Investing in the U.S. automotive industry is not for the faint-hearted. Given the well-documented woes of the auto industry, a buy-and-hold strategy would have proven disastrous during the past three decades. That’s why it’s important to closely follow and actively trade the stocks.

The auto industry is highly cyclical: demand falls dramatically when the economy is in recession, while manufacturers are able to practically mint cash in a good economy with robust sales volume. As a result, the stocks are unusually volatile, but this means lots of opportunity to pick up shares when they are beaten down and readying to rally.

The steady rise of foreign competition in the U.S. market has also played a huge part in market volatility. Back in 2007, when the latest recession started, the market share of the “Big Three” auto makers in Detroit fell below 50% for the first time ever. Declining market share has not been kind to sales or profit growth — but for reasons I’ll explain, I think the U.S. firms are due for a comeback.

A clean slate — and new opportunity…
After flirting with bankruptcy during the economic downturn in the late 1990s, both Chrysler and General Motors (NYSE: GM) had no choice but to enter bankruptcy toward the middle of 2009. The plummet in supply and drying up of the ability to take out loans to buy cars — courtesy of the credit crisis — were too much for these guys to overcome. As a result, they declared bankruptcy to work out their debts and also accepted bailouts from Uncle Sam that totaled almost $25 billion.

Given the opportunity to clean house, General Motors is a stock with great upside potential.  The company’s ability to rework its debt meant an opportunity to become as competitive as it has been in decades. GM has closed underperforming plants and reworked agreements with the United Auto Workers Union to lower pension and health care costs that previously added thousands of dollars to the cost of each vehicle produced.

GM has also been getting high marks for the quality of the cars and trucks it produces. This part of a multi-year improvement strategy that has resulted in higher independent rankings from the likes of Consumer Reports, which tripled the number of GM autos that had above-average reliability in a late 2010 ranking. Meanwhile, archrival Toyota Motors (NYSE: TM), which overtook GM as the largest automaker in the world, has been subject to a shocking number of recalls that has hurt its credibility and sales, especially in the United States. 

GM saw its share of the U.S. car and truck market decline from 50% in the 1960s to less than 20% in 2009, but since leaving bankruptcy it is proving to be more nimble and profitable by being smaller. GM became a public company again in November 2010 and raised $20 billion to shore up its capital base further and help pay back the government bailout. The IPO has allowed GM to build its cash position up to $26.6 billion, while long-term debt has been reduced to about $3 billion. This excludes an underfunded pension plan, though the company has stated a recent $5.7 billion payment into the plan will be all that is needed for several years, and a strong stock market has helped increase the fund’s value.

For starters, it is easier to grow from a smaller sales base, as new sales have a bigger impact on total growth. Market forecaster J.D. Power and Associates predicts 2011 sales will reach nearly 11 million automobiles, which is well below levels prior to the recession — but well above the lows of 2009 when only 8 million vehicles were sold. These low sales figures had been the norm for several years, so we could just be at the beginning of a new cycle.

Another nearer-term benefit is that the economy is improving, so sales should see some tailwinds as consumer confidence and spending return to healthy levels. Low interest rates are also making it easier for people to afford cars. Analysts project GM will grow sales more than 5% this year to just over $142 billion and that it will report earnings of just over $4 per share, or 28% above last year’s $3.11.

Action to Take –> At the current share price, GM trades at a very reasonable forward P/E of 8. The stock has also dipped below the IPO price of $33 on worries over what the earthquake in Japan will mean for the global economy. But this means investors have an opportunity to pick up shares at what could prove to be a very low point. The earthquake has also meant more bad news for Toyota, which has had to close a number of manufacturing plants, providing GM yet another avenue to return to its former glory.

I think GM’s P/E can increase at least 50% to 12 and profits can grow close to 10% a year for at least the next two years. The multiple expansion potential also equates to 50% upside in the stock, after which investors can reasonably expect double-digit returns for at least the next couple of years.

P.S. — According to my colleague, a Russian “nuclear catastrophe” will hit the United States in 2013… and when it does, 31 million American’s will suffer. Amazingly, no lives will be lost and a handful of energy stocks could rise hundreds of percent. I know it sounds bizarre, but this bulletin explains what you need to know…