Detroit Auto Rebound: Too Far, Too Fast?

US News

The U.S. auto industry is starting model year 2014 flying so high that one of the most burning questions may be whether the hot new electric Tesla will overtake Porsches and BMWs as the coolest car on Route 101 in Silicon Valley.

That's a near-total reversal compared with five years ago, when the talk was about which of the biggest U.S. carmakers would disappear first. Since that time, the industry has managed to both cut costs and boost quality ratings.

"All the big carmakers are doing well now with their respective strengths," says S&P Capital IQ auto analyst Efraim Levy. "It's recovery that's lifted all of the boats."

The car industry's annual U.S. sales have nearly doubled from their low, and at 15.5 million are back to the level they were at before the start of the recession. Analysts predict more sales gains in the year ahead.

[Read: Can Detroit Come Back Again?]

Auto stocks have been one of the strongest-performing sectors since hitting bottom in 2008 when two of the Big Three - General Motors and Chrysler, but not Ford - required government bailouts. The Dow Jones U.S. Automotive Index is up 26 percent so far this year and 90 percent over the past 52 weeks.

But concern is growing that stock prices have sped past the limits of earnings and sales growth for the foreseeable future. To be sure, the industry is crowded with competitors, and is still captive to economic cycles like any mature industry tends to be. Interest rates are rising and buyers, especially younger ones, continue to struggle with debt despite car financing rates that are among the cheapest in history.

The surge in car stocks "is a function of the recovery and their performance is consistent with that," says Annie Rosen, the portfolio manager who recently took over the Fidelity Select Automotive fund, which is up 32 percent year to date and 60 percent over the past 52 weeks. While few expect the automakers' sales to keep accelerating as they did in the recovery, the industry's pared-down costs mean that even small sales gains will boost profits over the next few years, Rosen says.

"The really amazing thing that has happened in the auto industry has been a massive reduction of excess capacity in North America," she adds. The car race is now focused on which company can produce the average car at the lowest price.

The cars themselves are getting better, too. That "average" low-cost car no longer means low quality, says Mike VanNieuwkuyk, executive director of global automotive at J.D. Power and Associates. "We have more manufacturers delivering strong quality, particularly in the area of defects and malfunctions."

In a sign of how narrow the quality gap has become between American carmakers and foreign rivals, one-time laggard GM topped Toyota for the first time this year in the J.D. Power and Associates Initial Quality Study for 2013 models.

[Read: Why Global Funds Are Buying America Now.]

"The vehicles we review and list get better and better," says Bill Swislow, chief information officer of auto site Cars.com. "That's in terms of safety, reliability, efficiency and features. While there are still quality hiccups, the gap between the best and worst cars has been closing."

That's made Detroit cars more competitive, even as the city fell into municipal bankruptcy this year. For the first time in 20 years, Automotive News reports, GM, Ford and Chrysler all gained market share during the past three years. Indeed, capping the recovery, Chrysler is again a full-fledged member of the Big Three after years of European ownership. It accounts for most of parent Fiat's sales, and there is talk that its common stock listing may move back to Wall Street.

A mixed view on what's next. But with a recovery confirmed, the industry faces a turn in the road. Car sales are reaching the upper limit of demand potential based on population growth and the rate at which cars are scrapped. That figure is estimated by industry sources to be 17 million. Sales are expected to be 15.5 million this year, and 16 million next year.

There is also worry that more people are hanging onto their cars longer than ever, in part because of improved manufacturing quality. Industry researcher R.L. Polk & Co, which tracks car market trends, says the average car on the road is 11.4 years old, the highest ever. This number has remained stubbornly high despite the waning recession, which usually leads to a contraction in average car age. Today's average is well above the 8.5-year norm in the 1990s, and Polk expects it to keep rising.

More bullish analysts see the aging of cars on the road as an indicator that many more owners will be looking to replace their cars. "People are being attracted by new features and new products," Rosen says. But some see buyer reluctance more as a reflection of debt, especially among cash-strapped younger potential buyers worried about college debt. Rosen says there has been a rise in buying by young adults, but it still lags levels from past industry recoveries.

[See: 10 Signs American Families Are Falling Behind.]

That may mean faster growth in other parts of the auto industry. Rosen says her fund is looking for new growth areas, such as parts suppliers that can play a role in meeting safety or pollution rules. She also sees the chance for gains in a global car industry that has lagged the U.S. market. (Fidelity fund managers do not issue forecasts or name individual stock picks.)

"Even though the industry is in good shape, it's harder to get enthused about the car stocks right now," Levy says. "We've given some downgrades recently, but they are based on valuations, not fundamentals."

Levy rates Ford and Toyota as "buys," but GM, Nissan and Honda as "holds." Outside the car-manufacturing sector, he has a "strong buy" rating on parts maker Johnson Controls and "buy" ratings on TRW, Lear and Goodyear.

Companies that make the "content" that goes into autos are the stocks to look for, Rosen says, since traditional quality improvements are less likely to give anyone a meaningful edge in basic car performance.

Now the competitive question is who will create the most impressive (see Tesla) and least-glitchy interactive technologies, Levy says.

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