Saturday, November 15, 2008

Looking Ahead To When Auto Sales Return

Value investors like to take advantage of markets like these, where cyclical dips allow investors to buy companies on the cheap. One particularly hard hit sector is the auto industry, where monthly new light vehicle sales recently hit a 15-year low. As most investors (institutions included) scramble to sell or short any stocks related to this industry (from baby car-seat makers to anti-theft services), this creates a buying opportunity for those with long-term outlooks who like to buy when others are fearful.

However, this is not to suggest any purchase in this sector will do. There are a few criteria to consider which will determine whether a stock qualifies as a low-risk, long-term investment.

First of all, one needs to make sure the company being considered is not overly reliant on debt financing. A cyclical downturn such as this will wipe out companies with high debt loads, as these companies will be unable make payments when demand is at abnormally low levels. For example, when we looked at a 2004 chart of GM and Ford's debt levels, we saw clear signs of their now widely accepted solvency issues.

Another important requirement for a worthy long term investment in this sector is that it should not be reliant on a few concentrated customers. A company's risk is much higher if it is too dependent on just a few companies. For example, while Linamar (LNR) is a well run parts manufacturer, its four largest customers account for almost 50% of its sales, which makes it susceptible to its top customers' problems, not just its own. The companies with the least risk are those that will make sales no matter who the market share leader is, whether it's Toyota or Tata.

Finally, it's important to consider whether the company's product is undergoing a secular downturn that is masked as a cyclical one. For example, companies manufacturing engines without hybrid technologies may never recover from this downturn, as the world becomes more sensitive to energy prices and environmental issues.

Know any companies in this industry that get a passing grade in all of the above criteria? Let us know, and we'll try to discuss them in our next rendition of The Mailbag.


Anonymous said...

What about dealerships, for example AutoNation (AN) and CarMax (KMX)

Anonymous said...

You guys mention the need for a good pick in the sector to have a diversified revenue base. Is that even possible when 95% of autos are made by maybe 10 companies?

Saj Karsan said...

Hi Anon2,

You are right there is a lot of concentration in the direct manufacture of autos. However, consider items that are not dependent on who makes the car. E.g. car alarms, baby car-seats etc...those types of companies have been hit hard, but aren't too dependent on just a couple of companies.