Author Archives: Sven Carlin


An Investigation Into the Relative Cheapness of the Automotive Industry

  • With a PE ratio of 5 to 10 the automotive industry looks attractive
  • The risks are that the industry is considered to be at a historical peak by most analysts
  • A global perspective gives a bullish outlook for the industry


The automotive industry is usually called a cyclical industry, considered elastic in relation to GDP and vulnerable to economic shocks. According to a former Ford chief economist a normal recession reduces sales by 15%. With sales being reduced by 15% and costs being inelastic the decline in sales is the one that makes the difference between strong earnings and big losses. Any sign of a recession puts people off from buying new cars and makes them stick to the car they have for a little longer. Connecting the cyclicality and cost inelasticity with the current valuation for automotive companies brings to interesting conclusions.

Automotive Valuation

The current valuation of the 10 biggest automotive corporations is really cheap. In the below table most companies have a PE ratio between 5 and 10. Fiat-Chrysler has PE ratio of 31.8 but adjusted earnings are much better due to a one-off charge of €830 million for the realignment of their US production which brings to a forward PE ratio of 5.1. Tesla is included in order to show how a positive sentiment can easily influence valuations in a completely opposite way than the industry standard.

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Figure 1: Automotive valuation. Source: Morningstar.

A PE ratio in the range of 5 to 10 when compared to the S&P 500 average 24.25 almost suggests that the car industry is about to go belly up. Even oil companies, that have witnessed severe declines in oil prices and revenues have better multiples, Exxon Mobil has a PE ratio of 22.3 and Chevron has 40. Most of the automotive companies trade at prices lower than their book value and price to sales ratios are also much lower than the S&P 500 average of 1.86. In order for the automotive industry to be valued similarly to the S&P 500 their prices should increase at least two fold and for some three fold. The low valuation suggests that there are some short to medium term negative factors expected for the industry.

Potential Issues

One of the potential issues that put off investors from paying higher multiples could be the expectation of higher interest rates. Higher interest rates, not only make it more expensive to pay for the debt the


Figure 2 U.S. gross domestic product in billions of dollars. Source: CBPP.

companies hold but also make buying a car more expensive for customers as up to 85% of new car purchases are financed.

Another issue could be the expectation of a recession. US jobs data is showing the first signs of topping out. Usually the job market peaks prior to recessions when the actual GDP surpasses the potential GDP and there is full employment.

Product recalls and regulatory issues also represent a big risk. Such news usually come as a surprise and have a large effect. The Volkswagen scandal of last September is a perfect example of that. But maybe all those potential bad effects are already priced in seeing the low stock valuations.

The most pessimistic analyst for the auto industry is Max Warburton from Bernstein Research who summarizes the above with the statement that:

“Buying autos this late in the global economic cycle is arguably dangerous–precedents suggest the sector usually delivers most of its performance early in the cycle.”

On the other hand, Warburton is mostly focusing on the US while the source of the bullishness for the automotive industry lies in emerging markets.

A Bullish Outlook

Increased interest rates and recession risks are lower than they were 20 or 30 years ago because the automotive industry has become a global one and is not confined to anymore to Europe and North America.

vehichle sales per region

Figure 3: Global automotive sales forecast by region. Source: Statista.

Sales in North America and Western Europe look stable and constant in the last 20 years but sales in Asia show huge growth. The global sales diversification from 1999 when more than 75% of car sales were made in North America or Western Europe to today’s numbers where about 50% of sales come from China and other Asia show how car companies have become globally diversified and increases in US interest rates or a US recession would have an impact but not as strong as it used to have in the past.
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Figure 4: Cars per 1,000 people in relation to GDP. Source: MDPI.

A positive long term catalyst is the still huge growth potential car companies have in Asia, South America and Africa.

In order to reach saturation levels like in Western Europe or North America the Asian market has still to grow more than 10 fold. This would mean global car sales would be at least double the current in a conservative estimation. Of course, the living habits and infrastructural possibilities in Asia are far from the ones in the West but the above chart shows how big is the automotive industry potential.

