InvestorsFriend Inc. Newsletter October 15, 2017
HOW CAR DEALERS MAKE THEIR MONEY
The average markup on a new car has generally been something of a mystery. Car dealers sometimes advertise “dealer-invoice” sales, implying they are selling cars at cost. Folklore has it that the dealers make their money from servicing cars rather than selling them and there may be some truth to that. Still, the notion that they regularly sell cars at their invoice cost is rather hard to believe.
Historically, car dealers were always owned by private companies and not by publicly traded companies. This made it difficult or impossible to obtain figures on the true average dealer markup on cars and trucks. But now there is a large Canadian publicly traded owner of auto dealers and they do reveal their markups. This information may be of interest not only to investors but to all automobile buyers as well.
AutoCanada Inc. is publicly traded and owns 57 separate auto dealerships.
Its gross profit is derived from four different areas as follows: new vehicle sales represent 27% of gross profit; used vehicle sales 9%; parts, service and collision repair 39%; and finance, insurance and other represents 25%.
This confirms the common understanding that parts and service account for much of the profits. But this is at the gross profit level and does not necessarily reflect the relative contribution of these four areas to the net bottom line profit.
I suspect that finance and insurance, where dealers earn commissions for selling financing and various optional insurance and warranty products provided by others, may be the biggest contributor to net earnings. It involves very little in the way of equipment or building space and not much in the way of staff costs. Service work, meanwhile, has very substantial staff costs and also requires a large investment in equipment and building space. Its percentage contribution to net earnings is therefore likely far lower than its contribution to gross profit.
AutoCanada’s figures indicate that the average gross profit or markup on a new retail vehicle is $3,563 or 8.3% of the average $42,928 selling price.
The corresponding figure for new vehicles sold to the “fleet” market is a gross profit of $577 or just 1.5% of the $37,551 average selling price. For used retail vehicles sold, the gross profit averaged $2,229 or 9.3% of the $23,884 average selling price.
Any notion that dealers were really selling cars at true invoice prices was always suspect and the above data seems to put that idea to rest.
The gross profit from finance, insurance, and other was an average of $1,975 per vehicle sold. If it is assumed that none of this revenue applies to fleet sales then the average rises to $2,364 per retail (new or used) vehicle or about 5.8% of the weighted average sale price of $40,748. And this 5.8% would be higher if it were adjusted to account for that fact that some purchasers pay cash or arrange their own financing and/or refuse to take any of the optional insurance products being sold.
So, on an average new car sale the gross profit is about 8.3% and there is typically at least another 5.8% for selling financing and insurance, for a total of 14.1% of the selling price. Every business should make a profit and so I would not expect to be able to negotiate the markup down close to zero. Still, it might be useful to have some awareness of these figures when negotiating a vehicle purchase.
It’s interesting to consider whether a dealer would offer you a discount for paying cash. I would say that the answer is a resounding no! Customers who pay cash don’t generate any finance fee revenue for the dealer, and they are probably also less likely to take insurance products such as extended warranties. The real discount for paying cash instead comes in the form of not paying interest. A dealer might be more likely to offer a bigger discount on the retail price to a customer who is financing and taking the optional insurance/warranty products rather than the customer who is paying cash. Offsetting this, perhaps the cash customer is in a better position to shop around.
THE AVERAGE INVESTMENT MANAGER CAN’T BEAT THE INDEX ACCORDING TO WARREN BUFFETT
Warren Buffett set aside time at the May 2016 Berkshire Hathaway annual meeting to explain with a vivid illustration exactly why investment managers on average do not and cannot beat the index. In fact, they must, on average and as a population, “tie” the index before costs and trail it after accounting for their fees.
To illustrate, Buffett (and I am paraphrasing here) asked his audience (an arena holding 18,000 people) to imagine that they collectively owned all the companies in America. In my explanation of Buffett’s illustration, I will assume the companies are publicly traded although Buffett did not make that assumption.
