- 6 rules value investors should master.
- Psychological factors that influence investor decisions must be taken seriously.
- Overview of GM and why I am long despite current situations.
Ever since the IPO of General Motors (NYSE:GM) in 2010, the market capitalization has been on a roller coaster. Fundamentally causing this roller coaster ride is nothing short of investor irrationality at its finest. Surely some still believe in modern portfolio theory; however, one should get a kick out of all the sentiment and emotional behavior of investors in GM the past few years. I highly encourage investors to take a deep look at their own emotions and attitudes toward stocks they own and don't own. Being less emotional and shedding off a little ignorance may add more than just a few percentage points to your annual returns. Below I present several instances where investors can reflect and learn from other's mistakes to help influence better decision making in the future. Most of the examples are in hindsight and I do my best to keep that in mind; however, the principles of each scenario merit continued practice to become a better value investor.
Let's start at the end of the old and beginning of the new GM. The government had to bail out GM and wiped out all previous shareholders during bankruptcy. This was a travesty. How a government can wipe out shareholders like that is beyond me and quite frankly a sad circumstance to all previous investors who got nothing of the new nimble and improved company. Coming out of bankruptcy and onto the IPO plans with major changes to its liabilities and cost structure, GM was in effect a fresh egg ready to hatch. The IPO hit, media galore, and opinions both outlandish and rational swept the investment landscape. As things usually go with a hot and public IPO, GM soared to a high of around $39 during 2011. Most of this was due to improving outlooks in the North American market and the return of profitable quarters. What was not foreseen was the European debt crisis and dwindling enthusiasm for the North American market. A little too much froth if you ask me, and then around August of 2011, GM was hovering over $20 a share.
Rule #1: If projections, forecasts, and sentiment are very rosy and positive, you're paying for that as well along with the stock. Tread carefully…
Once you dived down and figured out why GM was valued round $20 a share, one could realize the market had taken a complete 180 degree turn in their sentiment and outlook for GM and the industry as a whole. GM was in the midst of a couple expansion projects in North America, Russia, and China and preparing to undergo a large scale product refresh that had been put on hold during the recession. The industry was ripe for a comeback and auto sales were quietly picking up pace in a sluggish, but improving economy. Europe's overcapacity problems and restructuring costs were going to take years to fix to regain profitability. Wall Street didn't like that and the share price reflected such sentiment. Then, there were the investors who continued to label GM as Government Motors. Completely reluctant to shed off some ignorance and look at the value GM could offer for a long term investment. The earnings potential of GM the next few years greatly outweighed the risks facing the company; except for one major unforeseen risk.
Rule #2: When projections, forecasts, and sentiment drops and becomes negative, do not join the crowd. Seek answers and find out why it is undervalued and if those reasons are justified. If those reasons are not justified, take action.
Fast forward to the beginning of 2014 after a robust gain the equity markets, GM soared to an all-time high above $41 a share. We were back at rule #1, with investor sentiment, Wall Street analysts, and prominent hedge funds very jubilant and sporting rosy forecasts. One is not to sell here, fundamentally the company was delivering strong earnings and poised to do so with North American and China markets doing very well and European car sales beginning to stabilize and improve. Value investing requires patience and temperament. Patience to wait for opportunities to present themselves and temperament to not join the next gold rush. What happened next is a prime example of why every investor should invest with a margin of safety. When GM issued its first round of recalls and started the ignition switch investigation, investors were reminded first-hand the offshoot risks of owning an automobile company and how much Wall Street fears lawsuits. Now these recalls are going to cost GM billions of dollars and several lawsuits are still being challenged in court. If civil and class action law suits are allowed to continue and set trial with GM, then one can expect one dramatic drop in GM sentiment, earnings, and financial position. If this scenario plays out, then one will be able to take advantage of severe depression in GM shares sometime in the future and determine if indeed those fears justify the anxiety in the stock. Wall Street likes to overreact and be irrational at times. The odds of that happening are must be calculated and must be weighed against the potential returns GM offers today if held for a long period of time, say over five years.
Rule #3: Always invest with a margin of safety.
There have been various articles and publications suggesting GM is well below their intrinsic value. I would argue that like major banks facing low interest rate margins, regulation costs, and legal expenses, earnings power can one day be much higher than it is today. Mary Barra is all about cars and knows who buys cars and what they want in a car. Even Warren Buffett has commented on Mary Barra and called her "Dynamite." Although GM is not nearly as cheap as it was a couple years ago, it still is fairly priced and could potentially offer strong returns in the next 3-5 years. Buying today with potential legal and warranty expenses; however, warrant a sound investor to be ready and willing to buy more if it becomes cheaper without any major fundamental changes to the company. Additionally, management has been very prudent at managing capital and being shareholder friendly. They have eliminated the U.S. Treasury stake, reduced dilution though preferred stock purchases, and instituted a dividend.
Rule #4: Invest in a company that will be a lot more valuable 5 or 10 years down the road.
There is always comparisons to Ford (NYSE:F). Unlike GM, Ford didn't get the benefit of ridding itself of major liabilities and legacy costs. It took on a mountain of debt and financed itself with the help of the government keeping Chrysler and GM afloat. Little unfair yes, but competitively, Ford sold off brands that have still performed well and stuck trying to restructure Lincoln. Buick is heads and shoulders above Lincoln, and Cadillac has pristine quality and reputation. Restructuring a car brand is extremely difficult and expensive. Additionally, Ford relies heavily on its F-150 for operating margins and cash flow. GM has strong cash flows from China, its luxury brands, and North American operations. GM is more diversified and diversification in the auto sector deserves attention. Let's also not forget the significant position GM has in China that is paying huge dividends currently. GM is also reducing their pension cash injection requirements and lower legacy costs. Taken together, GM has superior free cash flow generation abilities than Ford. Ford is heavily investing in China, still on the hook for billions on pension and legacy costs, has a dual class share structure that favors dividends over share repurchases, and high debt and interest burdens.
Rule #5: Mr. Market doesn't care who is treated fairly or not, if a competitor is at a disadvantage, then see if it is a competitive advantage for the company or business of interest.
Finally, we all know Berkshire Hathaway owns a fairy large stake in GM. The owner of the stake is Ted Welsch. For reasons we will never know, he bought GM in 2011-2012, sold early in 2014, and bought some in mid-2014. Be careful of conformational bias and perceived justifications for owning this stock because of this. Remember, one must do their own due diligence and understand why it was undervalued when they bought it. If you fall asleep at the wheel, no pun intended, you can miss a warning sign and get yourself in trouble. Charlie Munger, the Vice Chairman of Berkshire Hathaway has been very adamant of not owning GM for a long time. Electric vehicles from China, legacy and liability costs of Detroit automakers, and past management carelessness have probably attributed to his thinking. I'm not one tenth as smart as him, but if I were an investor looking to buy GM today, I would be fully aware of all risks and rational expectations of your potential investment in GM thoroughly and as unbiased as possible.
Rule #6: Do not let conformational bias and follow the herd tendencies overcome due diligence and thorough research. Remember, these guys read over 500 pages of financial reports a week. Do you?
In summary, I would suggest for all investors to heed to these rules outlined here and see how they can improve your results. Controlling your emotions, shedding off ignorance, and working hard will produce solid results and a little luck on your side. You can get a pretty good feel for macroeconomics reading financial reports of individual companies. There is no need to focus on these factors; however, when they create opportunities in the market please take full advantage of them. I am long GM and believe that the mess Mary Barra inherited will take time and money to sort out; however, over the long term I believe GM will be a more valuable company in the future.