On Sept. 24, 2008, the U.S. Congress passed a bill to lend domestic automakers US$25 billion to help keep them solvent. The money helped for a while, but the rapidly declining economy was too much for prospective buyers and the car companies to handle. By the end of 2009, GM and Chrysler were bankrupt, and auto sales dropped to their lowest level in 27 years. The worst part? No one was sure if the auto industry—America’s pride and joy—would ever be the same.
It’s amazing then that, nearly four years to the day after the bailout announcement, the sector’s fortunes have almost completely reversed. In August, America’s auto industry saw a 20% year-over-year gain in sales, and it’s expected that by the end of the year 14.4 million cars will have rolled off dealer lots. That’s still below the pre-recession sales of 17 million, but a far cry of 2009’s almost three-decade low of 10 million. The big automakers are also running leaner operations—they closed a number of underperforming plants during the crisis—and their balance sheets are the cleanest they’ve been in years. With such a strong rebound, investors may be thinking they missed the boat. However, now’s still a great time to jump in. Valuations remain incredibly low, and there’s still plenty of growth—at home and in emerging markets—to come.
Warren Fenton, a portfolio manager and director of equities with Acuity Investment Management, is as surprised as anyone by the strong rebound. “It’s been a miraculous recovery,” he says. But it makes sense. Before the recession, the automakers had too much capacity and crushing pension liabilities, and could barely make a buck on their cars. Now that they’ve closed plants and restructured pensions (in the U.S., at least), they can make money even if they sell 12 million cars, says Fenton.
Better earnings are only part of the story. Investors can also expect to see growth over the next several years. In America, sales still lag behind their pre-recession levels. Carlos Gomes, a senior economist at Scotia Capital, expects sales to keep increasing for two reasons. First, many people are due for an auto upgrade. The average age of cars on the road is now 11 years, up from around nine normally. Second, auto sales are closely connected with job growth. When people get jobs, one of the first things they do is replace their clunkers, he says. If year-over-year job growth stays at 1% or more—which he expects it will—then motor vehicle sales will rise.
Even if U.S. growth suddenly slows, demand from emerging markets should keep the assembly lines humming. In the G7 nations, there are, on average, 600 vehicles for every 1,000 people. In China, the number is around 60. As incomes grow, so will people’s desire to own a vehicle. He expects emerging-market sales to grow between 5% and 10% every year.
There is one crack in the windshield, and it’s the big reason why price-to-earnings ratios for many of the companies across the sector are still low. European sales are dropping. In August, year-over-year car sales in France plunged 11%; in Germany sales fell by 4.7%; and in Italy sales plummeted 20%, the worst fall since 1964. Thanks to rigid labour laws, automakers haven’t been able to cut back in Europe as they have in the United States. There are still too many expenses weighing down their bottom lines, says Fenton.
Still, he expects good share-price growth over the next few years, and if Europe’s economic fortunes improve, then investors could see stocks soar. The sector, though, has so many moving parts it’s hard to know where you should put your money. You could invest in the auto companies themselves—many are trading at a steep discount. Ford, for example, has a P/E of 2.3 times earnings. Fenton, though, suggests looking at the auto-parts sector. It’s undervalued—parts suppliers are trading at around 11 times earnings, compared to 15 for the S&P 500—and it has additional opportunities for growth. Every car needs parts, so the more cars that get made, the better the industry does. But companies can also expand earnings if they can get more parts inside a vehicle or, in industry-speak, when content per vehicle (CPV) grows.
Like the manufacturers, auto-parts companies are also leaner than during the recession. Most of these businesses carry little debt, and they’re expanding sales in Asia. As well, many smaller players folded during the crisis, leaving more work for the stronger operators. The relationship between the suppliers and manufacturers has also changed. Before the recession, manufacturers squeezed the auto-parts companies whenever they could. “It was a combative relationship,” says Fenton. Now that the car companies are making money and there’s less competition in the auto-parts market, terms and pricing have improved.
While the auto-parts sector is cyclical—companies make most of their money earlier in the year, while automakers are assembling cars for September launches—many companies pay a dividend to get you through the slow times. Investors can easily find cheap, well-run companies with close to a 3% yield. The best auto-parts companies are ones that sell a non-commoditized product, says Massimo Bonansinga, a portfolio manager with Global Signature Advisors. Borg Warner, for example, specializes in turbochargers. It’s not something everyone can do, so it can charge a higher price. He also wants to see companies that have significant exposure to emerging markets. The more clients the company has, the better.
Since auto-parts companies have different avenues for earnings expansion, you want to see a business’s growth rate exceed the growth rate of the industry, says Bonansinga. To do that, a company should have a history of CPV growth. Fenton wants to see CPV grow at about 5% per year. If the industry grows at about 5% per year too, then that can translate into big earnings growth.
When looking at valuations, use price-to-earnings to compare companies. Efraim Levy, an analyst with S&P Capital IQ, also likes to look at enterprise value to EBITDA. The metric tells him what kind of money a company would get if it were acquired. “We can see at what price someone else would think it’s worth buying,” he says. He also keeps an eye on price-to-sales; it shows how investors value a dollar of company sales. A low P/S means it’s undervalued. He also likes to see strong cash flow.
When it comes to debt, Levy looks at debt-to-capitalization. He likes companies with a ratio of 30% or less. Bonansinga looks at debt-to-EBITDA and wants to see that ratio at less than one. Fortunately, it’s easy to find companies with little on their balance sheet.
Even if the world economy just delivers more of the same, automotive stocks should rise. “Investors will make good money on America’s more sustainable growth trajectory,” says Fenton. “But get a half decent recovery in Europe, and you’ll make a ton.”