8 steps to identify sector opportunities – from breakout to maturity

How does it feel like to pick a sector that doesn’t show much evidence of doing well when you notice it and yet you feel that in a growing economy, the sector cannot remain supressed for long? We traversed through such a sector for over 21 months.

Looking back, we are pleased with the outcome. The sector we are talking of is auto. A sector where we did not just pick our Prime Stocks from but also built a smallcase around it (note that our auto smallcase is no longer available for fresh investments). Our cherry picked stocks worked well. 

 And yet, the journey was also filled with hits and misses. This is an exploratory article on how stock prices and valuations evolve as a sector’s prospects turn around and how they even deceive us, with takeaways from the auto sector. We hope this will help you in not just identifying sector moves but in also picking the right stocks in the sector. 

#1 Sighting early movers in the auto space

Now, in every sector there would be companies that find ways to navigate the tough times in the sector and still do well. But they are few and they emerge as outliers when the sector tide turns.

SBI in PSU banks or L&T and Adani Ports in infrastructure or ABB and Siemens in capital goods or DLF and Godrej in real estate are such examples. We can date back and  extend it to Infosys and Wipro as well post the dotcom boom in 2000.

The same thing was happening in the auto sector where some companies managed to do well despite the sector going through stress.  These companies comfortably surpassed their FY19 sales (when auto sector volumes peaked out) in FY22 and FY23, just ahead of the full-blown recovery for the auto sector. Here are some of them.

This raised an important question to ponder: Why is it that some companies manage to do quite well when the entire sector is down? Thus began the bottom fishing for the first set of winners.

While it was the market share gain story for OEMs like TVS, M&M and Eicher Motors (Royal Enfield), the story for ancillaries was that of product diversification, tapping exports and non-auto segments to get rid of auto sector volatility; it also included acquisitions.  

So, the first clue was coming out from the numbers itself.

#2 Woes get addressed, sector upside confirmed

While the auto sector was struggling with semiconductor shortage and volume growth during FY2022, in the aftermath of Covid, their woes started receding from FY23 and the year ended on a healthy note, especially for passenger (PV) and commercial vehicles (CV). Halfway through FY23, consensus started emerging that the auto sector would do well as numbers started improving on a month-on-month basis and a clear growth trend was evolving.  

PVs and CVs did extremely well in FY23, posting a full-blown recovery. Two wheelers (2W) were still lagging and they are, even today.

The hunting ground also gets better for investors as a sector upturn offers wider opportunities to pick stocks that can perform. 

If we recollect, the first NFO from this sector after many years (UTI Transportation and Logistics was the only one till then), ICICI Transportation & Logistics fund came in October 2022 and was followed by IDFC Transportation & Logistics fund as well. Two more funds followed in 2023 as well. 

(At PrimeInvestor, we added the auto sector fund after our March 2022 Prime Funds quarterly review and it paid rich dividends 😊)

#3 Break-out candidates - when and how

As stock investors, the real challenge starts at this point. You know a sector is doing well and you wish to pick the biggest winners in that. But more often than not – with breakout winders – we may not know how and when they happen. 

To understand this better, let’s discuss what triggers stock price performance and how we may get deceived.

Let’s take the elusive two-wheeler space. Even today, 2W sales volumes have not surpassed pre-Covid (see table) levels, but we had some outliers. Some of them had clear evidence while others did not. 

We’re talking of Bajaj Auto, TVS Motor Company and Tata Motors. 

TVS Motor Company was a non-surprise winner as we mentioned earlier that it was already outperforming the industry growth by a wide margin and has doubled its sales from pre-Covid levels. A growth investor could have gotten into it (10 Yr revenue CAGR of 16%, PAT CAGR of 25%), if not deterred by relative valuations. It is still the most expensive stock at 55 PE.

Bajaj Auto, though, was a dark horse. The stock nearly trebled from its pre-Covid peak! And this happened despite OLA and Ather stealing the show in EVs and diverting investor sentiment against conventional OEMs. 

