Automobiles: Investing Essentials

What's the world's best-selling car? It depends on how you count. Ford's Focus (shown) and Toyota's Corolla both have strong claims to the title. Source: Ford Motor Company

For over a hundred years, the automobile industry has been bringing mobility to the masses. From the early days of Ford's Model T to today's high-tech sedans, relentless innovation driven by competition has steadily improved the cars we drive every day.

But over the last couple of decades, the automobile industry has changed: No longer are big automakers focused primarily on one region of the world. Today's big automakers are global giants, competing in all of the world's major markets, often with a single line of products. As a result, competitive pressures -- and the speed of innovation -- are greater than they've ever been.

Let's take a closer look.

What is the automobile industry?

Simply put, the global auto industry is made up of companies that make and sell "light vehicles", the industry term for cars, SUVs, pickup trucks, and small vans. 

For many years, the industry was dominated by regional giants: General Motors and Ford were the dominant players in the U.S., while Volkswagen was big in Europe and Toyota in Japan. 

To some extent, that's still true: GM and Ford are still the leaders in the U.S. market, VW is still on top in Europe, and Toyota still has the biggest market share in Japan. 

But globalization has muddied the national boundaries: Toyota is also a huge player here in the U.S., for instance, while Ford has a big share of Europe and Italy's Fiat is a major player in South America. 

And it has made for international mashups, as former regional powers seek global scale: Fiat and Chrysler have merged to form Fiat Chrysler Automobiles, and Japan's Nissan is closely linked with France's Renault.

Even widely recognized global brands are stronger in some places than in others. For instance, Audi is the dominant player in China's luxury-car market, but it trails several rivals in the U.S. Shown is the hot-selling Audi Q3 crossover. Source: VW Group

Recently, China has become a major factor in the industry. There are a host of up-and-coming Chinese automakers, some of which could become global players in the future -- but right now, China's massive auto market is dominated by VW and GM, with Ford a rapidly rising contender. Chinese tastes are a growing influence on the design of global vehicle models.

How big is the automobile industry?

According to figures from the International Organization of Motor Vehicle Manufacturers, 85.4 million new vehicles were sold in 2013, or about 2.7 every second.

That number has grown significantly in recent years, as you can see from the chart below. Quite a bit of the growth has come from China, now the world's largest new-vehicle market.

Source: International Organization of Motor Vehicle Manufacturers. Figures are in millions and include sales and registration data for passenger cars and commercial vehicles.

How does the automobile industry work?

Unlike many high-tech industries, product cycles in the auto business are measured in years, not months. Designing and building a new vehicle from scratch can take anywhere from two to four years from first design to the start of production. 

Automaking is a heavy industry, and the fixed costs are significant. It can cost a billion dollars or more to develop an all-new vehicle from scratch, and as much as a third of that cost can go to pay for the specialized tooling used on the assembly line, much of which -- like the giant dies that stamp out body panels -- may be specific to a particular model. 

Often, there will be several different factories around the world making a particular model. For instance, Ford's Fiesta is made in five different factories, in Mexico, Germany, China, Thailand, and India. To minimize high shipping costs and exposure to tariffs, automakers tend to locate their factories near to where their vehicles are sold. 

Those factories -- and the expensive tooling, and the skilled labor forces required to operate them -- are part of why we say that automakers have high fixed costs. Not only do automakers have to pay to keep their factories going, but they also have to continually invest in the development of future products in order to stay competitive.

That makes automakers especially vulnerable to economic downturns, when consumers and businesses tend to postpone new-vehicle purchases. In the past, automakers that haven't been able to sustain investments in future products through difficult recessions have found themselves at a disadvantage during the recoveries that have followed. 

Nowadays, nearly all of the global automakers maintain a hefty cash reserve of $10 billion or more in order to ensure that new-product programs won't be disrupted by an economic downturn.

Who are the major players in the automobile industry?

Nearly all of the big automakers are familiar names to Americans. These were the top ten by total sales in 2013:

Each of those automakers owns a portfolio of brands. Sometimes the portfolio is small: Honda, for instance, sells vehicles under the Honda and Acura brands, as well as other products (like motorcycles) under the Honda brand. 

But sometimes it's large: The Volkswagen Group includes the VW, Skoda, SEAT, Audi, Porsche, Bentley, Lamborghini, and Bugatti light-vehicle brands, as well as several brands of heavy trucks and the Ducati motorcycle brand.  

What are the drivers of the automobile industry?

Generally speaking, economic conditions drive new-vehicle sales, which in turn drive the fortunes of the automakers. Simply put, when they have the option, people (and businesses) tend to postpone new-car purchases when their jobs or profits are at risk, as during tough economic times.

But when we look at any specific automaker, what drives its success relative to rivals is the competitiveness of its products. This is the first thing to look at when evaluating an automaker as a potential investment. But it's not simple to gauge. Autos aren't commodities; they sell on a wide range of criteria, some of which are largely emotional and defy measurement. What makes a great car? It's a hard question to answer.

There are lots of reasons why Tesla Motors' Model S is so well-regarded. How many could you measure? Source: Tesla Motors

A competitive product is one that is seen as more desirable than others in its market segment, because of quality or design or technological advantages, or sometimes because of the power of its brand. Generally speaking, a new product will be more competitive than an older one, but there are exceptions.

Here's why it's so important: An automaker with a competitive product can charge more (or put another way, discount less), meaning it will make more profit per sale. 

The companies with many competitive products will tend to have strong profit margins (and fatter profits). That gives them more money to reinvest in future products -- or to pass on to shareholders via dividends. (That said, margins in the auto business tend to be thin when compared to some other industries: a 10% pre-tax or "operating" margin is quite strong for a mass-market automaker.) 

As investments, the stocks of automakers are considered cyclical, meaning that they tend to rise and fall with economic conditions. Because of those high fixed costs, an automaker needs to sell a certain number of vehicles just to break even. As sales fall closer to that number, profits shrink.

In the past, some automakers would endure several quarters of heavy losses during recessions. But most of the big global automakers have learned the lesson of the 2008-2009 economic crisis and have tried to structure their operations in a way that lowers their break-even point to about the rate of sales seen at the worst of the crisis, in late 2008 and early 2009. And, as mentioned above, most have established large cash reserves so that they can continue investing in new products even if -- or perhaps we should say when -- the next recession squeezes their profits.