- The automotive industry is expected to grow in the future. While the high barriers to entry eliminate new competition, it’s a perfect business to be in.
- The short-term debt cycle and stretched balance sheets indicate a contraction in revenues, margins, and profits.
- To make money with automotive stocks just follow the short-term cycle and be patient, it will hit stocks, it always does and it is close.
I have recently been nagging about the negative asymmetric risk reward situation the general stock market offers. In order to give you more value, I’m going to analyze a few sectors in detail with the hope of finding the ones that will give you better risk reward ratios.
Today, I’ll discuss the automotive industry. Many consider it extremely cheap, but valuations simply don’t want to hear about it and remain low. I’ll start with an analysis of the two cycles in the industry, continue with an overview of the fundamentals and a conclude with a risk reward estimation.
There are two cycles in the automotive industry, one is the megacycle we are in since cars have been invented, while the other are the short-term boom and bust cycles related to economic activity and debt.
The megacycle is pretty straightforward, there are and will always be more and more car buyers globally. Despite recessions, financial crises, or political issues, the number of sold cars is growing at a constant rate.
The current average of 75 million sold cars per year is already 44% more than the average of the previous decade. With global economic growth expected to be around 3% in the future, we can expect a similar growth in demand for vehicles.
Demand for vehicles will be driven by emerging markets as these markets are still far away from normal, developed world, car per capita levels.
Even if countries like India, Nigeria, Indonesia or China never reach the number of cars per 1,000 people as the U.S. has, even if they reach just half of it—or even a quarter of it for that matter—the outlook for the industry is stellar.
Stable demand is also going to come from developed markets. Those markets won’t grow much more but as we on average buy a new car every 7 years, we can expect steady demand.
On top of the above positives coming from the auto industry megacycle, we don’t have to worry about new competition as the barriers to entry are pretty high. The main entry barrier is the economies of scale which is the reason why the automotive industry is highly concentrated. On top of that, when you are buying a car, you also think about safety and somehow safety will always be better perceived with a company that has been building cars for the past 100 years than with a new company.
An example of how difficult is to succeed in the automotive industry is Tesla (NASDAQ: TSLA). It was founded in 2003 and today it still hasn’t managed to reach profitability. If it weren’t for its visionary CEO, I doubt a rational investor would enter into a venture with such a long road to profitability.
With the outlook so positive, the valuations should be sky high. Let’s take a look at industry fundamentals.
For fundamental indicators, we’ll look at the PE ratio, the cyclically adjusted PE ratio (takes 10 years of earnings into account), the dividend yield, price to book value, and total debt to assets. The total debt to assets factors seems better than others because car stocks usually have many hidden future liabilities like pension or tax obligations that don’t reflect normal debt ratios.
The difference between the CAPE ratio and the current PE ratio shows that we are close to the peak of the short-term cycle. Automotive companies will make less money per year in the next decade than what they’re currently making due to the fact that the above PE ratios are the result of an 8 year long sales boom cycle.
Given the relatively high debt to assets ratios, any decline in demand would quickly bring the industry into negative profitability and weigh severely on stock prices.
The short-term cycle in the industry can easily be assessed by looking at motor vehicle loans which have doubled in the last 7 years, inflated by low interest rates. As the short-term debt cycle usually lasts between 8 and 10 years, we can expect a contraction soon and lower car sales in Europe and the U.S., still the biggest markets globally.
The low PE ratios and high dividend yields might seem tempting, but I would avoid the sector and wait for worse market conditions to buy in. The best time to buy would be when the CAPE ratios are in the single digits while PE ratios are negative or double digits. This will happen at the bottom of the short-term credit cycle. As we are at the top of the current one, a bit of patience is required.
The positive megacycle is the main driver behind the industry and the margin of safety as weak demand can’t last too long in the industry. Therefore, just be patient and wait for opportunities like the market gave us back in 2009 during the global financial crisis, and in 2012 in the midst of the European recession.
Stay tuned to Investiv Daily for market and sector analysis as we continue on our quest to find the sector that has limited downside with huge upside potential. The opposite of what the stock market offers now.