You may have rarely come across Bajaj Auto as an investment idea or in the top holding of any PMS or a fund house. DII holdings in Bajaj Auto have continuously dropped from 13.23% in December 2021 to 8.66% at the end of December 2023 (Btw the stock nearly doubled between October 2023 and March 2024). 

Still, it delivered industry leading domestic sales performance in FY24 (+25%) while management initiated a surprise buy-back at Rs.10,000 per share. Both the growth numbers (despite weak exports) for FY24 and the buy-back price of Rs.10,000 took the street by surprise and triggered the run (Bajaj’s past 10 Yr revenue growth was 7-8% CAGR). 

But this 25% growth would not have been an easy guess early on, from the month-on-month numbers without seeing a few months of data. The industry shift also played its part on Premium (>125CC) bikes selling more than Value (100-110CC) and favouring Bajaj. If the trend stays on, valuations could also settle a tad higher for Bajaj Vs its historical average. 

Bajaj has traded at a median PE of 20 times in the last 10 Years while its current PE is 35 times.

The bigger surprise though, came from Tata Motors. The stock doubled in 2023 and was soon followed by announcement of a demerger of its PV and CV businesses. Sum of the Parts (SOTP) valuation, which is often a bull market innovation, played out with each business getting valued separately. It also had a successful subsidiary IPO in-between (Tata Technologies). Otherwise, Tata Motors was a complex business to value with its overseas subsidiary JLR quite often throwing up fresh troubles. 

Between FY19-23, Tata Motors made losses at consolidated level in 4 out of the 5 fiscals.

One thing that comes very clear is that the market was on target to reward the ones that emerged as outliers in terms of earnings performance in the first place.  After all, stock prices are a slave of earnings.

While TVS was running clearly ahead on the merit of its own growth, a combination of growth and valuation game played for Bajaj (buy-back) and Tata Motors (SOTP). 

The ancillary pack also threw up many winners, some of which we discussed in the previous session, and ones like Sundram Fasteners, Bharat Forge, Pricol, Lumax, etc lit up our portfolio as well. Here again, stock prices were following earnings only with additional valuation triggers coming on top of that for few of them. 

For example, we invested in Pricol at 24 times and saw its valuation rising to 40 times as the market got convinced that it is ahead of its competition, even as its competitor attempted a hostile takeover.  Meanwhile, Bharat Forge got a leg up in valuations for its defence foray.

#4 Past heroes may not make a big comeback

Meanwhile some of the richly valued stocks and leaders of the previous bull run until 2019 faced set-backs due to structural shifts. Be it Bosch (dieselisation trend reversing with stricter emission norms), Hero (demand shifting to premium, EV eating bottom end market share) or Maruti (segment shift to SUVs and small cars de-growing), their earlier bull market performance simply moved to oblivion.  Still, they were not out entirely.  These stocks too managed to hit new highs, though not with a run-away up move.

Despite facing headwinds, they also played their game with necessary tweaks to their businesses. Maruti did a commendable job of delivering volume growth despite its bread-and-butter small car segment de-growing 12% in FY24. It launched SUVs in quick succession and clocked volume growth of over 25%, mind you each SUV comes with 2X realisation of a small car thereby giving a big leg up to revenue.  

Hero too did some striking launches all the way from 200cc to 440cc (First Made-In-India Harley) with the objective of earning more from premium products.

This shows how tricky and deceptive it can be when it comes to returns when a sector turns around. It can throw up new winners and new leaders with multiple factors playing out in growth and valuations.

#5 Fortune favours the bold, in small doses

When you hunt for the best and settle with the best, you are safe. But you are not going to have a basket of multibaggers with the highest returns.

While finalising our Auto++ smallcase portfolio stocks, we came across two less-obvious choices - both highly leveraged companies. One was Tata Motors and the other was Ramkrishna Forgings. The key question in our mind was - why bet on them if they are that risky? 

