How do you evaluate an automotive stock?

Automotive stocks fall into the consumer durables sector. This sector includes companies that make products for consumers that are intended to last for more than a few years, like washing machines, furniture -- and cars and trucks.

Before investing in automotive stocks, it’s important to understand how economic cycles affect automotive companies and how these companies work to maximize profits and stay competitive during good and bad economic times.

Understand the auto sales cycle

Automakers and their suppliers are cyclical stocks, meaning that their profits rise and fall with consumer confidence. It’s easy to see why: When businesses and consumers are worried about the economy, they postpone buying new vehicles.

Auto sales’ cyclicality matters to investors because:

• Automakers have high fixed costs, including their factories, tooling, logistics networks, and labor contracts. These bills have to be paid no matter how many cars get sold.
• Automakers and suppliers also need to spend a lot on product development to ensure that they have a steady stream of competitive new products.
• High costs and steady spending mean that profit margins in the automotive industry tend to be low, even during good economic times.
• When sales slump, as in a recession, automotive companies’ profits fall sharply -- putting future-product spending and the companies’ future competitiveness at risk.

Cash reserve

Most automotive companies cut future-product spending sharply during the 2008-2009 recession. The few that didn’t, including Ford and Hyundai, had fresh products in their showrooms when the recovery began and were able to gain market share.

That was an important lesson for the industry. Now most global automakers have substantial cash hoards -- $20 billion is common -- to keep future-product efforts running through the next recession, whenever it arrives.

Many automotive companies also pay dividends to their shareholders. Some automakers planned to use their cash reserves to continue to pay dividends during a recession, but during the COVID-19 pandemic, Ford and General Motors both suspended their dividends to conserve cash.

Competition

Generally speaking, the automaker with the newest products will get the highest prices and the best profits. Automakers must invest constantly to ensure that they have a steady flow of new products in their pipelines.

Nowadays, virtually all automakers and many parts suppliers are also making big investments in future technologies like electric vehicles and autonomous driving systems. Most experts believe that those technologies will be necessary for automakers if they are to stay competitive in the not-too-distant future.

Electric vehicles

Some of the most exciting opportunities of the next few years will involve manufacturers of electric vehicles. Electric vehicles are new and different, and most analysts expect them to largely displace internal-combustion vehicles over time.

Electric-vehicle companies might see high growth, which is exciting for investors. But it’s important to remember that the processes involved in developing and manufacturing electric vehicles aren’t all that different from those used by makers of traditional internal-combustion vehicles. That means electric-vehicle manufacturers face high costs just like traditional automakers.

It’s also important to remember that all of the major “traditional” automakers are introducing electric vehicles of their own, and the competition in this segment of the market will be fierce in time.

COVID-19 and the car industry

Car companies were hit hard by the coronavirus pandemic in the first half of 2020. Most car factories around the world were shut down for several weeks during that period, and many dealers ran short of popular models. By the end of June 2020, most factories had reopened with new rules and equipment to protect workers from the virus, but 2020 sales remained sluggish compared to 2019 for most traditional automakers. Many electric-vehicle manufacturers, on the other hand, saw big year-over-year sales gains in the latter half of 2020, thanks largely to their ramped-up manufacturing capacity.

How do you understand automotive companies’ financial statements?

For the most part, automotive companies’ financial statements aren’t too hard to decipher. Here are three things to know:

• Auto investors tend to look at operating income, or EBIT (earnings before interest and tax), as well as operating or EBIT margins (calculated by dividing profits by total revenue), to track an automotive company’s financial performance over time. These include the direct costs of manufacturing and shipping vehicles as well as research and development expenses (which can be very high in the automotive industry) while excluding interest costs and taxes less directly related to the company’s ongoing performance.
• Often automakers will provide adjusted figures that exclude the impact of one-time charges and gains like write-offs and tax windfalls; those are useful for understanding the underlying performance of the business. (Note that one-time charges and gains can be important, too.)
• Many automakers have subsidiaries that are finance companies, providing loans and leases to customers and dealers. They’re generally quite profitable, but they can make automotive financial statements confusing for investors. To help, most automakers provide debt and cash flow figures specific to their core automaking businesses, often called “automotive” or “industrial” numbers. You can use those to understand a company’s debt, and for comparisons between automakers.

Are automotive stocks for you?

Automotive stocks can be important contributors to your investment portfolio. Because they rise and fall with consumer confidence, they can be useful indicators that economic trouble -- or a recovery -- may be on the way.