The Ultimate Value Trap

One of the lessons I learnt as a young value pupil was to take note of my surroundings and learn to view investing with a slightly different perspective. One lesson taught to me by Charles was an insight that investors are often “far too eager to discuss their investing successes than they ever will be in talking about their failures” and this should serve as an important lesson for where my investing education should build its foundation. For all the individual successes I’ve studied of various investors, I’ve examined a greater amount which have failed. It’s easy to label Warren Buffett as the most successful investor of all time, but very few ever consider or study his mistakes and what we can learn from them.

My Value Rules serve as a reminder of all the successes and failures that I’ve studied, learnt from and experienced in business. While they don’t guarantee success, they serve as a template and instructional tool for evaluating an investment from a number of different perspectives.

In my Taking Stock in^TM series I discuss companies that I invest in that hold a number of value criteria or Enduring Value characteristics. These posts might be a great teaching tool for readers about investing, but do they help identify companies that are of less or no value? What would a post in that series look like if I analyzed a company that I wouldn’t invest in? I discuss the impact of competitive advantages for companies, but what about a competitive disadvantage?

My post today is to discuss my pick for The Ultimate Value Trap: General Motors (GM).

It’s no surprise that in recent years GM has had some difficulties in a number of areas…well, a lot of areas. When you examine the company, not only is a value stimulus difficult to find – it’s possible that none exists. I won’t speculate on the recent rumours of potential bankruptcy, there is amble evidence at this time that the company is in some serious trouble.

When I examine investor activity in GM over the past four years, I encounter what I like to call a Value Investor Casualty List. The list includes a number of value oriented investors who currently hold or have held GM shares in the past few years.

The most dedicated of these value investors was Irwin Michael who held 360,000 shares in three of his ABC Funds at an average cost of $56.95 per share. After a loss of over 80% on the original value invested in the company, it was shared with fundholders on July 4th that ABC had liquidated all of its shares of GM that were held in the three funds. Other investors who have been burned badly on GM include David Dreman, Dodge & Cox, Brandes Investment Partners, Kirk Kerkorian and Bill Miller of Legg Mason Capital Management.

Investors know that GM has obliterated billions in market capitalization, that its shares currently trade near fifty year lows and that the number of manufacturing jobs that GM has cut or indirectly caused is in the tens of thousands. But I’ll take a different route and look at the qualitative side as I go through a brief history on GM to identify what warning signals should have been appearing to investors as the troubles began to brew.

It should be no surprise to an investor that GM has a history of missteps by management, massive pension obligations to its retirees, an expensive workforce, far-sighted union leadership and too much inventory. Still, many value investors were seduced by a high dividend yield in a company with consistent payouts, low P/E and P/B ratios, a long-standing member of the Dow Jones 30 and operating within an industry that provided predictable cyclicality.

With 15% global market share as the largest automotive manufacturer in the world, investors saw the competitive forces at work and made assumptions that earnings growth would return as the financing division of the company (GMAC (GMA)) performed well by providing consistent earnings over the interim. Add that the company’s CEO Rick Wagoner was buying shares and the stock looked to be mis-priced and undervalued. But remember back to how I organize my information on a stock: the situational analysis: SWOT & PEST.

What’s missing? What important or unseen factors have been overlooked or ignored?

Whether intended or not, it appeared that no one recognized or heavily discounted some tragic flaws in GM. For years the company had been paying its unionized employees wages and benefits well above what would turn out to be competitive and realistic levels. Through various negotiating means, union leaders created an ability to collectively wrestle the Big 3 into lucrative union packages where no one bothered to compare wage levels with those of similarly qualified workers in industries such as healthcare, education or other manufacturing sectors.

In 2005 came what the market generally expected with the rating cut by Standard & Poor’s of GM’s corporate debt, over $300B worth, to junk status. S&P at the time made the following comment, “The downgrade to non-investment-grade reflects our conclusion that management's strategies may be ineffective in addressing GM's competitive disadvantages.”

By 2006 investors watched diligently as management cut the dividend by 50% (its first since 1993), cut benefits of salaried workers and made cuts to executive pay, including trimming Wagner’s annual wage by half. In Q4 of 2006 profitability returned to the company, the shares appreciated more than 35% from their February low and reached a high of $42 in late 2007 despite some moderate write downs. Through all of this, investors had missed some of the most crucial flaws of the company: management's inability to address the most pressing issues.

For years GM and its employees had enjoyed the benefits of high demand for its even higher margin SUV products, and the impact from the US housing collapse and later credit crisis was finally felt and brought GMAC to its knees. For too long GM’s management had been swimming without any clothes on and when the tide went out, as Buffett might say, it wasn’t a pretty picture. GM went to the UAW & CAW and got concessions for a two-tier wage structure that would drastically decrease their costs of labour and created a UAW controlled VEBA that took $51B of retiree medical benefits off GM’s books in addition to offering a staggering number of buyouts to many of its senior unionized employees.

