loyal customers, a fine dividend, and even some growth with new brands and in emerging markets -- all of which makes it (and other stocks like it) a great stock to buy and put away for the long haul.

Automakers aren't like that, because buying a car isn't like buying a bag of chips. Automakers are cyclical -- like their sales, their stocks rise and fall with the ups and downs of the economy. That's because auto sales rise and fall with the ebbs and flows of consumer confidence. Why? Think of it this way: If you're not sure you're going to be employed next month, you don't buy a new car.

Automakers have very high fixed costs: All those factories, all those specialized manufacturing machines, all those labor contracts add up to very big numbers. Companies like General Motors (NYS: GM) need to sell a certain number (and not a small number) of cars and trucks just to break even. GM's CEO, Dan Akerson, has said that GM will now break even as long as the annualized U.S. auto sales rate stays above 10.5 million -- the level one would expect at the low point of a deep recession.

As of last month, that sales rate was running around 14.5 million. The difference between those two numbers is the difference between solid profits for GM, and no profits at all. And that means that a bet on GM, or any other automaker (or any other cyclical company), is -- at least in the near term -- a bet on the direction of the economy as well.

Factor two: The single best predictor of an automaker's prospects
What is the big factor driving Ford's (NYS: F) amazing turnaround? Why is Toyota (NYS: TM) an instant contender in any market it chooses to enter? For that matter, what is the one single factor that will either ensure Tesla Motors' (NAS: TSLA) success -- or trip the company up as it nears the finish line?

The answer in each case is the same: product. I was pretty sure that Ford's turnaround was going to work out well even in the dark days of 2009, because the company's newest cars and trucks represented huge improvements over what came before -- and were surprisingly competitive with key rivals, many of whom seemed caught off guard by Ford's leap forward. Likewise, Toyota's simple value proposition -- good quality transportation with top-of-the-heap reliability -- turns out to be just as appealing to Chinese buyers as it is to Japanese and American ones.

Of course, this cuts both ways: For all of Tesla's brilliance to date, it will not succeed as a long-term proposition if its new Model S sedan doesn't stack up well as a day-to-day proposition against the gas-powered luxury sedans it's angling to replace.

So what makes a car or truck "good?" Lots of things, ranging from styling, to handling, to its features list, to the quality of materials used in its interior, to -- yes -- its standing in the all-important Consumer Reports reliability surveys. As an investor, you can judge these factors to some extent by reading reviews -- and, to some extent, by going down to your local dealerships and test-driving a few cars.

But, it's important to judge, because the competitive standing of an automaker's product is, I believe, the single biggest predictor of the company's success. Here's why: Best-in-class vehicles can get premium prices. Also-rans need lower prices, and often added discounts -- those cash-back or cheap-financing "incentives" you hear about in TV ads -- to sell.

All big automakers use incentives to some extent. But over-reliance on incentives (or cheap starting prices, or both) erodes margins. That in turn leaves less money to invest in the next generation of products, and that leaves the automaker another step behind its top rivals.

In a nutshell, that's the story of the decline of Detroit -- and much-improved cars and trucks are the story of its renaissance. But, even today, when all of the automakers have upped their product games significantly, it's not too hard to tell which automakers are set for success and growth -- and which ones are likely to fall behind. Just drive the cars.

Ford's stock has been under pressure lately, dropping to levels not seen in a few years. But, the company is still performing very well at home and is investing heavily for growth abroad. Have these short-term pressures created an incredible buying opportunity, or are there hidden risks with the stock that investors need to know about? To answer that, one of our top equity analysts has compiled a premium research report with in-depth analysis on whether Ford is a buy right now, and why. Click here to get instant access to this premium report.

The article 2 Big Things You Need to Know About Auto Stocks originally appeared on Fool.com.

Fool contributor John Rosevear owns shares of Ford and General Motors. Follow him on Twitter at@jrosevear. The Motley Fool owns shares of Ford. The Motley Fool owns shares of PepsiCo, Ford, and Tesla Motors.Motley Fool newsletter serviceshave recommended buying shares of General Motors, PepsiCo, Ford, and Tesla Motors.Motley Fool newsletter serviceshave recommended creating a synthetic long position in Ford. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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