How do you evaluate an automotive stock?
Automotive stocks fall into the consumer durables sector. This sector includes companies that make products intended to last for more than a few years such as washing machines, dishwashers, furniture — and cars and trucks.
Before investing in automotive stocks, it’s important to understand how economic cycles affect automotive companies and how these companies work to maximize profits and stay competitive during good and bad economic times.
Understand the auto sales cycle
Automakers and their suppliers are cyclical stocks, meaning their profits rise and fall with consumer confidence. It’s easy to see why. When businesses and consumers are worried about the economy, they postpone buying new vehicles.
Auto sales’ cyclicality matters to investors because:
- Automakers have high fixed costs that include factories, tooling, logistics networks, and labor contracts. These bills have to be paid no matter how many cars get sold.
- Automakers and suppliers also need to invest in product development to make sure they have a steady stream of competitive new products.
- High costs and steady spending mean that profit margins in the automotive industry tend to be low, even during good economic times.
- When sales slump, as in a recession, automotive companies’ profits fall sharply — putting future product spending and future competitiveness at risk.
One way to avoid the cyclicality of the sector is to buy stocks exposed to the replacement market such as auto parts retailers or auto parts manufacturers that sell primarily to the replacement market.
Most automotive companies sharply cut future product spending during the 2008-2009 recession. The few that didn’t, including Ford and Hyundai, had fresh products in their showrooms when the recovery began and were able to gain market share.
That was an important lesson for the industry. Now most global automakers tend to keep substantial cash reserves so they can keep investing to develop new products through recessions.
One interesting development during the COVID-induced recession was that many automakers decided to forego investment in traditional internal-combustion engines in favor of electric vehicles.
Many automotive companies also pay dividends to their shareholders. Some automakers plan to use their cash reserves to continue to pay dividends during a recession. During the COVID-19 pandemic, both Ford and General Motors (NYSE:GM) suspended their dividends to conserve cash. Analysts expect both to resume dividends in the future.
Generally speaking, the automaker with the newest products will get the highest prices and the biggest profits. Automakers must constantly invest to be sure they have a steady flow of new products in the pipeline.
Virtually all automakers and many parts suppliers are also making big investments in future technologies such as electric vehicles, extra safety features, and autonomous driving systems. Most experts believe those technologies will be necessary for automakers if they are to stay competitive in the not-too-distant future.
Some exciting opportunities in the next few years will involve manufacturers of electric and hybrid electric vehicles. Electric vehicles and hybrids are new and different, and most analysts expect them to largely displace internal-combustion vehicles over time.
Electric-vehicle companies might see high growth, which is also exciting for investors. But it’s important to remember that the processes involved in developing and manufacturing electric vehicles aren’t all that different from those used by makers of traditional internal-combustion vehicles. That means electric-vehicle manufacturers face high costs just like traditional automakers.
It’s also important to remember that all of the major traditional automakers are introducing electric vehicles of their own, and the competition in this segment of the market will eventually become fierce.
COVID-19 and the car industry
Car companies were hit hard by the coronavirus pandemic in the first half of 2020. Most car factories around the world were shut down for several weeks, and many dealers ran short of popular models. By the end of June 2020, most factories had reopened with new rules and equipment to protect workers from the virus, but 2020 sales remained sluggish for most traditional automakers.
A rebound has been slow to emerge since automakers have been dealing with supply chain issues and a shortage in silicon chips. The supply chain is crucial for the automotive industry since it tends to run tight inventories using “just-in-time” production techniques.
Supply chain issues lasted through most of 2021, and production was continually pared back through the year. It’s unlikely production will return to normal before 2022. However, the good news is that used car sales are surging, which is an indication of underlying demand.