After all of these events, investors are still left asking themselves, “Does GM offer value today?” GM currently trades at a yield that hovers near 10% (assuming there’s no cut), trades at a significant discount to its value a few short years ago and at some point an investor might assume that its assets that are worth something. The difficulty of looking at a company like GM is that it still feels like a Value Trap even after already catching a number of investors. GM has now taken drastic measures with plant closures, more buyouts of employees and reorganization of their retiree obligations to cut costs, but will it be enough?

To put all this into a better perspective (The Big Picture) let’s look to just four of my Value Rules for some insight into why I wouldn’t invest in this company:

• Importance of Brands
• Do What You Do Best
• Strategic Management
• Never Compete on Price

In the past decade GM has sold automobiles under the brand names of Buick, Cadillac, Chevrolet, Daewoo, GMC, Holden, Hummer, Oldsmobile, Opel, Pontiac, Vauxhall, Saab, Saturn…Neptune…Pluto…get the point? Not only are there too many product lines in this company, but there’s overlap and duplication that borders on insanity; it simply doesn’t make economical sense. The Silverado & Sierra are the same vehicle. The Yukon & Tahoe are the same vehicle. The Solstice & Sky, Cobalt & G5, etc., are all the same vehicles. The only differences between them are a few changes to the trim, logos, interior, options and where they’re sold. Instead of doing one or two things as best as the company can, it’s done a lot of everything and lacks a core focus.

The core focus for GM’s management is best defined by three letters: S, U & V. For years now GM has gotten fat on the SUV and its manufacturing infrastructure is largely built on high margin, large framed vehicles. It has developed little in the way of innovative products that consumers want and has done an even poorer job of forecasting future consumer demand and perceptions. It does sell a lot of vehicles, but it also runs on a very dangerous structure of competing on price.

We’ve been here before but to summarize there are few serious problems with this approach. Once consumers get in habit of getting cheap, they expect cheap or want cheaper. Consumers to some degree make comparisons among similar products and can associate quality with a product or service of a slightly higher price. When you compete on price and your competition can make the same product cheaper, you’re dead in the water. Your competition will simply match your price, get fat off the higher margins, wait to take you out for next to nothing or let you self-destruct.

To make a comparison, Toyota (TM), GM’s top competitor, has only two brands: Toyota and Lexus. In each product category the brands have only one product offering and management focuses intently on consumer needs, demands and expectations for each product. Toyota spends a lot of time on market research, connecting with customers and its repeat purchases from existing Toyota customers are top in the industry. Walk onto any Toyota lot today with the expectation of competing on price and you’ll be quickly disappointed. Toyota doesn’t want to compete on price because it doesn’t have to. A company still has to remain competitive, but Toyota’s products are in high demand, it has limited excess supply and the cost of its workforce is a fraction of its competitors in GM, Ford (F) and Chrysler.

When you’re a lower cost producer and the competition decides to compete on price, your margins will speak for themselves. Not only is Toyota gaining market share, but it's making money, investing in its infrastructure and making inroads into product categories that have been dominated by the big 3 for decades. Add in high energy prices and consumer demand for more fuel efficient vehicles and the comparison quickly tips in Toyota’s favour.

While GM closes plants, Toyota continues to open more. When GM makes cuts to its R&D, Toyota expands with new product designs and technologies to meet higher demand. If product quality, price and all other comparisons are equal, Toyota will come out ahead based on its ability to make money and its positioning.

General Motors might appreciate significantly from here and an investor might assume that at this valuation the risk/reward premium is heavily weighted in his or her favour. But I would encourage any investor looking to invest in a troubled company to consider a few of the points I made in this post and to ask himself or herself if any of them apply. History does repeat itself and there are always exceptions, but generally in business you’ll find that managers run into corners more often than you realize.

Disclosure: No positions.

Comments

[JasonC:]

Good, fair, hard hitting article.

The one other point I'd make for value investors as a discipline to spot value traps is to look at where a company's debt is trading, and honestly ask yourself whether the common can outperform the debt, if the debt remains entirely sound. GM flunks this test, and so do many other classic value traps. (Which isn't a recommendation to buy GM debt, incidentally).

2008 Sep 16 01:16 PM

[Joey:]

GM's stock was $55 when Clinton left office and Ford's stock was $17.47. Now, GM's stock is less than $11 and Ford less than $5 per share under the Bush Administration. If we had all Democrats in the White House, Congress, and Senate, there would have been fuel efficient standards in place and the auto companies would not be in the mess that they are in today.

2008 Sep 16 01:43 PM

[Chris B:]

I agree with everything the author said except one point:

GM has to sell on low pricing because their products are generally inferior and consumers aren't demanding them. The damage to their brands is not due to selling at bargain prices, it's due to the fact that the average GM vehicle needs major repairs within 100k miles. The depreciation of used GMs is due to the perception that they are unreliable. That's why GM's 10-year cost of ownership is actually higher than their more expensive competitors.

