Trump’s tantrums signal bumpy road for Canadian auto parts stocks

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The U.S. Supreme Court did not say "the power to tweet is the power to destroy," but investors are finding that the country's president-elect is particularly adept at wiping out shareholder value with his periodic blurts. The latest victims, this time from an interview with Donald Trump, are Magna International Inc. and Linamar Corp., which fell nearly 4 per cent Monday, and failed to recover Tuesday, after Mr. Trump unleashed yet another attack on foreign automobile imports.

The two auto-parts suppliers, already cheap compared with their U.S. peers, may look even more like bargains to their advocates, some of whom call the stocks their very best investing ideas for 2017. But investors should consider whether the latest Trump tantrum and the uncertainty the president-elect continues to inject into the marketplace represents yet another risk factor that will help keep the shares suppressed this year.

I last looked at the Canadian auto-parts suppliers, which also includes the much smaller Martinrea International Inc., in July of last year after they fell sharply on the Brexit vote, another shock to consensus and stability. The argument is similar now as then: The three companies trade at significant discounts to their U.S. peers, despite the potential, particularly in the case of Magna, for above-market growth.

Brett Hoselton, equity research analyst at KeyBanc Capital Markets, was bullish on Magna then and remains so. He argues that Magna's recent financial guidance, issued earlier this month, suggests "organic" revenue – which is considered sales not aided by acquisitions – as averaging 6 per cent to 10 per cent annually for 2016 to 2019, which implies 3-per-cent to 7-per-cent outperformance to the broader auto-parts market.

Mr. Hoselton, who has an "outperform" rating and a $50 (U.S.) target price on Magna's stock, says 2018 "is likely to be a breakout year" for Magna as sales and profit margins accelerate. A decline in capital expenditures will help triple the company's cash flow to an average of $1.7-billion from 2017 to 2019, as compared with roughly $500-million in 2016.

In mid-December, the analysts at RBC Dominion Securities Inc. listed Magna as one of their 30 best global ideas, noting it traded at a multiple of 4.5 times its estimate 2018 EBITDA, or earnings before interest, taxes, depreciation and amortization, while its peer group traded at 5.4 times.

When RBC instead used a multiple of five in its calculation of a target price for the shares, it came up with $55 (U.S.) – an implied return of nearly 20 per cent.

Of course, RBC also noted investors should watch for trade and taxation changes – "with the changing political landscape in the United States, potential changes to NAFTA can clearly impact the auto industry. Decades have been spent optimizing the supply chain across borders; any added tariffs or other trade friction could impact Magna."

Yes, trade friction. This is what occurred Monday when the German newspaper Bild published an interview with Mr. Trump in which he warned German car companies he would impose a border tax of 35 per cent on autos imported to the United States. "I would tell BMW that if you are building a factory in Mexico and plan to sell cars to the U.S.A., without a 35 per cent tax, then you can forget that," Mr. Trump said, according to a Reuters report on the article. (The German economy minister pointed out that the United States would benefit more by building better cars.)

It remains to be seen whether Mr. Trump is more serious about threats issued during interviews than threats issued in Tweets, or whether it's all just the verbal diarrhea he's unleashed on his enemies, real and perceived. However, the president of the United States has unilateral power to impose certain tariffs, albeit not as high as 35 per cent, and not permanently. That short-term problem can and should hang over the auto makers, and their suppliers, until we see whether anyone can talk any sense into Mr. Trump.

In this environment, then, it's all well and good to talk about these companies' discount to the broader market. At the close of Monday's trading, Martinrea, Linamar and Magna had three of the four lowest price-to-earnings multiples among a group of 24 parts suppliers, according to Standard & Poor's Global Market Research. They all may put up some fresh numbers this year that convince investors that distinction is unwarranted, and investors will have a robust return as the Canadian names return to favour. There's a pretty good chance that could happen.

There is however, a better chance that the volatile Mr. Trump, the authoritarian vulgarian, will launch a reign of error Friday that will constantly put investors' gains in these names at risk. Buckle up.