The half of the audience on the right side of the arena would purchase their half of all these companies through a very low cost index fund that tracked the stocks and thereafter would hold their position indefinitely for, say, the next 50 years. (But the example works exactly the same whether it is 50 years or 50 days). Each audience member would not need to invest the same dollar amount, but this half of the audience would collectively purchase half of the total stock market value of all companies. They would therefore collectively receive exactly half of all the dividends paid by the companies. And they would collectively experience exactly half of the capital gains or losses in stock prices over any time period. Each member of this half of the audience would make exactly the same percentage return in any given time period. They would all make the index return, less whatever tiny cost the index fund imposed.
Meanwhile, the left-hand half of the audience would collectively invest an equal amount of money but would do so indirectly, with each person choosing an active manager who would invest for them. The managers would study which companies were likely to see stock prices rise fastest. Each manager would choose different companies and industries to concentrate on. They would use a variety of fundamental and technical analysis techniques to do this. At the end of the day, this half of the audience would also collectively receive precisely half of the dividends from the population of companies and would experience exactly half of the capital gains or losses each year, month, day, and hour of trading.
Some of these active managers and their investors would assuredly do better than others and better than the index average. But that could only come at the expense of some of the other active managers and their investors doing worse than average. It is a mathematical fact that this active side of the audience would collectively (though not individually) earn exactly the same returns before costs as the buy-and-hold-the-index side. But their investment management fees would be far higher and they would therefore collectively and on average trail the index and the index investors after costs.
This illustration and math should be sobering to all of us who deviate from a strategy of merely buying and holding the index. Most active investment managers or advisors might be inclined to disbelieve or deny the math and very few would ever point it out to anyone. But at InvestorsFriend we are highly ethical and have no interest in hiding from this truth.
Equity investors in aggregate and on average do make positive returns over time. Those returns are ultimately attributable entirely to the profits of companies. Over time, there is a flow of money from customers of companies to the owners of companies. Layered on top of that is trading activity, whereby some investors try to make higher than average returns. This trading-with-other-investors activity is undeniably a zero-sum game (and negative after costs). For one active investor to beat the index by a dollar, another active investor must trail by that dollar.
But it is also undeniable that some active investors will beat the index. Some investment managers will beat the index consistently. Buffett has often pointed out that a certain group of disciples of Benjamin Graham, including himself, went on to consistently beat the market for decades.
I certainly agree with Buffett’s point that given that the clients of active managers as a population will trail the index by whatever fees they pay, it becomes very important for those who choose active investment to look for low-fee approaches.
The (paid) subscribers to InvestorsFriend have chosen to pursue an active investment style as opposed to only holding only broad indexes of equities. Nothing in Buffett’s message, or most certainly in his own approach, suggests that any particular active investor will fail to beat the index. He does warn however that the average active investor will fail to beat the index after costs and that paying higher fees makes such failure to beat the index more likely. A subscription to InvestorsFriend combined with a discount brokerage account can result in a very low cost approach. And of course, at InvestorsFriend we believe we are following rational approaches that can beat the approaches of most other active investors.
Buffett also did not address the fact that many investment advisors provide services and benefits beyond attempting to beat the market. In fact, an increasing number of investment advisors do not seek to beat the index.
Benefits that investment advisors can provide over and above selecting equities include building risk-appropriate overall portfolios, consideration of income tax effects, education regarding the use of RRSP and Tax-Free Savings Accounts, and the all-important encouragement and facilitation of regular monthly investment programs.
It is also true that even the average active manager will beat a particular index such as the S&P 500 in some time periods. That happens because managers do not restrict their investments only to stocks in the S&P 500 or to only companies traded in the United States. Compared against an index properly representing all of their investments, the average active manger, by definition, cannot beat the index. The requirement to choose a proper index raises the point that it is not that easy for investors to find and select such an index or group of indexes. Many investors require some form of advice even if they choose to be purely passive buy-and-hold-the-index(es) investors.
For more detail regarding Buffett’s thoughts about the folly of investors paying excessive fees for investment advice see his 2005 annual letter, which is available at berkshirehathaway.com. Look at the section titled “How to Minimize Investment Returns” starting at page 18.
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The above material (with minor edits here) was originally published in the Internet Wealth Builder published by Gordon Pape Enterprises. Shawn Allen via InvestorsFriend Inc. is a contributor to the Internet Wealth Builder.
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