Beating the Street (36 page)

Phelps Dodge's mines and other facilities were in excellent shape. Unlike a computer company that must spend vast sums every year on new product development or to cannibalize old products, Phelps Dodge spends very little to maintain its mines. It's also better off than a steel company that invests a fortune on upgrading its plants, only to be squeezed by foreign competitors who sell steel for less.

No matter what happens to capital spending or its various subsidiaries, the fate of Phelps Dodge is tied to the price of copper. The basic math is as follows. Phelps Dodge produces 1.1 bilion pounds of copper a year (it says so in the annual report), so a penny increase in the price per pound creates an extra $11 million in pretax earnings. With 70 million shares outstanding, the extra $11 million in earnings is worth 10 cents a share after taxes. Ergo, every time the price of copper goes up a penny a pound, the earnings go up 10 cents, and if copper goes up 50 cents a pound, the earnings improve by $5 a share.

If people know what the price of copper will be next year and the year after that, then they automatically become geniuses on the subject of when to buy and sell Phelps Dodge. I claim no such prescience, but I thought copper was cheap in 1990–91 because of the recession, and I imagined it wouldn't be cheap forever, and I was certain that when it got more expensive the shareholders of Phelps Dodge would be the principal beneficiaries. All we have to do is wait and be patient and continue to collect the dividend.

Table 15-2. CONSOLIDATED STATEMENT OF CASH FLOWS—PHELPS DODGE CORPORATION

The autos, often misidentified as blue chips, are classic cyclicals. Buying an auto stock and putting it away for 25 years is like flying over the Alps—you may get something out of it, but not as much as the hiker who experiences all the ups and downs.

In 1987, I reduced my holdings in Chrysler, Ford, and other auto stocks that had been my biggest positions in the Magellan Fund because I sensed that the great car-buying spree that began in the early 1980s was about to end. But in 1991, a year into the recession, with the auto stocks down 50 percent from their recent highs, and with widespread gloom in auto showrooms and car and truck dealers playing pinochle to pass the time, I decided to give the autos another look.

Until someone invents a reliable Hovercraft for home use, it's a certainty that cars will continue to be America's most beloved personal possession. Sooner or later, we all replace our cars, either because we are tired of the old ones or because the brakes are shot and we can see the road through the rusted floorboards. I've held out as long as I could with my 1977 AMC Concord, but even Old Faithful is beginning to sputter.

When I took a big position in the autos in the early 1980s, annual car and truck sales in the U.S. had declined from 15.4 million vehicles in 1977 to 10.5 million in 1982. It was possible, of course, that sales would fall further, but I knew they couldn't go to zero. In most states, cars have to pass a yearly inspection, which is another reason that people can't keep their clunkers forever. Eventually, these clunkers will be barred from the road.

It's true that a new gimmick may have retarded the rebound of the auto industry from the latest recession: the 60-month auto loan. In the old days of the 36-month auto loan, a car was paid off by the time the owner decided to get rid of it. Usually, there'd be some equity left in the car when it was driven onto the lot for a trade-in. The 60-month paper has changed all that. Many four- and five-year-old cars are now worth less than the outstanding loan balances, and their owners can't afford to trade them in. But eventually, these loans will be retired.

One useful indicator for when to buy auto stocks is used-car prices. When used-car dealers lower their prices, it means they're having trouble selling cars, and a lousy market for them is even lousier for
the new-car dealers. But when used-car prices are on the rise, it's a sign of good times ahead for the automakers.

An even more reliable indicator is “units of pent-up demand.” I located this telling statistic in a chart that's published in a Chrysler Corporation publication called
Corporate Economist
—another good candidate for summer reading at the beach. (The chart appears here as
Table 15.3.
)

In the second column we find the actual car and truck sales, arranging by calendar year, with each number representing 1,000 vehicles. The third column, called “Trend,” is an estimate of how many cars and trucks
should
have been sold, based on demographics, sales in previous years, the ages of cars on the road, and other considerations. The difference between the two gives us the units of pent-up demand.

In the four years from 1980 to 1983, when the economy was sluggish and people were trying to save money, actual car sales lagged the trend by 7 million vehicles—7 million people who should have bought cars and trucks had delayed their purchases. That told us to expect a boom in auto sales. Sure enough, we had a boom from 1984 to 1989, years in which auto and truck sales exceeded the trend by a combined 7.8 million units.

After four or five years when sales are under the trend, it takes another four or five years of sales above the trend before the car market can catch up to itself. If you didn't know this, you might sell your auto stocks too soon. For instance, after the boom year of 1983, when car sales increased from 10.5 to 12.3 million vehicles, you might have decided to take your profits in Ford or Chrysler stock because the auto boom was over. But if you followed the trend, you could see that there was still a pent-up demand for more than 7 million vehicles, which wasn't exhausted until 1988.

