With the country in lockdown and the sound of traffic noticeable by its absence, now might be a strange time to consider investing in the auto sector. Historically, the auto sector has not been a great industry for investors either. It can be quite fragmented, cyclical and does not have fantastic levels of growth. Solid players like Toyota and Honda have earned 10 per cent or so returns on equity over history – not terrible, but not fantastic. Yet in recent years, the gap between price and value of some global auto players has widened, and that’s even before the declines caused by the coronavirus pandemic. For those brave enough to invest in today’s market downturn and willing to take a multi-year perspective, that has opened up an opportunity for investors to buy what we consider are very good value bargains.
Among the key reasons for this gap to have widened is the current economic cycle. Sales in China have been declining for two years. The outlook for auto sales globally, is weak. But, long-term investors will recognise that cycles come and go and it is typically most rewarding to invest amidst the gloom of the ‘down’ phase of the cycle when pessimism reigns. In typical cyclical downturns, auto industry leaders tend to have valuations of around book value at the trough. In other words, it is very rare that you get to buy well-capitalised industry leaders for less than the combined accounting value of their factories and inventories. But, the market is serving up even better bargains today.
Honda, for example, has only rarely traded below book value in the past but it is now priced at close to half that level today. Investors are effectively saying that Honda’s future will be significantly worse than its past: either the auto sales cycle will never recover or Honda’s future has somehow been fundamentally impaired, perhaps due to technological disruption such as electrification and autonomous driving. On all those counts, we think the market is being too pessimistic.
For example, the more we have followed the situation for electric cars the more we have concluded it won’t necessarily be a significant game-changer in terms of industry structure. Yes, electric cars are much simpler to make than cars with internal combustion engines which have been refined over 100 years and have become mechanically complex, but Tesla is very much the exception in terms of being able to break into the market.
Tesla has unfortunately shown that electric cars are not yet profitable to sell due to low real demand from ordinary households. If and when electric vehicles do become profitable – because battery costs sufficiently decrease, or subsidies encourage it, or regulators crack down on emissions – the Hondas and Toyotas of the world will be fully prepared from a manufacturing, sales and distribution perspective for that.
The hype you see in the stock market is quite different from the reality on the ground. Tesla’s market cap is more than twice that of Honda’s, but with Honda you’re getting more than 5x the revenue and 40 years of history as a profit-making enterprise. Tesla has been loss-making in each of the past ten years.
Similarly, the more we look at autonomous driving the more it seems to be a very distant prospect, at least as an industry disrupter. Sharing autonomous vehicles, for example, would require a major shift in mindset due to the loss of the convenience, practicality and safety of our current system. There is also a way to go before we have safe execution at scale of autonomous driving. It does not appear to be a necessary material factor to consider yet, even for long-term investors.
Two stocks are particularly well placed to deal with the changing automotive industry landscape.
Honda
In addition to the current valuation, the hidden gem with Honda is that it accounts for 35-40 per cent of the world’s motorbike market, where it is the biggest player by a stretch in what is a more attractive industry sector than cars. The company made more money last year on motorbikes than cars, but despite this, at today’s valuation Honda is priced as if it’s just a cyclical, car-company basket case.
The shares historically have traded at an average price to book of closer to 1.5x. Given that motorbikes are actually a high-quality business that deserves a pretty decent P/E (price-to-earnings multiple), Honda’s car business– which is still among the world’s best – is even cheaper. We think the value case for Honda is particularly compelling.
Toyota
Governments and regulators are undoubtedly going to crack down on emissions further in future. This is inevitable as the green agenda takes hold, but Toyota, with its significant lead in hybrid cars, is in a much better position than those companies which aren’t prepared for major emission controls.
Hybrids – combining the technology of electric vehicles with petrol technology – are an excellent way to get emissions down without forcing consumers into the highest-cost option, and we believe that hybrid technology will continue to play an increasingly significant role in the industry’s evolution. In our view Toyota’s leadership in commercialising this technology provides it with a significant competitive advantage.
More broadly, the company is one of the biggest scale players – number two in global market share behind Volkswagen – with a full product line not only in hybrids, but in big SUVs, minivans, small run-around cars, cars that run all-petrol, all-electric, or all-hydrogen. Whatever the regulatory regime or consumer tastes, it can provide what suits the market at price points that work for it and for the consumer.
Even in a weak market, both Toyota and Honda have been taking market share and growing nicely in China. Toyota also has one of the best balance sheets in the industry, which positions it well to both weather the current crisis and to continue to make the investments necessary to compete. The current turmoil triggered by Covid-19 has caused further uncertainty in an industry with already depressed valuations. For investors who are able to stomach the short-term volatility, these companies are well-placed to handle the changing auto world and offer prime long-term opportunities at attractive valuations.
Ben Preston is manager of Orbis Global Equity fund. The views expressed above are his own and should not be taken as investment advice.