In Search of Value - The Prequel

The article explores and provides observations across certain stock market segments where there could be mispriced value available as part of top down analysis approach

We live in times when markets believe in reverse theories. Flavor of the season strategies are pushed and what can not make quick money to compete at relative CAGR is put at side. Every strategy is good and suitable for a specific investing or trading style, comes with its own pros and cons and undergoes over its own cycle of popularity and criticism. Also, many a times a strategy is misinterpreted for its name. So, to start with, let me clarify my meaning of “value” as there are no standard definitions.

Though from a fundamental investing point of view, any investment which can be sold at a higher sell price than price by convincing the buyer its monetary worth is value. Sometimes, value can be sold easily as there is no doubt among new buyers during prolonged times of euphoria supported by earnings. However, there is a second scenario for value where the current headwinds raise doubts in the minds of new potential buyers due to poor current business environment and only over a period of time, when things turn for better, appreciation of value emerges. As per my observation, most of sectors or companies go through the second scenario quite a few times in their journey and hence, most of the businesses are cyclic though vary on extent and growth potential.

The USP of an investing mind lies in differentiating these value scenarios from a structural down-trend scenario which leads to ultimate death of sectors and businesses. It is not an easy task because when the atmosphere is gloomy, the atmosphere pushes more towards structural down-trend than any kind of cyclic behavior. There are two approaches to do it - Top down and bottom up approach. Today, in this post, I will try to take a top down approach to find out some of the sectors where there could still be value left on the table which market is not willing to factor due to the pessimism around. Currently, the two sectors which I have found worth studying since Oct 2021 from a misplaced value perspective are:

1. Auto and Auto Ancillary

2. Banking and Financial Services

In this article, I would try to provide a view over this belief for auto and auto ancillary sector through some data and analysis. Let us get to the business and start with Auto. Data plays an important role in getting over any kind of qualitative biases and more often than not, history does not repeat but it rhymes.

Let us try to understand if auto industry is also a cyclic one through its data history. Below table provides average monthly sales of various auto company types for all auto segments for last 16 years. These segments are:

1. Passenger Vehicle (PV)

2. 3-Wheeler

3. 2-Wheeler

4. Utility Vehicles

Data source: Ace Equity and own analysis

If we look at YoY growth rate of each of these sub-segments and overall in terms of count of vehicles sold, few key patterns come up:

1. The growth rates are not linear followed by some exceptionally good and some really poor years

2. Every 3-5 year, industry goes through an year of negative growth followed by revival and then few years of higher growth

3. 2019-2022 has been an odd scenario of continuous 3 years of de-growth for well known reasons as Covid has been one of the century kind of events where mobility got hit badly

4. Not all growth sub-segments are in perfect correlation. This is reflected by column Growth Segment share % which highlight out of above 4 sub-segments, what % of sub segments showed positive growth rate. This number do have years when it was not 0 or 100% which means some went up and some went down

5. If we try to correlate between overall vehicle growth rate CNX Auto Index growth rate which is an indicator for listed auto companies, we can see that there is a decent association between how index grows YoY vs Vehicle count YoY except few years 2011 or 2018 where despite of industry showing positive growth, index have negative return. One possible reason could be extraordinary returns in preceding years where market factored way too much into valuation and then index cooled off before the actual industry under-performance started

6. Another important observation is that industry peaked in 2018 and it has been on decline since then, this is first of kind of 4 year of bear cycle from demand perspective. This is evident when we see the peak CAGR which has been around 8-9% but currently hovers around 2.9% (check top 2 rows above “total” column). This is to say that the current vehicle CAGR growth rate is not even half of historical GDP growth rate of India. 2.9% of 15 years of CAGR despite growing at 8% until 2-3 years back looks way too bad

Now, the key question is whether:

1. This is cyclic or this is structural from a demand perspective?

2. Are the new technological or social changes like EV technologies, Work from Home going to permanently change the demand scenario for the industry or this is a stretched passing by phase for the industry?

3. Even if a part of it is structural, then, which are sub segments and businesses going to be least impact and heavily impacted?

4. Above all, at peak valuations for CNX Auto, the CAGR return from 2006-18 was 17% which was almost double than vehicle count CAGR growth rate. This can be attributed to multiple reasons - Rerating of sector between 2006 to 2018, frothy valuations at cyclic peak, justified valuation due to lift in revenue per vehicle and profit per vehicle etc. We would need more data at sector and index level to say with confidence.

5. However, what provides bit of relief is CNX AUTO is still below its 2017 peak even after 4 years which kind of compensates for the last 2 years of positive return of CNX AUTO despite pessimistic demand numbers. Also, this is the 1st time in last 16 year history of CNX AUTO that it has not crossed its previous 2 year high.

6. We may even need to bifurcate the above sales numbers between export and domestic sales to see if the story is different. However, given, the whole world has been struggling from Covid, last 3 years, case has been same across the world

The 16 year 2.9% CAGR does make a strong case to look at this industry from value perspective if we can ensure that:

1. Demand: There is enough demand to be served at sector or sub-sector level and not a structural down-trend

2. Valuation: Prices and valuations are still reflecting the pessimism which is evident in the de-growth numbers for last few years and there are enough opportunities to fish in the market

3. Timing: We have reasonable skills to time the entry around pessimistic times and exit if the optimistic times come when new buyers would be convinced at a price which gives us decent CAGR that there is value for them

We try to study businesses and find value. We used the above hypothesis as starting point for our top down research based on suggestion from like minded folks and tried to find value pockets among auto ancillary companies. Below is one such use cases where I collaborated with colleague Youtuber , Shubham Sethi, to explore the idea in deep. You can learn more about it here: