Auto Ancillaries

Hello friends,

The idea to look at this important sector occurred out of a request to examine a particular auto ancillary stock by our dear friend Ramubhayya (Rameshwar Laddha), an avid investor. I myself own a few auto ancillary stocks but have not had opportunity to look at the sector in totality. So thanks to Ramubhayya for being a trigger for this piece.

Auto ancillaries are the businesses supplying parts and systems that go in to making of an automobile, be it a two-three-four wheeler, passenger, commercial, a farm tractor or even an earth mover. The components count literally in thousands but broadly can be segregated in to a few categories like engine valves, pistons, steering systems, suspension systems, interior, castings, electricals etc. None of the auto companies manufacture the individual components and are, at best, assemblers with a brand that assures quality. All of them have their own preferred ancillary suppliers which in turn supply to multiple auto manufacturers. The auto industry is giant but concentrated with established large-cap players whereas the ancillary industry is far more distributed while being equally big in size but mostly comprised of small-cap companies. The competition in both is intense and margins low. The ancillaries in particular lack pricing power as they are at the mercy of big auto companies, though usually the auto majors do not change vendors as it involves switching costs.

However, the auto sector was not doing too well in the last five years with small single digit growth rates and then the pandemic dealt a severe blow to this already ailing sector. The ancillaries, being small and not so strong bore the brunt, especially those with high leverage, sounding the death knell for the weaker of them.

Only when the tide goes out do you discover who’s been swimming naked

Warren Buffett

The tide seems to be back now, at least the stock prices indicate so, if not their bottom lines. Not yet. As the tide floats everything with it, the stock prices of almost all stocks are up and near their 52 week high prices. This attempt, therefore, is to find out which ones are inherently strong, are leaders in their niche segments and are most likely to benefit from the tailwinds of expected surge in economic growth post the pandemic. The usual business parameters like the product fit, trend, position on growth S curve etc are similar to all companies as these are all established businesses. The management factor, sector leadership, financials and valuations will therefore be important in evaluation at this stage. Considering the number of stocks, this exercise may be considered as a primary filter to get at the stocks to be further examined for investment.

Auto sector Future: The face of the sector is changing with entry of electric cars and technology in every aspect of car building. There is far more automation, electronics and even artificial intelligence involved. New concepts like driverless cars and hitherto unknown features like personal assistant, wellness care interiors, hyper connectivity, auto parking, virtual side mirrors, biometrics and what not are slowly becoming reality. It may not affect the conventional auto ancillary companies in the short term, but eventually companies leading the upcoming technology wave will be the real wealth creators in the long run. The internal combustion engine is not likely to get extinct anytime too soon but the trend against it is irreversible. Remember the Kodak story? Another aspect we need to consider is the work-from-home culture introduced by the pandemic and how it affects the overall auto demand in the long term. So, ancillaries dealing in car control electronics, batteries and communication are preferable to companies dealing in pistons and valves. Look at the video of upcoming Apple car to get an idea of how the future cars going to look like.

Auto sector revival also depends on the inflation rate which in turn will affect the RBI controlled interest rates. The commodities, especially steel prices are up of late. Higher interest rates and higher steel prices are more than likely to add to the costs and dampen the demand. Overall, the revival, if and when happens, is likely to be slow. The factors supporting the revival are 1) expected burst in economic growth in the next two years, subject to control of the Pandemic 2) Advent of tech savvy cars. The factors going against are 1) high commodity prices 2) high interest rates and inflation 3) WFH culture and 4) failure in controlling the worldwide Pandemic. The stock market, as usual, is optimistic and forward looking and therefore we see the surge in stock prices without tangible earnings recovery.

As mentioned above, the technology part will be more and more pronounced in the new age automobiles. The ancillaries that may face the heat in the long term could be Pistons, valves, ignition, exhaust systems and die casting. The ancillaries that may get some tailwinds are the ones dealing in electrical, electronics, communication, lighting, batteries and automation in general. Chassis, axles, steering, gears etc. may remain neutral to this change. Having said that, the technology sweep is at times much faster than anticipated, surprising most of us and it is therefore prudent to keep only the high tech stocks on the long term radar.

The pace of change and the threat of disruption creates tremendous opportunities.

Steve Case

As mentioned above the auto ancillary stocks are divided in to three categories as below.