A year to sell auto stocks was 1988, when the pent-up demand from the early 1980s was all used up. The public had bought 74 million new vehicles in five years, and sales were more likely to go down than up. Even though 1989 was a decent year for the economy at large, auto sales fell by 1 million units. Auto stocks declined.

Starting in 1990, we've once again begun to build up a little pent-up demand. We've had two years under trend, and if things continue on their current course we'll build up 5.6 million units of pent-up demand by the end of 1993. This should produce a boom in car sales in 1994–96.

Table 15-3. U.S. AUTO AND TRUCK INDUSTRY SALES, ACTUAL VERSUS TREND

(in thousand units, by calendar year)

Even though 1992 sales are above 1991 levels, we're still well under trend, and it will take four to five good years of auto and truck sales to catch up.

Timing the auto cycles is only half the battle. The other half is picking the companies that will gain the most on the upturn. If you're right about the industry and wrong about the company, you can lose money just as easily as if you're wrong about the industry.

During the upturn that began in 1982, I concluded (1) that it was a good time to own auto stocks and (2) that Chrysler, Ford, and Volvo had more to gain than General Motors. Since GM was the number-one automaker, you would have thought it would do the best, but it didn't. That's because GM's reputation for excellence far exceeded any desire to live up to it. The company was arrogant, myopic, and resting on its laurels, but other than that it was in great shape.

The filmmaker of
Roger & Me
wasn't the only person who had trouble getting into GM buildings. On one trip I was assigned to an investor relations guy who couldn't find the research-and-development center, which was roughly the size of a big college campus. It took the two of us a couple of hours to figure out where it was. When the investor relations department hasn't read the locator map, you can assume that the rest of the company is just as lost.

GM in the 1980s left a bad impression among buyers of auto stocks. GM stock doubled in 10 years, but the people who bought Chrysler near the 1982 bottom made almost 50 times their money in five years, and those who bought Ford made 17 times their money. By the end of the decade, GM's foibles were no secret. A man on the street could tell you that America's number-one automaker had lost a war to the Japanese.

But in the stock market it rarely pays to take yesterday's news too seriously, or to hold an opinion too long. As GM was declining, the popular view on Wall Street was that this was a powerful company with a profitable future. In 1991, the popular view was that GM was a weak company with a miserable future. Though I was no fan of GM in the past, my hunch was that this latest popular opinion would prove to be as misguided as the last one.

You could almost take the old articles about Chrysler being the stumbling giant of 1982 and switch the name Chrysler to General Motors, and you'd have the same story all over again. The only difference is that GM has a better balance sheet in 1992 than Chrysler did in 1982. The rest is the same: powerful enterprise forgets how to make cars, loses the public's confidence, lays off thousands of workers, heads for the scrap heap of has-been corporations.

It was all this negativity about GM that attracted me to it in 1991. A glance at the third-quarter 1990 report and I knew I was onto something. While most of the attention is focused on GM's flagging car sales in the U.S., it turns out that GM can succeed without selling more cars in the U.S. Its most profitable businesses are its European operations, its financing arm (GMAC), plus Hughes Aircraft, Delco, and Electronic Data Systems (thank you, Ross Perot).

All of these other GM divisions are doing so well that if the company can only break even on the U.S. auto business, it could earn $6–8 a share in 1993. Giving these earnings a p/e ratio of 8, the stock should sell for $48-$64, a big advance from the current price. If GM's auto business improves beyond the break-even point, as it should when the economy revives, the company could earn $10 a share.

The closing of several plants will cost thousands of workers their jobs, but it will also enable GM to cut costs in its least profitable enterprise. The company doesn't need to win the war with Japan and recapture the American car buyer. GM is upset that its market share has shrunk from 40 percent to 30 percent, but that's still bigger than the market share of all the Japanese carmakers combined. Even if GM gets only 25 percent of U.S. car buyers, its auto divisions can once again contribute to earnings by scaling down their manufacturing and reducing their expenses (something they have already started to do).

The very week that I'd arrived at this conclusion, the newspapers reported that several GM cars had won major awards, including the much-disparaged Cadillac, which once again had charmed the critics. The trucks looked good, the mid-sized cars looked good, and the company had plenty of cash. Since GM's reputation could hardly be worse, all the surprises should be happy ones.

CMS Energy

Utility stocks were the great growth stocks of the 1950s, but since then their main attraction has been yield. For investors who need income, buying utility stocks has been more profitable in the long run than buying CDs from the bank. With a CD, you get the interest plus your money back. With a utility stock you get the dividend, which is likely to be increased every year, plus a chance at a capital gain.