The Tesla Craze

Tesla is often called the “big disruptor” in the industry with the hope that electric cars will take over the world and Tesla will be the leader. Well, reality is far from that. The recently announced Model 3 deliveries will start only in late 2017 and the profitability of it is highly questionable seeing that the Model 3 is similar to the current Model S and Tesla is currently losing $18,331 per sold car. On the other hand, Chevrolet, part of the GM group, will start delivering Chevrolet Bolt by the end of 2016 with more than 200 miles of range and for a price around $30,000. Other competitors with much more experience and better cost efficiency than Tesla are also entering the electric market. For example, by the end of this year Hyundai should introduce its electric vehicle, Ioniq.


Companies with PE ratios from 5 to 10 with positive future global growth prospects seem a crazy idea. But, historical perceptions of the risks related to the automotive industry keep their valuations low and provide investing opportunities. Regional recessions or interest rate increases should be offset by emerging markets growth in the increasingly global automotive market. The speed at which old car companies adapt to new technologies like electric vehicles and unlike new competitors (Tesla) manage to be profitable show that it is better to stick to the old dogs in this case because they are fast in learning new tricks and manage to keep the old fashion profitability. Due to the above mentioned risks every investor should assess his own tolerance for cyclicality but the current yields are very tempting.


Is Brazil an Investing Opportunity?

  • The political situation is corrupted but the country shows growth potential.
  • From a long term perspective, the market is undervalued and currency effects can bring to gains of 80%.
  • Brazil is still a developing economy with a young population and huge potential.


On Sunday the Brazilian congress voted for the impeachment of president Dilma Rousseff. When the senate, likely in the next few weeks, confirms the vote, the Workers party will temporarily be replaced by a center-right administration government. The move from left to right creates hopes for investors as they look for a more investing friendly environment. Before analyzing investment opportunities, a further note on the political environment is necessary. Of the 513 deputies in the Brazilian congress more than 150 deputies are involved in crimes but are protected by their parliamentarian status and in total 303 deputies face charges or are being investigated for serious crimes, therefore any investment in Brazil has to be discounted for corruption issues that are widespread in Brazil. As the figure below shows Brazil is highly corrupt.

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Figure 1: Corruption perceptions index 2015. Source: Transparency International.

This means that the rule of law is weak and some logical investment decisions or expected results might be completely turned around by corruption issues.

Brazilian Economy

On the other hand, the Brazilian economy is the 7th World economy with a GDP per capita of $15,153, thus with still lots of room to grow in order to reach the developed levels. In addition, it has a young population with 40% of the population being younger than 25 (US – 33%, Germany – 23%). Also Brazil is rich in natural resources ranging from iron ore to agricultural products. All these positive circumstances strongly influenced Brazil’s economic growth in the last 25 years.

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Figure 2: Brazil’s GDP annual growth rate. Source: Trading Economics.

Except for the 2009 crisis and some minor recessions in the past Brazil has seen high levels of growth in the past. The question now is: Is the current recession a temporary and natural halt to the growth cycle or there are deeper structural reasons that will disable Brazil’s future growth? With the current political situation it will for sure take a while before things return to the previous growth levels but for those investors that stick to the “Be greedy when others are fearful and be fearful when others are greedy” Brazil might be the place to look at.

Investment Perspective

All this political turmoil and economic recession resulted in the fact that Brazil is among the cheapest markets by the Cyclically adjusted price earnings ratio (uses 10-year average earnings for PE ratio calculation).

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Figure 3: Brazil’s CAPE ratio. Source: Star Capital.

The average normal PE ratio for Brazil is high at 42 but that is logical due to the current recession and high interest rates. Any improvement in Brazil could quickly bring the CAPE valuation to a more appropriate one for such a young, rich in natural resources and still developing country.

Another potential catalyst is the Brazilian currency. From a stable range of R$1.5 to R$2 Brazilian Reals for one US dollar the Real had depreciated to R$4 for a dollar in 2015 and currently the exchange is R$3.61 for a dollar.

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Figure 4: BRL per 1 USD. Source: XE.

