Rely on auto sector

With many stocks hitting 52-week lows, this could be a good time to enter. But be prepared to hold for two-three years

Sluggish car sales through the festive season were followed by flat sales in November and declines in December. Various reasons for the downturn have been cited, ranging from poor rural demand, to high fuel prices, to high equated monthly instalments.

But there is consensus that the industry is facing “challenging” times. Note that the base effects are hard to adjust for, because automobile manufacturers faced extreme sales volatility in 2017 due to the GST launch.

The industry has a long value chain — probably the longest overall. It sources primary materials (metals, rubber), secondary materials (plastics), high-end electronics and computers. It provides employment to people with various skill-sets, ranging from miners to management graduates, financial whiz-kids and movie stars.

Recessions are cyclical and, given that long value-chain and the employment the industry generates, it’s hard to believe that GDP can grow at over 7 per cent, when the auto industry is feeling challenged or facing recessionary conditions.

However, the most interesting question for an investor is the impact on price as the bottomline deteriorates. There are a fair number of listed companies in the sector, with decades worth of track records and in most cases, strong and stable management. A recession is unlikely to drive them out of business though it may mean several quarters of earnings downgrades, or losses.

It’s very likely that the Oct-Dec 2018 (Q3, 2018-19) results will be disappointing for this sector. It is also very likely that this current quarter, and the next will be disappointing. Somewhere down the line, the sector will recover from the current slowdown.

What sort of price pullback should investors be looking for? This is important for those who are already exposed to the sector since they will have to be braced to withstand some pain. It is also important to somebody who is looking to take fresh positions and would ideally seek to do so when prices have slid close to a bottom.

There are a few important points to note. Just looking at price-earnings ratios can be deceptive. During recessions, profits can evaporate very quickly and a company can rapidly run into the red. Similarly there can be sharp earnings growth when the cycle turns up.

This means valuation by price-to-earnings (PE) can provide counter-intuitive signals. During an up-cycle, you are likely to find periods when the PE drops even though the share price climbs because earning growth accelerates so much. Conversely, during downturns, earnings can drop so fast that the PE goes from low to high to minus in the space of a month.

Purely in terms of price, 50-75 per cent retractions from the high price of a previous cycle to the bottom of the down-cycle are quite common. Indeed, we’ve seen 65-70 per cent retractions in the last year in Tata Motors, 40 per cent retraction in Eicher, and about 35 per cent in Maruti, Bajaj Auto and Hero Motors. There’s every chance that there could be further dips if Q3 results are poor and guidances are sluggish.

We have also seen a fair amount of correlation within the sector in that stock prices tend to move in the same direction, although there are obvious differences in the performance of individual companies. In addition, auto-ancillaries have similar cyclical swings and correlations.

When the next upcycle starts, a 200 per cent return is also common and more than that is also possible. Hence, cyclical as it may be, the auto sector along with its ancillaries can provide multi-bagger returns.

Is this a reasonable time to start buying auto stocks? Many of them hit 52-week lows in December and January. Most are within 10-20 per cent of their 52-week lows. There is still a downside but this could be a reasonable time to start accumulation.

But be prepared to average down and be prepared to hold for a two-three year period. The big listed businesses will see their ups and downs, and it could be mostly the latter in the recent future. But they won’t go out of business and if history is anything to go by, this is among the most reliable of sectors when it comes to big returns on the cyclical upswing.­­­­