How to gain from the cyclicality in auto sector

The auto sector has been a leading actor in the economic recovery. In the last two years, auto stocks have delivered outperformance relative to the overall market. The auto majors are heavyweights that make large contributions to the market movements and sentiment.

Unit sales registered a solid volume growth in the Q3, 2010-11 across all categories. Advisories suggest volume growth will continue. However, January saw dramatic decline in share prices. Every stock in the sector has been hit and many have underperformed the overall market.

The Nifty has lost 12 per cent since early January. But that’s less dismal than the returns of Tata Motors (-15 per cent), Hero Honda (-20 per cent), Maruti (-15 per cent), Bajaj Auto (-21 per cent), Ashok Leyland (-16 per cent), etc., in the corresponding period. The broad downtrend implies nervousness across the entire space affecting two-wheelers, three-wheelers, cars, trucks, tractors.

This is a strongly cyclical industry. Its performance is often a lead indicator for the macro-economy. It is very sensitive to factors like commodity raw material input pricing (metals, plastic, glass), interest rates (most sales are financed, and the auto businesses has high working capital needs), fuel pricing, etc. When the industry goes downhill, it drags its value-chain down with it.

The input variables look worse now than they did three months ago. Interest rates are rising, metals are firm, plastics (derived from petrochemicals and hence, dependent on crude prices) are more expensive. At the same time, fuel prices are up, which means slowing demand and little room to pass on cost increases. Soft export markets are more potential bad news. All this would have been factored into the falling prices.

In the last economic cycle, the auto sector peaked out several months before the rest of the stock market. This time, the overall market and the auto sector’s moves appear to be more or less coinciding but auto stocks are more volatile and always liable to correct deeper.

Historically, declines of greater than 60 per cent or more are absolutely normal for auto stocks during a downturn. So, there’s plenty of room for further declines from current levels. Downturns also typically tend to last for three-four quarters, so the time element favours bears. Given that there’s ample liquidity in the sector, including in stock futures, this opens the way for lucrative short positions that can be rolled over, as they gain.  

Another point can be made from the very long-term perspective of the investor targetting the next up-cycle, whenever that comes along. Price recoveries tend to be equally strong. A move from the low of a bearish cycle to the peak of the next bull run move generally yields around 150-200 per cent returns for most auto stocks. A strategy of selectively shorting auto stocks on the way down followed by steady accumulation near the bottom of the cycle could therefore, be one way to churn out profits over the next year to 18 months.

The author is a technical and equity analyst