But with the lowest allocation, we decided to give them a chance. If the sector really does well, such companies would also do well as a combination of operating leverage, margin expansion, cash flow improvement and debt reduction would follow in a sequential order and lift valuations. Focusing on allocation is one rational way to play such opportunities; heads you win, tails you won’t lose. 

Eventually, they turned out to be two of the biggest winners.  

Of course, everyone would like to buy truckloads of such multi-baggers! But then how to buy so much when you don’t know it for sure, but count only on probability?

Let’s also discuss one more company, which we discussed in our PrimeInvestor community as well – Force Motors.  A family owned, family run company with no great track record of profitability or RoCE. Why would one bet on it? Few management actions during the downturn that enhanced the probability of it doing well in future included - winding up loss making businesses and challenging its own product with a sophisticated one (launched Force URBANIA on top of Traveller). But then, the new product was launched at ~40-50% premium in a category that was largely (travel & tour) known for self-employment and took the biggest hit in Covid.

However, things worked magically later when the premium product took-off, sales sky-rocketed, margins came at the best in a decade, yearly cash flows equaled LT debt and market had to give the valuation it deserves. 

But how could you have figured out all these to take a bigger bet? You don’t need to! Instead, if you managed to make even a smaller bet based on the probability of doing well, that would have been rewarding. Because returns would still be far superior to what you could have made in a safe bet with a much bigger allocation. 

The message is that it pays to be forgiving of the not so clean metrics in companies sometimes and give them a chance with low allocation – provided you are an early mover  in a sector.

#6 The most important thing – the market

When Howard Marks wrote his book “The most important thing”, the purpose was to draw attention to a few critical factors that play a decisive role in returns – be it second order thinking, value, risk, cycles, contrarianism or even the role of luck.

If we must point out the most important thing from our learning, it is about understanding “how the market works”.  If our objective is to make returns, it is inevitable to understand the way the market values stocks at different points of time. 

As we pointed out in the beginning, there wasn’t anything clearly visible initially that the auto sector is heading for good times. At that time, the stocks were not priced for growth. 

But as numbers unfolded through the course of FY23, valuations started moving up slowly to price the stocks for growth. We saw PE ratio going up for many of the stocks in our Auto++ smallcase by 20-40%. 

And you read earlier in this article on how the valuations evolved for Bajaj Auto, Tata Motors, TVS Motor Company and even Force Motors. 

Despite being early into the sector, at PrimeInvestor, we also got deceived by how valuations played out for Bajaj Auto and Tata Motors. We were not thinking about optionality such as buy-back, IPO of subsidiaries, demergers, etc before they happened and gave a big leg up to valuations.

So, the stocks that were NOT priced for growth initially started to get priced for growth (first leg of re-rating) and then topped up with additional valuation triggers. 

Even more interesting is the debt-ridden companies; be it Tata Motors or Ramkrishna Forgings or Force Motors. Their valuation would typically be based on Enterprise Value (EV which is M Cap + debt) to EBIDTA (or to say takeover valuation or fresh equity infusion valuation) at the bottom of the sector cycle. When they do well during sector up turns, margins would go up, debt comes down, earnings pick up and valuation moves from EV to EBIDTA to PE Ratio or SOTP. 

The key learning is that we need to have a rough template on valuation to get a sense of the starting valuation point and where it could be headed to get less deceived by the market or commit premature exits.

#7 Premature exits, the biggest mistake you can commit

Fortunately, we somewhat avoided the disaster of premature exits so far in our Auto smallcase, barring in one stock, Ramkrishna Forgings. That mistake used to warn us whenever we thought of other exits. For us a near 100% return form a leveraged forging company was a good outcome and we exited at 2X sales and 20X earnings. Still, the stock more than doubled from there.

The biggest penalty from premature exits is that they will permanently keep you outside of the sector or a stock by creating a mind block. 

