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Commodities plateauing? Don’t party yet

In our Commodities Spike note, we highlighted that auto stocks always underperform in an inflationary period. Surprisingly, the reverse is not true. Of the two instances of commodity plateau, auto stocks underperformed, barring an outlier. In four instances of deflation, the auto sector was the clear outperformer only in FY09 and FY13. In rest of the cases, it was more stock-specific. Statistically, M&M has outperformed maximum times.

What has driven the outperformance? Better-than-expected revenue/margin cycle or a strong product tailwind. Hence we continue to be stock-specific. We maintain ‘BUY’ on TTMT, M&M, AL and BJAUT, and ‘HOLD’ on HMCL, MSIL and EIM.

Peaking commodity prices – An opportunity but don’t party yet

In our Commodities Spike note, we argued that auto stocks underperform irrespective of revenue growth (strong or not) during the inflation phase. However, and surprisingly, the reverse is not true. Of the six instances (after inflation phase) that we have covered, except for M&M, stocks have underperformed at least three times or more. FY09 outperformance was driven by favourable interest rates and excise duty in the aftermath of the GFC despite low single-digit revenue growth. FY12–13 performance was driven by strong revenue growth. In rest of the periods, stocks have underperformed despite strong revenue growth.

The jury’s divided this time

This time around multiple micro and macro events can play in favour of or against the auto sector. A favourable base and pent-up demand are the strong tailwinds for the sector that can drive margins. Supportive interest rate/liquidity scenario might be at its fag end; any reversal in the RBI’s stance can emerge as a headwind. And supply chain issues are impacting production in the near term. Besides, commodity trend is not yet clear as of now – whether they will plateau or enter deflationary phase or sustain upward momentum, albeit at a slower pace.

Outlook and valuation:

Being stock-specific matters We prefer stocks that have a strong demand/margin tailwind and/or a compelling product cycle. We believe CVs’ demand recovery has gotten postponed, and expect it to bounce back like a springboard (FY21 MHCV truck sales are 60% below FY19 peak and 2% below FY14 low). Refer to our note Super Recovery.

Pricing power in the tractor segment is generally high and hence we expect OEMs to focus on margins unless demand collapses (looks unlikely for FY22). Hence we like Tata Motors (JLR as well as India PV witnessing strong product cycle tailwind) and Ashok Leyland. We also like Bajaj Auto for its exports business (beneficiary of INR depreciation) and high dividend yield. We like M&M for its strong tractor/LCV franchise (comparable to MSIL in PVs), product revival in PVs, improving capital allocation and strong performance by key subsidiaries.

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