- With a PE ratio of 5 to 10 the automotive industry looks attractive
- The risks are that the industry is considered to be at a historical peak by most analysts
- A global perspective gives a bullish outlook for the industry
The automotive industry is usually called a cyclical industry, considered elastic in relation to GDP and vulnerable to economic shocks. According to a former Ford chief economist a normal recession reduces sales by 15%. With sales being reduced by 15% and costs being inelastic the decline in sales is the one that makes the difference between strong earnings and big losses. Any sign of a recession puts people off from buying new cars and makes them stick to the car they have for a little longer. Connecting the cyclicality and cost inelasticity with the current valuation for automotive companies brings to interesting conclusions.
The current valuation of the 10 biggest automotive corporations is really cheap. In the below table most companies have a PE ratio between 5 and 10. Fiat-Chrysler has PE ratio of 31.8 but adjusted earnings are much better due to a one-off charge of €830 million for the realignment of their US production which brings to a forward PE ratio of 5.1. Tesla is included in order to show how a positive sentiment can easily influence valuations in a completely opposite way than the industry standard.
One of the potential issues that put off investors from paying higher multiples could be the expectation of higher interest rates. Higher interest rates, not only make it more expensive to pay for the debt the
companies hold but also make buying a car more expensive for customers as up to 85% of new car purchases are financed.
Another issue could be the expectation of a recession. US jobs data is showing the first signs of topping out. Usually the job market peaks prior to recessions when the actual GDP surpasses the potential GDP and there is full employment.
The most pessimistic analyst for the auto industry is Max Warburton from Bernstein Research who summarizes the above with the statement that:
“Buying autos this late in the global economic cycle is arguably dangerous–precedents suggest the sector usually delivers most of its performance early in the cycle.”
On the other hand, Warburton is mostly focusing on the US while the source of the bullishness for the automotive industry lies in emerging markets.
A Bullish Outlook
Increased interest rates and recession risks are lower than they were 20 or 30 years ago because the automotive industry has become a global one and is not confined to anymore to Europe and North America.
A positive long term catalyst is the still huge growth potential car companies have in Asia, South America and Africa.
The Tesla Craze
Tesla is often called the “big disruptor” in the industry with the hope that electric cars will take over the world and Tesla will be the leader. Well, reality is far from that. The recently announced Model 3 deliveries will start only in late 2017 and the profitability of it is highly questionable seeing that the Model 3 is similar to the current Model S and Tesla is currently losing $18,331 per sold car. On the other hand, Chevrolet, part of the GM group, will start delivering Chevrolet Bolt by the end of 2016 with more than 200 miles of range and for a price around $30,000. Other competitors with much more experience and better cost efficiency than Tesla are also entering the electric market. For example, by the end of this year Hyundai should introduce its electric vehicle, Ioniq.
Companies with PE ratios from 5 to 10 with positive future global growth prospects seem a crazy idea. But, historical perceptions of the risks related to the automotive industry keep their valuations low and provide investing opportunities. Regional recessions or interest rate increases should be offset by emerging markets growth in the increasingly global automotive market. The speed at which old car companies adapt to new technologies like electric vehicles and unlike new competitors (Tesla) manage to be profitable show that it is better to stick to the old dogs in this case because they are fast in learning new tricks and manage to keep the old fashion profitability. Due to the above mentioned risks every investor should assess his own tolerance for cyclicality but the current yields are very tempting.