Most of the time - markets are efficient. Companies are priced based on their forward looking revenue generation and on the strength of their current balance sheets.
But that's not always the case. At times, Mr. Market greatly misprices certain securities thereby resulting in an enormous discrepancy between underlying value and quoted price.
I believe that such is the case today with General Motors (GM).
It seems that investors have fallen in love with the largest automaker in the world. Since Mid 2012, shares have climbed by an astonishing 175%. It's almost as if everyone conveniently forgot that the ailing automaker filed for bankruptcy only three years ago. Take a look at the chart below.
And when investors are that excited, you can always count on various rating agencies to support them and give them the "thumbs up" precisely at the wrong time. Only recently, Moody's (MCO) upgraded GM's debt rating by two notches - to Baa3 - from Ba1. This will definitely make it much easier for the car behemoth to refinance its heavy debt in the years to come.
There are some good reasons for this warm embrace from shareholders and rating agencies. For one, there's a strong bull market in auto sales going on right now. In fact, U.S auto sales have just hit 16 million per year, which is just 6% below the peak of the housing boom. That's highly impressive.
In addition, people are now willing to spend more money for a new car. According to TrueCar.Com, the average price per car is now $31,125 - a rise of more than $2,300 in the past three years.
But you can't trust the stock market to make the right investing decisions for you. You have to do your own homework. Judging GM by its fundamentals tells you a totally different story.
Flag #1: Stagnant net income
GM's net income applicable to common shares have barely risen since 2010 (!). Three years ago, GM generated net income of $4.67 billion. It's now generating only a bit more - $4.86 billion.
The main reasons for this are heavy competition from the global auto industry and the company's own staggering interest payments on the debt it owes to the U.S as well as the Canadian governments.
Surprisingly enough, this has not stopped the "General and Administrative" provision in the income statement from advancing at a rapid clip. Back in 2010, the company paid its employees and management a total of $11.4 billion. This amount rose to $12.1 by the year 2011, and to - $13.6 by the end of 2012.
It seems that the employees at GM aren't directly affected by the stagnant net income of the company. They're well compensated either way.
Flag #2: Shrinking profit margins
In the first six months of 2012, GM had automotive revenues (cars sold) of $74.5 billion from which it made an operating profit of $2.8 billion. This translates to a lowly profit margin of only 3.75%.
But the numbers are quickly deteriorating. In the first six months of 2013, GM had automotive revenues in the same amount. But the operating profit shrank by 28% to $2.1 billion. This resulted in an even lower profit margin of 2.8%. Apparently, costs have been on the rise but GM hasn't been able to pass these costs on to the customers.
Flag #3: Heavy financing
GM has to compensate for its razor- thin profit margin by booking heavy sales volume. And the quickest way to increase sales volume is to loan money to eager auto buyers.
The artificially manipulated short term rates are obviously helping automakers. Car loans, which normally have a 3 to 7 year duration have declined substantially thanks to the Fed, and have made cars much more affordable to the public.
But GM has taken it to the extreme. The company's loan book has ballooned to over $11 billion (!). Even if only a few percent of these loans will evaporate - GM will be on the hook for billions of dollars. With more and more new cars flooding the roads, demand will at some point cease. The market will be flooded with used cars and the price of new cars will take a hike. People with heavy debt on their cars will simply choose to leave them by the road side rather than pay down the debt they own on them. That's an extremely risky financial exposure for an auto company like GM.
My final take
GM's stock has been riding the wave of a global recovery in auto sales and the artificially low interest rate for auto loans. But GM the company - has gone nowhere but downhill. Its profit margins are shrinking, its net income is stagnant, and it's highly susceptible to dangerous financing risk. Invest accordingly.