Any indication of a political stabilization and a positive economic outlook would quickly improve the exchange rate and create currency gains for foreign investors. The current base interest rate in Brazil is 14.5% which implies that there will be strong demand for the currency if the investment environment stabilizes. A return to the exchange levels prior to the current economic crisis of R$2 for $1 would create returns of 80% just from currency benefits.

Another positive for Brazilian companies is their surprisingly high level of financial transparency. The financial statements are easily accessible on most of their investor relations web pages and also translated into English.

How to Invest

The easiest way to invest in Brazil for foreigners is through American depositary receipts (ADR) of Brazilian companies traded on the US stock exchanges. Below is the list of the 25 Brazilian ADRs traded on the US stock exchanges.

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Figure 5: Brazilian ADRs. Source: TopForeignStocks.

Another option is to invest thorough Brazilian ETFs. Some of the most popular are the iShares MSCI Brazil Capped ETF (EWZ) that tracks the MSCI Brazil 25/50 Index and the Market Vectors Brazil Small-Cap ETF (BRF) that tracks Brazilian small-caps.

Current Situation

The current market situation shows that the bottom in the Brazilian market was reached in January 2016 with a low of 37,497. Since then it has grown to the current 52,894 or 40% influenced by the expectation that a new government will improve the situation and the 15% appreciation of the Brazilian currency.

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Figure 6: Brazilian stock index BOVESPA 1-year chart. Source: Bloomberg.

The latest 40% surge creates an uneasy feeling of being late to the party but positive economic news and political catalysts could further improve the situation.


Investing in Brazil should be considered high risk because as the market grew 40% in the last few months, so it can quickly decline. On the other hand, the risk/reward is very tempting. Signs of economic strength or a positive outlook would quickly strengthen the currency and bring to immediate gains. Consequently, a lower base interest rate would bring to a much needed relief for Brazilian businesses. The average CAPE of 8.2 further increases the upside potential. South Africa, a country that can be compared to Brazil, has a CAPE ratio of 19.1. A similar CAPE ratio for Brazil would mean a 100% gain on top of the potential currency gain. But, the risks are also very big. A continuation of the current political turmoil does not help a country in economic trouble. New political scandals like the Petrobras scandal where 100 people, including senators and top executives have been arrested, could happen in almost any company in Brazil. An example of how high the corruption goes in Brazil is that the president Dilma Rousseff was a chair at Petrobras when the money laundering activities started back in 2004. Further political instability could further destabilize Brazil, weaken its currency and quickly reverse the above mentioned potential gains. Investor must be aware that although Brazil has a potential for 100% returns, it also has the potential of huge losses.


A Coal Perspective on Commodities

  • Coal has seen lots of bankruptcies but companies continue to produce and the price remains low.
  • Iron ore provides better investing opportunities and a better demand scenario.
  • Low cost and low debt producers with increasing demand should be the best risk/reward investments.


Yesterday’s newsletter mentioned that there might be opportunities in the commodities markets. Today’s letter is going to elaborate on why the coal mining industry is seeing many bankruptcies and extract important insights in order to enable finding opportunities in other commodities that minimize risks and maximize returns.

Coal Mining Industry

If commodities prices go down, as it is the case for coal, slowly but surely, some of the companies engaged in the production of the specific commodity are bound to fail. As the below figure shows, the decline in coal prices is not an extreme case seeing that the price decline from the 2010 high is about 50%.

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Figure 1: Thermal coal price from 2001. Source: InfoMine.

Oil (65%), copper (53%), iron (72%) and natural gas (62%) prices have all declined more than coal prices from their highs but coal miners are the ones having the most difficult times. In January Arch Coal Inc (NYSE:ACI) filed for bankruptcy and last week Peabody Energy Corporation (NYSE:BTU) did the same increasing the already long list with Walter Energy, Alpha Natural and Patriot Coal that filed for bankruptcy last year. If we would add Cloud Peak Energy (NYSE: CLD) to the above list, we would have more than 50% of US coal production bankrupted. The high number of bankruptcies in coal implies that commodities do not always rebound from a downturn cycle as most investors and managers expect and that down cycles can last longer than liquidity available to companies. Other things that are not helping coal miners are environmental pressures and low gas prices that are lowering domestic and international demand. Apart for slowing demand, another factor that influenced the above mentioned bankruptcies was chronic indebtedness. BTU had 69% of assets financed by debt, CLD 67% and ACI 65% back in 2011 when things still looked good for coal miners. With the bad sentiment, debt became more difficult to refinance, impairment charges become imminent and declining margins brought to the above mentioned bankruptcies.

