Why a Car Fund Took Off

What's the best-performing domestic mutual fund so far this year? You'll never guess, so don't even try. The answer is Fidelity Select Automotive, up 94%through September 4 -- or nearly 80 percentage points better than the U.S. stock market as a whole. It achieved this remarkable gain despite having to own stocks in a sector that has suffered horribly during the recession.

Sales of vehicles in the U.S. this year are projected at ten million, down from 16 million in 2007. Two of the three largest U.S. automakers recently emerged from bankruptcy reorganization, and Toyota Motor, generally considered to be the best-run car manufacturer, lost $4.3 billion in the fiscal year that ended last March.

So what gives? The answer provides important lessons about the nature of investing.

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How it happened. Select Automotive's 2009 recovery follows some truly terrifying losses. The fund (symbol FSAVX) lost 61% in 2008, 24 percentage points more than the decline of Standard & Poor's 500-stock index. For the entire bear market, from October 9, 2007, through March 9, 2009, the fund plunged 80%.

Michael Weaver has been managing Select Automotive only since February, but he's been following the sector for many years. His explanation for this year's success: "We're coming off a very low base. The worst-case scenarios did not play out. Consumer confidence stabilized, and the sector has benefited from government actions. The outlook is good, especially in developing markets, and new-car prices are strong relative to used-car prices."

All true. The recession may well be over. And, by pumping tens of billions of dollars into General Motors, Chrysler and the auto-financing firm GMAC -- plus adding a few billion more with the "cash for clunkers" program -- Uncle Sam gave the auto industry a special boost that toy stores, microchip makers and others didn't get.

But the recovery of the auto sector and the amazing returns of Select Automotive tell a more complex and instructive tale. When you look at the 15 stocks that account for 81% of the fund's assets, you see few familiar names -- and none of them are automakers. Weaver has 2% of the fund's assets in Ford Motor and BMW, but that's it.

Chalk up Select Automotive's performance this year to a heavy concentration in two subsectors: auto dealers and parts suppliers. Why have these groups worked so well? In a recession, weak firms get weaker -- and sometimes die. As customers cut back, businesses battle over the remaining demand, slashing prices and often losing money and going bankrupt. The supply of businesses shrinks, so competition declines, and prices may even rise. The strong survive and thrive.

Consider car dealers. As part of their Chapter 11 reorganizations, GM and Chrysler announced earlier this year that they would end their franchise agreements with about 1,900 dealerships. Dealers that sell Fords and foreign cars and trucks are closing as well because sales have dropped off. Fewer outlets for your product may not be helpful to a manufacturer, but it's delightful for the owners of the survivors.

With fewer competitors (Dallas alone has already lost about 20 dealers, with more to depart), the remaining franchises will naturally benefit -- a bit now and even more when auto sales pick up with the economy in 2010 and beyond.

At last report, Select Automotive's fifth-largest holding was Asbury Automotive Group, a retailer headquartered in Duluth, Ga. Number ten was Group 1 Automotive, a Houston-based dealer. Ranked 12th was Lithia Motors, in Medford, Ore. All are small; Lithia Motors has a stock-market value of less than $300 million. Also among Weaver's top 25 stocks are much larger dealership chains: Auto-Nation, Penske Automotive Group and Sonic Automotive. Together, the six stocks represent nearly one-fourth of the fund's assets.

Asbury, Group 1 and Lithia are all well-capitalized companies that are strongly diversified by brand and geography. For example, while second-quarter sales for Group 1 fell 30% from the same period in 2008, the company earned a profit and scored free cash flow of $35 million. Shares of Group 1 skyrocketed 158% in the first eight months of 2009. Asbury has nearly tripled, and Lithia has quadrupled.

The story is very different for manufacturers. With governments here and around the world propping them up, there's a glut of makes and models. But parts suppliers have been clobbered the way dealers have, thus offering opportunity. Weaver looks for suppliers that have strong balance sheets and exposure to emerging markets (where most of the global growth is likely to occur) and that provide a growing number of features per vehicle produced.

Weaver's largest holding by far is Johnson Controls, which represents a whopping 21% of his portfolio. The company makes a wide variety of products for cars and trucks, including door panels, digital instruments, headrests, map lights and complex energy-management systems. A Johnson subsidiary that provides advanced battery technology -- a fast-growing field -- already accounts for 15% of the company's revenues.

Also among the fund's top holdings are Autoliv, a Swedish firm that makes safety devices, such as airbags and seat belts, and BorgWarner, which makes transmissions and clutches. These firms appear to have sturdy balance sheets. But Weaver also owns a few companies that look shakier, including Tenneco, which makes parts that control emissions, such as catalytic converters, and stabilize rides, such as struts and suspension systems. The Value Line Investment Survey gives the company a low financial-strength rating of C. Still the shares have soared more than 400% this year.

One of the lessons of Select Automotive's rise is that stock prices anticipate the future. At the bottom of the market in March, Johnson Controls was trading for a little more than $9 a share because the future, not just the present, looked dismal. As federal money poured in, consumer confidence firmed, and Johnson's competitive position improved, the future looked a lot better even though the present remained not so hot. That better future has not been fully realized yet, and even if it is, investors will be looking beyond the next hill. What they see may not be so encouraging.

The consensus of economists is that U.S. gross domestic product will grow only about 2% next year -- an anemic recovery. Europe's expected growth, at less than 1%, is even worse. Over the next five to ten years, Weaver told me, auto-sales growth would be "outside mature markets." The forecast for GDP growth in China in 2010 is 8%; in India, 6%; in most other emerging markets, about 3%. Although the parts suppliers sell globally, the vast majority of their revenues come from North America and Europe. Asbury and Lithia sell all their cars and trucks in the U.S., while Group 1 has some franchises in the U.K.

A few questions, then:

Is the auto sector's run over? There is no way to tell. The critical issue is whether the restructuring forced by the recession will mean strong earnings despite a questionable economy.

Should an investor buy a sector fund such as Select Automotive for the long term? Weaver told me that, like other Fidelity sector-fund managers, he stays fully invested in his industry, rather than trying to time the market by moving into cash. But when I asked him whether individual investors should engage in such timing when buying sector funds, he would not answer. So I will: Buying a sector fund with the intention of holding it for the long term makes more sense when the industry has above-average growth prospects for years to come. The auto industry does not fit that profile. Investing in technology and biotechnology for the long haul might be a better idea -- as long as the group is not egregiously overpriced, as tech was in early 2000. In any case, don't make a big bet on any single sector.

What out-of-favor sector will be the next to surge? Out of 98 industries ranked by Value Line for timeliness, the worst recently was "Banks." Fidelity Select Banking (FSRBX) lost 21% in 2007 and 38% in 2008 and gained a measly 1% so far this year. Are you ready to bank some of your money on it?

James K. Glassman is executive director of the George W. Bush Institute in Dallas. His next book on investing will be published in April. he does not own any of the stocks mentioned.