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.

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.