My interest in the automotive industry started because of the low P/E ratios currently found there (see the first table below). A low P/E often means that the industry's future is not bright and that an earnings decline is expected. In this article I want to shed light on the automotive industry and show that there is great long-term possibility because of the short-term cyclicality assumption. A purchase of automotive industry stocks now would be in line with Buffett's mantra: "Be greedy when others are fearful."
P/E ratios and dividend yield of the world's 15 largest motor vehicle manufacturers
Sources: Bloomberg; Yahoo.
The cyclicality of the automotive industry
I found the best insight into the automotive industry's cyclicality in a speech by Martin B. Zimmerman, a vice president at Ford Motor (NYSE:F), from prior to the 2009 crisis. I intentionally looked back to before the 2009 financial crisis, because I think such an event is a definite outlier in the industry, and a similar shock can be expected to happen only once in 50 years.
Zimmerman explains how a typical recession lowers sales by 15% at Ford, and that makes the difference between strong earnings and big losses. In a recession, people simply put off buying a new car, and the effect on the automotive industry is immediate and sometimes devastating.
As the main issues that can affect the cycle in the industry he mentions a rise in interest rates (higher interest rates make car financing more expensive) and economic shocks (like pricier oil making cars a less attractive means of transportation). These shocks are a strong influence on vulnerability in the industry, and the main problem is they are impossible to forecast. I believe the fears of cyclical shock persist in the minds of auto industry investors after the painful 2009 recession. This perception of vulnerability has resulted in low P/E ratios.
What's really going on: Growth perceived as cyclicality due to potential short-term volatility
I'll start with a chart that shows world motor vehicle production from 1950 on:
Source: U.S. Department of Transportation.
If we apply the statistical method of canceling the outliers (including the 2009 crisis) we would have a graph that shows constant growth with minor bumps. But even the 2009 crisis resulted in only a two-year gap, after which growth quickly got back on track and resumed its pre-crisis trend. If we showed this chart to investors without revealing it was illustrating the automotive industry, I bet they would be eager to jump into the market. But the fear that arises in humans because of past events is still persistent in today's stock prices, and they do not reflect the market growth and potential of the industry.
Of course the industry will be influenced by short-term cyclicality, but in the long term, the growth megacycle in the automotive industry will continue. As Zimmerman said shocks are impossible to forecast, I will focus here on the long-term industry outlook.
Comparing the previous graph (global auto production) with gross world product (GWP) growth (below), it is clear the automotive industry historically grows in line with GWP.
Gross World Product, 1950 to 2011
GWP has increased a little more than eightfold in the period since 1950, and motor vehicle production followed the same path. To complete the picture, it is important to forecast possible future growth. In the following graph, we can see the OECD's GWP growth expectations, which will probably be reflected in the auto industry. It can be summarized into an average 2% yearly growth.
A more positive outlook on the automotive industry can be found in the comparison between the developed world and emerging economies like India and China. As the GDPs of developing countries are poised to continue strong growth paths, it can be expected that somewhere in the future, the automotive market will become saturated and then stabilize. In a saturated market like the U.S., a driver buy a new car, on average, every 8 years. But until than stability comes, the below figure shows there is still a long way to go -- meaning there is still plenty of growth ahead for the automotive industry.
Comparison of per-capita GDP and vehicle ownership
On one side we have growth in developing markets, and on the other side we have the projection that people will be buying new cars every 8 or so years.
The cyclical investor's dilemma
Stocks give investors higher returns than bonds because of equities' short-term higher uncertainty. An even higher level of short-term uncertainty is usually expected in the automotive industry. The main point here is that it is impossible to predict the shocks that may affect the industry, and thus the higher returns you may realize.
But if we take a longer-term view, the increasing globalization of the industry -- where the markets for manufacturing become more and more diversified -- increased penetration into developing countries allows us to assume more stability once because the industry is not as dependent on certain limited regions. Below you will see the expected regional percentage of GWP in 2050, which, as we established, can easily be projected onto the automotive industry in turn.
Regional percentage of Gross World Product
Currently the industry still relies on the E.U. and U.S., but the tide is slowly shifting towards other manufacturing centers, including China, India, Mexico, and Indonesia. This shift will bring more stability to the industry, and possibly help neutralize the effects of acute economic shocks.
In order to seize the maximum investing opportunity the automotive industry provides, we have to consider downside risks along with future possibilities. As mentioned, we cannot predict the next contraction in the car industry; it might be soon, after 5 years, or even after 10 years. In the meantime, the industry is growing at 4% a year.
In such an environment, an investor should behave in relation to his risk appetite. An investor who is more risk-averse should buy into the industry with a small percentage of his portfolio, so he can gain a bit of exposure to future growth; if a shock hits the industry soon, he should increase his position at the resultant lower prices. He protects his downside by limiting his exposure to the industry and by slowly increasing the automotive portion of his portfolio by reinvesting dividends and capital gains. A more risk-tolerant investor may have a higher stake of his portfolio in the industry because of the higher current returns, and also increase his position if there is a fall by keeping an equal percentage of his portfolio in the automotive industry.
I want to conclude by reiterating that the automotive industry is a growing one and will continue to see growth for years to come. I suppose the majority of people want to live by the highest standards, and that involves car ownership. Thus there should be no fear with regard to the car industry in general.
In order to best exploit investing in the automotive industry, the goal should be to find the companies that have the smallest downside and good upside potential. The factors you should be looking at when assessing a car manufacturer are the flexibility to absorb shocks in vehicle demand and to overcome those periods without fears of failure (diversified markets, strong balance sheet, and good reputation). The possible benefits of investing in a car manufacturer can be seen in my article on Daimler (OTCPK:DDAIF, DDAIY), in which I proposed a dividend reinvestment strategy. A more detailed analysis of the weaknesses and strengths of individual companies will follow in my next article.
Disclosure: I am/we are long DDAIF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.