When fortune favours a sector, it is less than a crime if you are a seasoned investor and get this wrong 😊

We exited Tata Motors at 40-45% returns, but the stock turned out to be the first doubler from auto pack in a year. Sadly, for us, we could get no insight coming from any corner of the market on its valuation, a complex business and equally notorious for not making money.  

VOLVO, which China’s Geely bought from FORD at the same time that Tatas bought JLR from FORD is having a valuation of $12 billion after a successful IPO in 2022 while the valuation ascribed for JLR in the sum of the parts seems far higher than that. This is no justification to our exit, but this kind of valuation evolution was not in our minds.

#8 When it’s fully priced, there is little room for error

No party will last forever. If that is true, the opposite of BUY also becomes relevant at some point. 

With both volume recovery, margin expansion and earnings recovery playing out in the last 2 years, much of stock price appreciation would have come by already. 

If stocks are already priced for growth and topped up with some icing such as buy-backs, demergers, IPO of subsidiaries and SOTP, maybe it is the right time to ask the opposite question - What to avoid, as opposed to What to buy?

When stocks appear fully priced, there are several risks that can quickly pull them down. For one, valuation tools such as SOTP are not sustainable across market cycles. Markets will start using basic tools to evaluate once the tide turns. Besides, any inkling of sector decline can spell big trouble. Since we are discussing the auto sector, let’s look for cues on where it’s headed now after completing a full-blown recovery (barring 2W) in the last two years.

Until Escorts came out with a warning on decline in FY24 for the tractor sector, no one was figuring out this possibility. The sector was in its own bull run for 5 years despite the broader auto sector struggling, as the farm sector was not affected by Covid. Market is still pinning hopes on a good monsoon to revive sales. 

Meanwhile ICRA has come out with a de-growth warning for CV in FY25.

Hyundai also came out with its take that the PV sector growth could moderate to 2.5-3% in FY25 Vs 8.5% in FY24. This needs to be counted when it comes from the second largest player by market share.  But what if the government cuts GST on Hybrids (as proposed by the Union minister) and  a company like Maruti gains market share in SUVs and grows at double the industry growth rate next year as well? The share may not fall! And this is what makes it difficult to time exits based on industry data. Maruti will fall only if its own numbers disappoint. 

Like the step-by-step up move, the fall in a sector can also be a gentle decline, following the numbers, if they moderate. It cannot be drastic unless triggered by any serious industry headwinds.

But at this stage, it may be time to go back to basics and not pay attention to anything beyond conventional valuations, to avoid being trapped by the market.  Remember, just as the market woos you, it can trap you if you waited till the end! Hence, instead of hunting for buys, you would do well to avoid the traps.

Conclusion

Here’s what this report tried to convey:

• We attempted to bring out our learnings on stock prices and valuations in the auto sector, as it moved from break-out to maturity. Starting from some early indicators on numbers to how valuations evolved over time, some of these may also have parallels to what happened in other sectors as well. 
• In every sector, the valuation journey from pessimism to maturity happens in stages and has multiple triggers. But one obvious thing is that stocks are valued based on Enterprise Value (or takeover value or fresh equity infusion value) at bad times and at PE and SOTP at good times (the latter gives the maximum value, so much so that promoters may dilute stakes to encash or raise money comfortably).
• The journey of the stock between these extreme valuation scenarios (from Enterprise Value to PE or SOTP) creates most of the wealth. Otherwise, the returns you get from a stock will be just equal to its earnings growth. 

Do you remember the post Covid IT sector rally when the stock price of Top tier players like TCS, Infosys, HCL and Wipro doubled and the second-tier players trebled or quadrupled? Just prior to Covid, they were priced like value stocks with dividends and buy-backs being the routine. A repeat of the same happened to the auto sector in 2023.  

Please note that the stocks discussed in this article are only for illustrative purposes and should not be treated as our recommendation. Some of the stocks may be part of Prime Stocks or our Auto++ Smallcase portfolio as well. Please refer to Prime Stocks for our individual stock recommendations and read our Disclaimers and Disclosures here.

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