How the automotive supply chain crisis is leading to efficiency and investment opportunity

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Collapses in the global automotive supply chain have spawned a crisis among carmakers, but experts say the same issue now represents a rare long-term investing opportunity.

Gains in production efficiency, combined with pent-up consumer demand and the elimination of costly dealer incentives have allowed automakers to expand profit margins and focus more production on higher-margin vehicles.

“Global supply chain problems are not going to disappear overnight, but there are silver linings for the automakers that are probably not appreciated by a lot of investors,” says Elliot Johnson, chief investment officer at Evolve Funds Group Inc. in Toronto, who oversees Evolve Automobile Innovation Index Fund CARS-T.

“The Street is so focused on quarterly shipped units and nothing else, so it doesn’t really appreciate the nuance of how many of these disruptions have actually been beneficial,” he adds.

That’s why this is a great opportunity for investors to buy in now, particularly if they have a five- to 10-year time horizon, he says.

Dan Fong, investment analyst at Veritas Investment Research Corp. in Toronto, reached a similar conclusion in a report published in April, telling clients that “an investment in autos could represent an attractive risk-reward profile for those with a longer-term investment horizon.”

In an interview, Mr. Fong explained the cyclical nature of the automotive industry in which the natural order after a period of heavy contraction is recovery.

“Right now, we’re in a heavy contraction,” he says. In a recovery phase, “automotive stocks tend to outperform the broader market wildly.”

His analysis found whenever U.S. auto sales were in a recovery phase, the average stock returns of the Big Three U.S. automakers – Ford Motor Co. F-N, General Motors Co. GM-N and Chrysler-maker Stellantis NV STLA-N – outperformed the broader market by an average of 37 per cent.

Meanwhile, global auto parts suppliers such as Martinrea International Inc. MRE-T, Linamar Corp. LNR-T and Magna International Inc. MG-T averaged a 40 per cent compound annual growth rate (CAGR), compared to just 10 per cent for North American stock indexes.

“If the supply situation starts recovering in the second half of this year, the cycle could rapidly enter into a strong recovery phase,” Mr. Fong’s report said.

Pricing, inventory and production

Furthermore, the “meaningful disconnect between vehicle demand and supply” throughout most of 2021, led to what a recent DBRS Morningstar report described as “very firm pricing.”

“In addition to pricing, firmer product mix also contributed to the improved profitability of the [North American automakers] and most of the industry,” the report said. “This reflects carmakers allocating semiconductors to more profitable models.”

Automakers used to pay an average of US$2,200 in incentives to dealers for selling a certain make or model of vehicle, according to Evolve’s Mr. Johnson. Now, because there’s less supply than demand, they don’t have to pay those incentives.

“Even without improving the efficiency of the individual manufacturing operations themselves, there’s a balance sheet efficiency that comes from the supply constraints that is not intuitive, but is, in fact, the case,” he says.

While the DBRS Morningstar report found current automotive inventory levels are “not sustainable,” it also found several carmakers have indicated they are unlikely to revert to pre-pandemic inventory levels because they derived certain efficiencies that should enable them to carry lower inventories in the future.

The challenge posed by lower inventories is more about production consistency than the level of sales, according to Mr. Fong.

“You might be running your production line at 90 per cent of capacity one week and then the next week it could drop to zero,” he says. “The problem with that is you’re not able to flex your costs that quickly, and labour is an issue as well because if you start taking people off the line, those people might not come back.”

That’s likely to maintain a “volatile situation” in the short term for automotive stocks, Mr. Fong says.

How higher interest rates affect the market

However, higher used vehicle prices can offset investor concerns about the impact of rising interest rates on auto sales. Roughly 80 per cent of new vehicle purchases made in North America involve either a loan or a lease, Mr. Fong’s research shows, yet almost as many – between 60 and 70 per cent – of new vehicle sales also involve trading in a used vehicle.

“So, the higher your used vehicle price is, the more valuable your trade-in is and the less it costs to buy that new vehicle,” Mr. Fong says. “In the case of leases, higher used vehicle prices also equate to higher residual values, which makes your lease payments lower.”

Mr. Johnson says supply shortfalls, particularly for electric vehicles (EVs), are also helping to offset the impact of rising interest rates on the automakers themselves.

“It’s pretty common practice right now for anybody who is making EVs to be taking deposits just to get a spot on a waiting list that could be 12 to 18 months long,” he says. “For the automaker, that’s an interest-free loan for 12 to 18 months, which is not only pretty good financing, but you also get a locked-in customer who is unlikely to go elsewhere.”

Despite the financing boost, the DBRS Morningstar report warns “automotive margins may nonetheless be subject to meaningful compression [as] the progressive electrification of automotives will increase expenses, notably in research and development (R&D), further undermining margins.”

Mr. Johnson also believes the front-loaded nature of automotive investments in the EV transition will likely produce some disappointing quarterly results, although he argues that would only bolster the case for a longer-term investment.

“One way or another, the automakers who invest the least right now in EVs will lose in the long term,” he says.

“If anything, [you want to see] reports that [an] automaker missed estimates because of R&D in EV technology.”

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