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How to solve the auto puzzle?

Dec 23, 2010

Over the past few weeks, the performance of auto stocks has been quite mixed. While some stocks are trading near their all time high levels, some have retreated quite sharply. But till a while ago, one thing was common. Almost every auto stock was on a tear. And the key reason for the same was the strong sales volumes. This was the case across segments - commercial, two-wheelers, three-wheelers and passenger vehicles.

With the same happening, valuations of most of the auto stocks entered uncomfortable territories. At least we believe so.

And it's quite possible that you as an investor were quite unsure about what to do. A few questions going through your head would include - 'Have I missed the bus on auto stocks or should I enter at current levels?', 'Are the sales volumes expected to grow at such a fast pace?', 'Are auto stocks' valuations justified at present?'

Well, we hope this article empowers you to answer these questions when they come to your mind in the future.

The core idea behind this article is that auto numbers will eventually return to their normalised growth levels. This is especially true for the more cyclical sub-segments such as commercial vehicles.

The inspiration behind this idea is Peter Lynch. He discussed this topic in one of the books he authored. Mr. Lynch is of the opinion that customers will defer their purchase during difficult times. Here difficult times could include high interest rates, higher vehicle operation costs as well as vehicle prices. The latter indirectly depends on commodity prices or input costs. In addition, the poor economic conditions also play a factor as it leads to less consumer spending.

However, once the scenario improves or normalises, so does the customers' sentiments. Those who had put their purchase plans on hold will end up buying their desired vehicles. And thus, the volumes will increase.

The same logic can be used for good times as well.

As we saw in FY10 and in the year till date, auto sales have gone through the roof. But going by Mr. Lynch's logic, the same would have happened as demand is playing catch to the normalised growth level.

Let's explain this with the help of an example.

*- Normalised volumes, M&HCV– Medium and heavy commercial vehicles.
Data Source: SIAM India, Equitymaster research

As you can see from the above displayed chart, we have shown the actual industry M&HCVs (medium and heavy commercial vehicle) sales volumes of every fiscal. We have also shown what the volumes would have looked like in a normalised environment (discussed in brief below).

As you can see, post the FY00 slowdown period, CV sales volumes rose significantly. The same is the case in FY10 and the year till date i.e. after the decline in FY09.

Even in FY08, the sales volumes growth was flat before declining by a sharp 32% YoY in FY09. But come FY10 and the auto sales volumes shot up by about 33% YoY.

The scenario in the year till date (FY11) is similar. During the eight month period (April 2010 to November 2010) total M&HCV volumes stood at about 213,000 units. This is nearly 80% of the full year FY10 sales volumes figure. And from the looks of it, it seems that the sales volumes for the full year FY11 would be in the range of 300,000 to 320,000 units. And if we compare this to the figure we get from the normalised growth rate, it is almost the same. Therefore we have a reason to believe, at least keeping the current scenario in mind, the volumes growth for the next year should slow down to the normalised growth rate.

We must mention here that the normalised=" growth rate (10% in the above example) is calculated based on the compounded growth rate during the FY98 to FY10 period. The rate could be quite subjective.

From the looks of it, this seems like quite a tricky task. But it would definitely help one get an idea of the trend going forward. We believe that taking a multiple of the GDP or IIP growth can be a good number to go by. Not to mention that predicting these figures for the long term is a task in itself. As per the management of commercial vehicles major Ashok Leyland, a CV industry growth of nearly two times IIP growth is possible.


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