Another crucial factor for miners and other commodities producers is the cash cost in relation to the average selling price.

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Figure 2: Coal production costs. Source: Martson.

As US production is the most expensive, combined with the declining demand, high debt the large number of companies bankrupt or close to bankruptcy should not be a big surprise. But all the data above should give a clear indication of what and where to look for in order to find over performing opportunities in the beaten commodities world.

What to look for?

Now that the things to be careful about are known let us see if there are better commodities markets that allow grasping the opportunities that a downturn commodity cycle brings. The coal case brings to the conclusion that before investing in miners or other commodities producers, investors should look at:

  • The supply/demand structure of the commodity. Declining demand with unrestrained supply leads to ugly scenarios.
  • High debt levels combined with cycle downturns make refinancing very difficult and lead to bankruptcies.
  • The lower the cash cost of producing the commodity the more time the company has to weather a cycle downturn.


Oil might experience a coal like scenario if electric cars become able to weaken the increasing demand for liquid fuels. For now, the general expectation is that oil production will grow at a slower pace than demand seeing the lower oil prices.

Figure 3: World Liquid Fuels Production and Consumption Balance. Source: EIA.

A look at the production cost curve shows where to look for survivors if the slump in oil prices continues.
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Figure 4: Oil production cost curve.

The above figure shows that the lowest cost producers are mostly state owned companies and western world corporations have lower margins. This limits the investing potential and increases the risks as the lowest cost producers are not investable. On the other hand, with the ease of adding production in relation to increases in oil prices it can be estimated that the price of oil and thus also oil stocks will be volatile. Investors should always keep in mind the possible coal scenario due to the potential decline in demand influenced by electric vehicles.

Iron Ore

Iron ore is a commodity that is strongly related to steel production and steel production is strongly related to World GDP growth. As World GDP growth is strongly correlated to demographics most long term analyses show that the global economy will grow at about 3% in the long term as global population is expected to reach 9.5 billion in 2050. This growth should be reflected in demand for steel and consequently demand for iron. The cost production curve is more favorable for investors as the lowest cost producers are corporations and not state owned companies like for oil.

Figure 5: Iron ore cost production curve. Source:

The biggest producers like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Fortescue (ASX:FMG) and Vale (NYSE:VALE) have the lowest production costs and are trying to eradicate the higher cost producers by keeping supply higher than demand.

Figure 6: Supply and demand for iron ore. Source: LKAB.

The supply is just marginally higher than the demand but by looking at the above cost curve (figure 5) any production shut downs from the more expensive producers could quickly erase the current supply glut.

A look at the debt ratios from the above mentioned iron ore producers shows that RIO has 59% of assets financed with debt, FMG 65%, VALE 62% and BHP is the best with only 48%. A deeper investigation before investing is necessary here as most of the above companies are involved in more commodities and not just iron ore.


The combination of low cost production, low debt, demand growth for the product and a compelling price is surely one that is hard to find. But seeing that commodities prices have fallen more than anyone expected there might be opportunities created by market panic. Goldman Sachs, notorious for its bullish oil price forecasts of $200 per barrel for 2009 and $100 for 2015 that ended with oil prices down to $40 in 2009 and $30 in 2015 is a perfect example how experts can be dead wrong. Wrong bearish forecasts by experts should be the ones that create the biggest opportunities for investing in commodities.

