How to choose auto component stocks

Listed vehicle manufactures are only a handful in number. But it is not so when it comes to the auto component space, which has a number of mid- and small-cap stocks. The supply chain for the auto companies is quite long, consisting of at least three tiers of vendors. Thus, the auto component industry is highly fragmented. With auto being a cyclical industry, the fortunes of many parts suppliers also wax and wane with ups and downs in the cycle. Typically, companies having a diversified client and geography base, those supplying to more than one segment of vehicles (i.e., cars, bikes, trucks, three-wheelers, tractors, off-road vehicles) as well as those that cater to both the new vehicle as well as the replacement market requirements tend to weather a storm better. How should investors go about picking auto component stocks? Here’s a guide:

Parameters

To arrive at a short-list, we screened auto component stocks on parameters such as five-year CAGR in sales and profits, EBITDA margins, debt levels and return on net worth. A double-digit growth in profits and/or sales in the last five years, consistent double-digit EBITDA margins and return on net worth as well as low debt levels were favoured. Five years is long enough for a cyclical industry to go through ups and downs and deliver. From an initial set of stocks that showed double-digit five-year CAGR in profits and or/sales, we further eliminated those that had relatively higher debt and lower margins and return on equity. The performance in the first six months of this year has been considered as the final filter, but has not been given undue weightage for the overall short-list, considering the extraordinary circumstances.

Who made the cut

Many of those that made the cut are not very surprising names. The list includes Balkrishna Industries, Endurance Technologies, Sundram Fasteners, Suprajit Engineering and Amara Raja Batteries (not in any particular order). Balkrishna Industries is a tyre manufacturer having the twin advantages of geographic diversification (only one-fourth of its revenues from India) as well as presence in a segment where there is substantial replacement demand due to wear and tear.

Endurance and Amara Raja too are a play on geographic diversification and presence in replacement segment, respectively. Sundram Fasteners, is a market leader in fasteners and makes value-added components for various auto segments. while Suprajit whose products include cables and lighting solutions, again has global exposure. But there were also some under-the-radar picks in Fiem Industries, GNA Axles, and India Nippon Electricals.

Depressed earnings and sharp rise in stock price has seen valuation of many of the stocks discussed here move up steeply. The challenge today is picking stocks that are good, but still trade at reasonable valuations. Currently, only Fiem Industries fits in here.

Fiem’s business lies in in automotive lighting and rear-view mirrors space. The company is a supplier for the two-wheeler industry, with Honda and TVS Motor being its biggest clients. While the stock has more than doubled since the March lows, it trades at about 15 times its trailing earnings. This is in almost in line with its 3 and 5 year average historical valuation.

The company bounced back to profitability in the three months ended September 2020, after making losses in the April-June quarter. Apart from this blip, the company’ s profit growth has been healthy in earlier quarters. It’s EBITDA margin stands at about 11-12 per cent in the last five years, better than peer, Lumax Industries.The company’s return ratios ( return on equity / capital employed) took a downswing from the over 20 per cent levels five years ago due to its LED lighting business, not taking off as quickly as expected. The return ratios in the last four years have been at 12-17 per cent levels. LED lighting is a promising long-term opportunity though, for the company. Its debt to equity ratio as of FY20 is 0.3.

For other stocks in our short-list, investors can wait for price correction and/or recovery in near-term earnings, to accumulate.