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Automobile sector seems to be an interesting gamble

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The front pages have been highlighting new vehicle launches, which are timed for the festive season. If these are successful, it could mark the bottoming out and turnaround of the automobile sector. The October-December quarter traditionally sees higher sales of all consumption items, especially big-ticket stuff like cars and consumer electronics.

Auto sales have been flat for the past four or five quarters. Two-wheeler sales have also been nothing to write home about. The usual cyclical factors are responsible. High interest rates and high fuel prices have hit demand. High raw material costs coupled to high interest rates have hit margins. Manufacturers' associations like Society of Indian Automobile Manufacturers (SIAM) have been lobbying for lower excise duties.

What has changed in the last month? Interest rates are still high and although banks have started cutting mortgage rates, they haven't cut vehicle loan rates yet. Vehicle loans are of course, short-term and hence, fixed rate-fixed EMI, compared to housing where a buyer might reasonably hope floating rates will reduce over the next two years. But the recent moves on the reform front might just make prospective buyers more enthusiastic and the industry must be hoping for this.

Undoubtedly, there will be discount schemes over the festive season. Maybe the Reserve Bank of India will finally cut rates. But vehicles will still be high EMI/high interest in comparative terms. If the rate cycle has switched, going by prior experience, it will fall for months if not years. This means a prospective car-buyer could almost certainly get a better deal in calendar 2013 in EMI-terms. However, if new vehicle launches over Q3, 2012-13 kickstart some demand, falling rates through 2013 would just reinforce the cycle.

It's an interesting gamble buying into the auto sector now. Share prices seem to have bottomed out and spiked up, along with everything else in the past two weeks. Balance sheets aren't in great shape and the Q2 results will be poor given unit sales numbers. However, share prices always anticipate fundamentals so that doesn't help us much to make a call on the second half, 2012-13. If, and this is a big if, sales do spurt in Q3, share prices could have a lot of upside.

The classic signal of a cyclical, like the auto sector being in the sweet spot, is a scenario where share prices gain but PE ratios drop. This indicates earnings is growing faster than its being discounted. It tends to happen because even the best auto companies edge into the red or close to it, at the bottom of a cycle, and there is huge EPS growth in the early stages of the turnaround. I'd be prepared to commit some money to the sector now, but I would wait for that sweet spot to arrive.