We are often asked about why Insync don’t invest in BMW and have a negative view on the automotive sector. Surely the trend towards autonomous cars is going to be a boon for the industry. Well at a fundamental level companies like BMW do not meet the 3 criteria we are searching for in a great business of the future – Benefitting from disruption, benefitting from a global megatrend and generating a high ROIC. BMW generated a ROIC of 4.5% in 2018 which compares to an average ROIC of over 40% across the stocks in the Insync portfolio.

Disruption – our biggest concern

At Insync understanding the impact of global disruption is at the core of the investment process which we consider to be critical in today’s complex and fast changing world. As Gen Zers become a larger part of the global workforce understanding their consumer buying habits is going to be critical in picking the winners of tomorrow.  A disturbing trend emerging for the automotive industry is that about a quarter of 16-year-olds in the United States had a driver’s license in 2017, a sharp decline from nearly half in 1983, according to an analysis of licensing data by transportation researcher Michael Sivak. J.D. Power estimates that Gen Zers will purchase about 120,000 fewer new vehicles this year compared with millennials in 2004, when they were the new generation of drivers—or 488,198 vehicles versus 607,329 then.

Key factors that are impacting this decline according to J.D. Power include:

• As Gen Zers are reaching their 20s, more are moving to big cities with mass transit, where owning a car is neither necessary nor practical.
• Many face substantial student-loan payments, making them more cautious about big-ticket purchases. Total student-loan debt has soared to $1.5 trillion, surpassing Americans’ credit-card and car-loan bills.
• Cost is increasingly a challenge. The average price paid for a new vehicle in the United States was $32,544 in 2018, up from $25,490 a decade ago, according to J.D. Power. The average monthly payment on a new-car loan reached $535 a month last year, or more than 10% of the median household income, a level most Americans can’t afford, said Cox Automotive.
• And of those who do buy a car, many more in the older generations, opt for used ones.

Cyclical slowdown

This first signs of a cyclical downtrend in the US auto market are starting to appear. For the first time in six years, first-quarter car sales have fallen below 3 million units, according to a joint forecast by J.D. Power and LMC Automotive. This has been followed up with data in the used vehicle market, which according to a J.D. Power survey, saw wholesale prices of used vehicles up to 8-years in age fall by 1.5% in February relative to January. February’s performance was the month’s worst result in the past 20 years and only the second time there has been a material decline in prices during that time.

The majority of new vehicle transactions include a trade in. So, the more your vehicle is worth, the more buying power you have. It’s part of the transaction. The new vehicle market is fuelled by replacement demand. I got this old one, I want your new one. The more my old one is worth, the newer I can buy. If the price of your old car is declining, you are less likely to buy a new one.

All of this comes at a time when the Chinese car sales are also in a cyclical decline. China is both the biggest manufacturer and the biggest market for cars globally. But after two decades of rapid expansion, sales fell in 2018 by 6% to 22.7 million units.

Profitability and valuation

BMW is a great brand and optically it appears to be cheap trading on 8x earnings. Quite often investors focus on P/E ratios and if it is trading on a low ratio then investors automatically assume that it should be a buy. Particularly when one considers it is a well know global brand. But the missing piece is the underlying quality of the business. What are the operating margins, how fast are they turning over their inventory, what about its profitability based on return on equity or invested capital, does it have a long run way of growth opportunities, is the business at risk of disruption and how is the business actually generating sales and is this a sustainable way of growing its business.

So why does BMW trade on a low P/E ratio:

• The automotive sector is a notoriously cyclical sector where operating margins, using BMW as an example, ranging between 0.5% in 2009 and 10% today. It is interesting to observe there has been no operating profit growth between 2014 and 2018 despite sales increasing from Euros 74.7Bn Euros 97.5Bn over the same period
• The ROIC for BMW is 4.5% which is very low
• Risk of disruption – As the buying habits of Gen Zers is moving away from purchasing cars and the market rapidly moving to electric vehicles, and autonomous over time, how well placed will BMW be in a highly competitive market and will they be able to differentiate their vehicles in the same way as the traditional combustion engine cars. The trend to electric vehicles is accelerating as countries around the world implement policies for faster adoption. China, for example, announced its New Energy Vehicle (NEV) mandate, part of its plan to sell 4.6 million electric vehicles by 2020 and ban cars with traditional internal combustion engines over the long term. China announced its New Energy Vehicle (NEV) mandate, part of its plan to sell 4.6 million electric vehicles by 2020 and ban cars with traditional internal combustion engines over the long term.
• 44% of the total reported group profit at BMW is accounted for by profit reported on the sale of vehicles from the automotive industrial business to the financing division for the purposes of leasing contracts. What will happen to their profitability if residual values of cars continue to decline?

So buying BMW with low profitability, at a time when we appear to be reaching a cyclical peak in the global automotive cycle and with the risk of major disruption ahead seems like a highly risky proposition. The risks appear to be skewed significantly to the downside. The share price is depressed and may well bounce in the short term, but we are struggling to see how it will compound investor’s wealth. Certainly, a low ROIC company, like BMW, with high risk of being on the wrong side of disruption does not fit into Insync’s universe of investable companies.

For more information on other Megatrends, please visit Insync Funds Managers’ Website here.

EQT Responsible Entity Services Limited (“EQT”) (ABN 94 101 103 011), AFSL 223271, is the Responsible Entity for the Insync Global Quality Equity Fund and the Insync Global Capital Aware Fund.  EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).  This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) (“Insync”), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

*The views and opinions expressed in this article are those of the author and do not necessarily reflect the views and opinions of Reach Markets.

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