What's driving auto stocks?

Key takeaways

• From a legacy car producer abandoning most of the sedan market to electric vehicles charging up the ranks on consumers' wishlists, the auto industry looks like it is shifting gears.
• Pickup trucks and SUVs are increasingly dominating demand in US markets, while China (the world's largest car market) recently became the largest market for electric vehicles.
• Keep a close eye on margins in this changing investing landscape.

Do you have a new car, or have you been in one recently? Compared with the not too distant past, it might seem like the automobile industry has already been through a revolution. New car features used to include CD players, anti-lock brakes, power windows, and Bluetooth connectivity. Now, it's self-driving capabilities and other autonomous safety features, like lane control and early braking systems, aided by a proliferation of electronics—backup cameras, touch screens, pop-up displays, wireless charging ports, and more.

The auto industry investing world has also been undergoing massive changes as industry giants and relative newcomers alike traverse winding roads. Here's a look at the auto investing landscape and what you might expect.

Changing lanes

It's not just a new paint job. Here are some of the many engines of change that have been driving the auto industry:

• Ford's (F) recent announcement that the Detroit-based car producer will no longer offer sedans in North America (excluding its Mustang and Focus models), instead choosing to focus on trucks and SUVs.
• Tesla's (TSLA) Elon Musk taking control of production as the California-based company grapples with ongoing production issues to meet a glut of existing orders.
• Strict new laws recently passed by several national governments aimed at cracking down on emission-standard violations in the wake of German automaker Volkswagen (VLKAY) being hit with a $30 billion fine for its 2015 "dieselgate" scandal.

Pick up in pickups

Ford's decision to exit the sedan market, for the most part, was driven by changing consumer trends. "US consumers love their pickup trucks, crossovers, and SUVs more than ever, especially since their fuel-economy gap with sedans has narrowed," says Elliot Mattingly, portfolio manager of the Fidelity^® Select Automotive Portfolio (FSAVX).

Indeed, by 2022, 73% of all consumer vehicles sold in the U.S. will be trucks and SUVs, according to auto industry forecasting firm LMC Automotive. For Ford, the percentage is expected to be 90%, and for General Motors (GM), 84%.

"Pickups essentially represent the only segment where these US automakers make money," Mattingly notes. "In general, they lose money on sedans, make a little on crossovers, and take big profits on pickups."

As of May 31, Mattingly's fund was underweight Ford relative to its benchmark (the FactSet Automotive Linked Index), primarily as a result of disappointing earnings guidance issued early in 2018, as well as a fire at a supplier's facility temporarily suspending production of its iconic F-150 pickup truck in May.

"However, I am still optimistic about pickup sales longer term," Mattingly says. "As long as the construction industry continues to do well, I think truck sales will too. People working in these industries like and need their trucks."

Mattingly's fund was overweight GM, relative to the benchmark, as of the end of May 2018. It also held non-benchmark exposure to Allison Transmission (ALSN), which supplies components for heavy equipment.

Electric charge

The re-emergence of increasing demand for electric vehicles (EVs) is another force that may increasingly shape the road. While still representing a small percentage of the passenger car industry, many signs are pointing toward EVs becoming a more significant factor in the near future. A 2018 survey by AAA found that 20% of US consumers expressed an interest in buying an electric car, up from 15% in 2017.

Additionally, China—the world's largest car market—supplanted the US last year as the largest market for electric vehicles (see chart below).

Then there's Tesla, the California-based electric car maker that recently became the 4th largest auto producer by market cap, trailing only Toyota (TM), General Motors, and Honda (HMC), and just ahead of Ford—all of whom currently sell significantly more vehicles than Tesla. Much of Tesla's market cap is attributable to orders for its first mass production vehicle, the Model 3.

"A major source of momentum for electric vehicles has been cost, with battery prices dropping at a faster rate than many expected," notes Mattingly. "If this continues, cost parity between gas-powered cars and EVs could come in the next few years—which is much sooner than many analysts are now anticipating."

Still, the EV market represents a small—albeit growing—percentage of passenger car sales. Mattingly believes the next litmus test as to whether EVs can be both cost-competitive with traditional vehicles, and profitable for auto manufacturers, will be the margins Tesla can achieve on its Model 3 sedan.

"If Tesla is successful in achieving a mid-20s gross margin on the Model 3, this could accelerate the launch of EVs by other automakers," Mattingly says. This may spread to more higher-end models in the next few years, with Mattingly pointing to the expected 2019 release of the Porsche Mission E as an example—which can reach an 80% charge in just 15 minutes.

As of May 31, the Fidelity Select Automotive Portfolio held a larger stake in Tesla than all other automakers outside of General Motors and Toyota.

Car sales to speed up

Amid the shifting auto market, it's looking like another strong year thus far for car sales. Global auto sales of cars and light trucks are expected to increase 2.1% year over year to a new record high of 97.3 million vehicles in 2018, according to data from LMC automotive.

Historically, the auto industry has benefited from factors that help cyclical parts of the market—such as an improving jobs market, rising wages, and higher GDP growth. Currently, unemployment is below 5%, wages have risen (marginally) this year, and global economies remain on mostly solid footing.

With that said, there are reasons to put the brakes on being too optimistic about the auto industry. In addition to the potential for trade war tensions to negatively impact the auto industry, rising financing costs may increasingly become a negative factor for auto stocks if interest rates continue to increase. There are also specific risks for individual automakers (as Volkswagen’s dieselgate scandal underscores).

Autonomous driving

Longer-term, the potential widescale adoption of autonomous driving might be another revolutionary disruptor in the car market—although it remains to be seen if and how quickly consumers adopt autopilot capabilities, as well as the pace at which state and federal regulators/legislatures embrace autonomous driving.

"Fully autonomous vehicles (AVs) are very exciting, but I think they are going to take a long time to develop and fully affect the market and original equipment manufacturers," Mattingly says. "That said, we are already seeing a different sort of autonomous driving in urban centers. For example, GM, which acquired Cruise Automation in 2016, has announced a robotaxi pilot in San Francisco, spending a billion dollars on the program."

Other players in this space include Waymo, which has plans for a robotaxi fleet in Phoenix, and Aptiv, which purchased NuTonomy in 2017. "Commercial robotaxi rollouts are likely to happen in urban centers very soon, in my opinion," Mattingly notes. "I think companies like Uber and Lyft are the most likely to be disadvantaged, as their human drivers will no longer be needed."

New and used

These dynamics have the potential to impact not only the new car market, but also the used car industry.

"For example, when you look at the potential spillover effects of advanced driver assistance systems (ADAS), which describes the accelerating adoption of all kinds of safety bells and whistles, this could be a game changer affecting future trade-in and used-car values," Mattingly says. "Consumers are showing a preference for the latest safety innovations. Consequently, who wants to pay a relatively high price for a car without the latest useful safety equipment?"

As the auto industry evolves, both car consumers and investors alike may increasingly have new roads to navigate.