The new General Motors will be turning three years old in early July. GM’s rocky childhood has given evidence to what disadvantage small investors are at when it comes to making educated equity investment choices. Let’s look at some of the lessons to be learned from one of history’s largest busted IPOs (along with the recent Facebook debacle) and consider the current underreported risk factors.
Let’s start by realizing that the single best indicator of how “successful” and healthy a publicly traded company is would be the company’s stock performance. Professional money managers and those that control the majority of the investment capital in the world have the best insights into how profitable a company is likely to be in the future. When big investment houses underwrite IPOs like GM or Facebook, it is likely that the shares will get positive ratings once the quiet period ends since those giving the ratings have a vested interest in seeing the newly issued shares perform well. Media sources help spread propaganda well before the IPOs go off, as seen with both GM and Facebook. But when the stocks start trading on the open market and share price doesn’t match the hype, you know that those in the know are not putting their money where their mouths are.
Individual investors are further deceived by analyzing fundamentals and considering the data to be reliable barometers of a stocks value. As with any stock, GM trading at such a low forward P/E ratio is most likely an indication that expectations have been overstated and risks understated. If there is one thing that both GM and Facebook teach us, it is that it is wise to be skeptical and consider a contrarian view when there is an abundance of rosy projections.
Let’s move on to those understated risks for GM. While TV networks that receive big advertising bucks from GM give an optimistic view of the company (note the difference in Facebook coverage), those that control the wealth obviously must be aware of the downside. I warned of these risks here in March of 2011 when GM shares traded at $31. Shares have declined about 30% since then. Around that time, the Obama Administration could have begun the process of exiting its taxpayer-funded stake in GM. Treasury’s stake has seen an approximate $5 billion loss in value since then (and they criticize JPM for risky trades!) as the awareness of the hazards for GM grows.
UAW and pension obligations remain tops on the list of GM risks. Pensions are under funded by about $25 billion. This number would have been worse if GM did not manage to get an unusually high return on pension investments of 11% in 2011. Future returns are not expected to be as high as GM stops whatever risky trading strategies they used to achieve the 11% return. The company will be spending up to $4.5 billion just to relieve a small portion of the burden. This is not a problem that is going away any time soon and GM did not greatly improve the situation during its bankruptcy process that saw UAW interests protected.
It is also clear that the UAW will want a major cut of any future profits at GM. In an industry that is very competitive, GM will continue to be at a disadvantage. UAW workers have every right to receive fair pay, but profit margins for GM are never likely to reach the rosy projections that GM has made while labor costs exceed that of the competition. Future UAW gains will be GM shareholders’ losses.
Other risk factors remaining have not changed since the writing of my original piece. Competition is fierce putting constraints on pricing power, Obama-appointed management is still questionable, Europe is a mess and GM still does not have an established captive finance arm capable of handling all of its needs. Government-owned Ally Financial’s future contribution to funding car purchases and dealerships may be at risk, particularly if Mitt Romney wins the election in November. Any financial downturn in the markets would put GM in a precarious position, especially if credit becomes harder to find.
Heavy dilution is also likely in a scenario where Romney is elected. The political reasons for Treasury holding GM shares will be gone and Romney has indicated he would not continue the folly of the current market-timing strategy that sees taxpayer funds put at risk. In addition to the dilution caused by the sale of government’s share, GM may need to offer more shares in the future to fund its pension obligations, a trick that they have quietly pulled in the past.
Of course, macroeconomic factors are the most important determinant for any auto industry player. The industry is cyclical and highly correlated to the general economic environment. Those pundits that are bullish on the sector point to auto sales returning to “normalized” levels as the economy improves. Besides the fact that the economy may not be improving, it is questionable what “normalized” auto sales are.
The perception that the US auto sales rate seen at its highs of around 17 million per year is obtainable in the near future is debatable. Pent up demand may not be as high as believed to be. Cars are lasting longer and the drivers of past sales (primarily loose credit, high home equity and a stronger economy) are no longer in play. Car owners have been borrowing more at longer terms, a condition which leads to potential new car buyers being “upside down” on their trade-ins, discouraging the purchases of new cars. Credit is currently fairly loose and we may be at “new-normalized” sales at the current 14.5 to 15 million a year. And any downturn to the economy can see that number fall.
GM and its media friends point to China as a driver for future profits. China is far from being the main source of profits at GM and may be the riskiest area as the Chinese economy continues to slow. Hoopla about Chinese sales at GM along with false claims of great potential for vehicles like the Chevy Volt as US market share declines only lead me to be more suspicious that there is underlying weakness at the company.
The fact remains that the markets have not bought into the GM hype. Individual investors should be aware of the risks when they see “market masters” like allegedly corrupt hedge fund guy and former Car Czar, Steve Rattner, implying on a major financial network that GM is a sure bet to increase in value. As with any speculative and cyclical stock, it is not a given that GM shares will be trading at higher levels in the future. At the worst, an eventual second bankruptcy is not out of the question, despite what you might hear from the politicians and so-called experts.
Mark Modica is an NLPC Associate Fellow.