I'm not saying this to rile up GM fans, and I'm certainly not promoting any car. Nor do I care about your personal car that acheived xxx,xxx miles. My point is that companies that produce low-quality products or services are eventual value traps. Value investors: consider the product or service. Does it make economic sense?

Look at Microsoft. They have been making an inherently unstable, inherently insecure, and inherently bloated operating system for years, and charging out the nose for it. Competitors with superior products are continuing to innovate and perfect their products, and can easily beat MSFT on pricing while delivering a better product. To me, MSFT today looks like GM in 1977, and Vista is the El Camino Deluxe.

2008 Sep 16 02:35 PM

[Miken:]

A couple of corrections:

1. Toyota has three brands: Toyota, Lexus and Scion (you know the ones that look like kitchen appliances in which you burn bread).

2. The UAW is not far sighted, they have succeeded in killing themselves. As recently as five years ago, they had over 200,000 GM members...they now have less than 60,000. If the UAW were so far sighted, why are all of the U.S. based car maker importing more and more vehicles?

3. Have you noticed that the current set of GM leadership has removed more than $9 billion in structural cost? The current issues are not the fault of the current team. At the same time launching acclaimed vehicles such as Malibu, Aura, Enclave, Hybrid Tahoe, etc.

Since the author is Canadian, I suppose it seems to him that GM is still a high cost producer. Canada has taken over as the most expensive place in the world to manufacture cars.

I think I'll take my investment advice from someone other than a nurse (no offense to nurses, you perform a great service to humanity, but investment advice is simply not one of them).

2008 Sep 16 05:57 PM

[Brad Ferris:]

Good responses.

Miken - in my submitted draft I did include all three brands of Toyota and why this was edited back to my original article I can't say. Maybe editors choice?

Any reader is welcome to question my advice or insights, but my business fundamentals are sound as I completed a business degree from Wilfrid Laurier University prior to going back to school for my BScN. I've had consulting experience both in Canada and abroad and do more than just change dirty diapers when in a hospital.

2008 Sep 17 08:49 AM

[Mister Jimmy:]

Nurse Brad, you fail to mention facts such as the Chevy Malibu beating out both the Accord and Camry in the JD Powers initial quality survey, or that the Cadillac CTS was named Motor Trend Car of the Year this year (GM had 3 in the Top 10, Toyota had zero), or that GM is close to introducing the world's first high volume production fully electric car, The Volt. No, to you, GM is "not competitive". Now go give someone else an enema, would you.

2008 Sep 17 12:36 PM

[bill d:]

Great article and all the comments are also except for idiot Joey.
I would add Honda to probably the best of the bunch.
I own all American except for a 68 VW for short trips.

2008 Sep 17 01:58 PM

[tedstr:]

Great article. Motor Trend or otherwise, GM does not make a product that is competitive. Period. Anyone who thinks any of their cars stand up in either perception or reality to any Japanese or german car is in denial.

The Volt will be a dollar short and a day late. The only play here is that gas goes back to $70-$80 and SUVs return. Happy days are here again. Unfortunatley, a good chance that this is already underway.

The best way to stay away from value traps is to simply start with the top line. If your products aren't selling, no amount of cost control or financial acumen will save you.

2008 Sep 17 04:31 PM

[Billwzw:]

American economic history is full of once-great companies that have died, partly due to strong unions, and partly due to changing economic circumstances. GM is one of these and may well go the way of the railroads, steel, shipbuilding, newspapers, airlines, etc (and now financial houses)

The analysis of GM shows the WISDOM of the UAW, who has collected many plums while the shareholders got coal. Like all unions the UAW is run for the benefit of it's CURRENT workers, not it's future workers. So a deal to take 50 billion out of the company to guarantee benefits for current workers at the cost of the company's future makes sense from their point of view if not Miken's. So if the company goes under the union can honestly say that they got theirs (and the heck with the shareholders).

The highly cyclical automotive industry has a lot of negatives not mentioned in the article - for example it is one of the most regulated industries, has huge capital demands, has long product implementation periods, and currently has too many players (some of whom are government supported). GM's current management has done a better job than many in the business and they have made great strides to address the legacy issues. But that doesn't make the company an attractive investment. The entire industry is questionable.

I refer you to Warren Buffet's comments about airlines and propose that the auto industry is more of the same.

2008 Sep 18 03:18 AM

[imnotadoofus:]

In my life I have only bought one foreign vehicle, a Volvo, which was ultimately bought by Ford. Its periodic repair bills were expensive in the extreme, which I attributed to the fact that the dealer felt that his franchise was superior. Other than that one time (although I inherited my father in law's 1961 VW) I have stuck with GM, from a 1957 to a1966 and a 1972 Impala which I still own. Currently I own an '05 Buick SUV and a '90 Sierra pickup. Both have had excellent repair records and except for minor problems, such as lights going out, I go to the dealer for oil changes and periodic maintenance requirements.

A happy GM car enthusiasts.

2008 Oct 11 10:01 AM