A) Sectors that may experience tailwinds due to advent of new technology and electric cars	B) Sectors that may remain unaffected by new technology	C) sectors that may eventually may get outdated
Batteries, cables & lighting, electrical, locks, automation	Axles, bearings, brake linings, castings, gears, ignitions, seats, steering, suspensions, shock absorbers, tyres, steel rims	Exhaust systems, pistons, valves

So friends, get set for an avalanche of data. There is really no escaping a diligent look at data, gathering related information and a reasonably good interpretation of these two to arrive at investment decisions that will stand you in good stead in the future.

Stock analysis data for sector A is as below. The analysis is based on financials and valuations. The stocks highlighted green can be considered for investment after due diligence. Stocks highlighted yellow to be kept on watch.

Wabco is one stock that does not reflect here (Included in Niche/Misc stocks) but it really belongs to this category. A futuristic stock. As brought out earlier, the valuations of most of the stocks are stretched in the forward looking market. There may be, however, opportunities to buy on dips. Also please remember how the valuations are considered least important as explained in the 60:30:10 principle (You can read it here). A glaring example is the Apple stock, which in the last ten years always quoted at a PE between 40 to 50, was considered pricey, but the stock multiplied 15 times during the same period. There are many such examples in the Indian stock market as well. The reason to cite Apple is that it is a top stock at global level. Therefore, if the business is having good growth potential, it is preferable to buy it now than missing it altogether.

I can’t stop myself in recounting a similar experience. Thirty eight years back, I, with a few friends, travelled from Nagpur to Mumbai to join IIT Powai for a PG course in chemical engineering. We reached Dadar at around 4:30 PM with trunks (read suitcases) and hold-alls (Remember those?) and duly changed platforms to catch a local train to Vikroli (Taxi was a luxury those days). The first train that came, was left alone since it was too crowded. Same with next two trains and then it suddenly dawned on us that the rush was actually increasing at a rapid rate. We then held up the baggage on our heads and barged in to the next train like a charging rhino. We reached our destination alright. Buying stocks at stiff valuations in the bull market is a much similar exercise. Also remember that the valuations of good stocks are likely to ease up with good earnings.

Moving to the stocks that may remain generally unaffected by the advent of technology and automation. These are parts that will still be required to build an automobile.

A staggering horizon this. Staple diet stocks in the auto ancillary sector.

I came across two auto parts trading stocks which really have very good financials. The reason is simple. They can supply whatever is selling in the market and will never be affected by product speciality. Perfect proxy plays. Proxy plays are a nice way to benefit from a trend without being actually in to the main business. Let me relate the classic proxy play story here. During the California gold rush of 1849, thousands rushed to California to make their fortunes. The early gold seekers made a lot of money. But two people, who did not go after the gold, made most money. The first was Samuel Brannon, who set up stores around gold fields, bought all the gold digging related equipment and resold it at enormous profits. Second was Levi Strauss who made durable pants (trousers) for the gold diggers which became extremely popular. The Levi brand went on to become so big and it still exists.

There are some Niche product companies which do not have much competition and are worth looking at. As mentioned earlier, Wabco is a potentially high growth stock, though currently too expensive.

Finally the internal combustion engine related stocks which may become outdated once the electric cars become the new normal. This may not happen soon and for the time horizon of five years or so, it is reasonably safe to get in to these stocks.

As said earlier, the auto ancillary sector is a big skyscape with many small stars. In a way the ancillary business is a proxy play to the main auto sector. Many of these ancillary companies also have good aftermarket business. There are companies from some reputed groups like Murugappa, TVS, Munjal, Minda, Rane, Suprajit, Hero, Talwar etc. The managements of these groups are known to be good. This is very important, especially for small-cap stocks that the auto ancillaries are.

Valuations of most of these stocks have become stretched in the current raging bull market but the outlook for the economy is good and there will be some pent up demand too. So despite high valuations, it is time to add some good stocks to your portfolio, if you have not done so already. I have seen stock blog writers declaring their holdings in their blogs for the readers to draw their own conclusions about influencing aspects. Following that practice, I would like to inform that I hold Minda corporation, Amara Raja batteries, TVS Srichakra, Suprajit engg, LG Balkrishnan and Swaraj engines. The last one is a company supplying diesel engines only to Mahindra tractors. I also have Mayur Uniquoters which is a good stock, somehow not reflected in the stocks analysed here. It supplies textile fabrics and artificial leather to auto industry.

Do revert with your comments, queries and suggestions.

Often the journey is more interesting than the destination

bhushan

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Happy investing