The main factor that drives share prices in the automotive sector is the expected future cash flows of the companies that comprise the sector. Thus, when these expectations change for whatever reason, the share price changes based on this new development. Share prices are always discounting news and events immediately even if the effects are not realized until some time in the future. Some of these catalysts are specific to a company, such as a change in management or an operations-based decision that can change the trajectory of the stock. Others are out of a company's control, such as a change in government policy or the state of the economy.

For example, if signs of a slowing economy emerge, this negatively affects the sales and earnings of automotive stocks. Sales drop in anticipation of reduced cash flows. Stocks in the automotive sector are considered cyclical stocks. For cyclical stocks, swings in price are influenced by economic conditions.

Another way the automotive sector is cyclical is its competitiveness. Auto manufacturers must aggressively invest in their own operations; research and development; and marketing to maintain market share. Competitors are doing the same, and any mistake can set the company's reputation back for years. Cars and car parts are in some ways a type of technology. Technology prices tend to have a natural downward tilt in terms of price and margins, while improving in quality because of competitive pressures.

Additionally, there are limited gains from additional improvements in operations and avenues for growth are limited. Most major markets have been entered; those yet to be entered are not significant enough to impact sales growth. Increasing sales by increasing volume and cutting prices is not feasible given the razor-thin margins. The biggest variable for the company, on a year-to-year basis, is the strength of the economy.

Compare this to a growth stock. Growth stocks can continue to increase sales and earnings even if the economy stumbles, albeit at a slower trajectory. These companies have room to grow. At one time, auto stocks were growth stocks. This is one of the major economic stories of the first half of the 20th century.

In contrast, cyclical stocks have grown into new markets for the most part. Their sales figures are determined more by improvements in employment, personal income and consumer confidence. Thus, auto stocks are sensitive to economic data, and the economic growth rate determines the trajectory of the share price. One exception is companies that have organic growth and are winning market share through superior technology. They are less sensitive to economic data and more driven by the efficacy of their operations. Another exception is a company that errs in execution, such as an automaker that brings a car with safety issues to market.

  1. When during the economic cycle should I invest in the automotive sector?

    Discover the best time to invest in the automotive sector when the economy is in a recession and interest rates have already ... Read Answer >>
  2. How does an economic downturn affect a cyclical stock?

    Discover the effects of an economic downturn on cyclical stocks. These stocks are highly leveraged to the business cycle ... Read Answer >>
  3. What is the average return on equity for a company in the automotive sector?

    Discover the average return on equity, or ROE, for companies in the automotive sector and the importance of ROE as an equity ... Read Answer >>
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