One final warning, the interesting thing with coal is that even if the biggest players declared bankruptcy, they did not stop producing. This trashes most managers’ and Saudi Arabia’s thesis that the downturn will end when companies start failing, because even if companies go bankrupt they will continue to produce as long as production costs are lower than the market price.  All a bankruptcy does is shift ownership of the company to the debt holders and continues to depress the commodity price, since these bankrupt companies do not immediately stop producing.  This clearly explains why oil fell from above $100 to $30 per barrel and has had a difficult time recovering.  As long as a company can produce at a cost lower than the market price, it will continue doing so. Therefore certain commodity prices could remain low for an extended period of time, which strengthens the thesis that the low cost and low debt producers are the best risk/reward investments, when acquired at a reasonable price.


What to Expect from the US Stock Market

  • The S&P 500 has not grown in the last 14 months.
  • A fundamental and interest rate perspective show that the S&P 500 is overvalued.
  • Strategies that include stock picking, emerging markets or beaten down cyclicals might prove best.


The S&P 500 has rallied in the last two months, from the February 11 low of 1829 points to the current 2083 points. This is an increase of 13% but to understand what is going on in the markets a longer term perspective has to be taken. The S&P 500 reached its all-time high in May 2015 with 2130 points but it had already crossed 2100 points in February 2015. This means that the S&P 500 hasn’t grown in the last 14 months. If the S&P 500 does not break the all-time high level in the next 30 days, it will be the longest no growth period since the 2009 financial crisis. The previous longest no growth period was from April 2011 to June 2012.

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Figure 1: S&P 500 from 2006 to 2016. Source: Yahoo.

A halt in growth for a longer period of time could mean several things. Before analyzing those implications let’s first take a look at the market’s fundamentals.

Fundamental Perspective

The PE ratio for the S&P 500 is 22.95. This means that the earnings related returns investors can expect from stocks in the long term is 4.35%.

“Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so also will the portfolio’s market value.” Warren Buffett

This return could increase if corporate earnings grow in the future but currently this is not the case. S&P 500 corporate earnings have declined by 15% since their high reached in September 2014. The decline in the corporate earnings could be one of the explanations for the halted growth of the S&P 500.

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Figure 2: S&P 500 corporate earnings for the last 10 years. Source: Shiller Yale.

When talking about market fundamentals the best person to go to is Nobel laureate and Yale University professor Robert Shiller. Shiller developed the Cyclically Adjusted Price-Earnings ratio (CAPE) which uses 10 years of Earnings Per Share (EPS) data to calculate the price earnings ratio (PE) for stocks in order to get a more accurate measure of overvalued or undervalued markets. The below figure shows the historical CAPE and long term interest rate.
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Figure 3: CAPE Price earnings ratio and long term interest rate. Source: YALE.

The current CAPE ratio is 26.24, thus at similar levels to the 2007 CAPE. The enigma factor is the low interest rate which enables liquidity and inflates assets. From a historical and fundamental perspective, the stock market is overvalued. The fundamental overvaluation increases the general risk of investing in stocks and when combined with the low interest rates the risks are even higher.

The Interest Rate Perspective

The low interest rate makes the current historically low returns from stocks seem acceptable as investors are in search for any kind of yield. The current yield on the 10-year treasury note is 1.75% which implies that investors are expecting a premium of 2.6% for investing in stocks seeing that the indirect return from earnings is 4.25%. Any increase in the relatively risk free yield on the treasury notes would strongly influence the expected return on stocks. The overview of the FOMC (Federal Open Market Committee) participants’ assessments of appropriate monetary policy indicates that more rate hikes are plausible and consequently higher rates on treasuries and also an increase in expected returns from stocks should be expected.

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Figure 4: FOMC participants’ assessments of appropriate monetary policy. Source: Federal Reserve.

The target long term interest rate of 3.5% would probably induce a 4.5% treasury yield that, when adding a stock risk premium like the current one of 2.6% would result in an expected return from stocks of 7.1%. The 7.1% expected return would translate in a PE ratio of 14.08 for stocks. With the current earnings of the S&P 500 this would imply a level of 1277.9 points or a 39% decline from current levels.  Except for the fundamental overvaluation and low interest rate influence there is another trend that makes stocks risky, the ETF trend.

Technical and Behavioral Perspective

An interesting article was recently published by Morningstar discussing the shift from actively managed funds to passively managed exchange-traded funds. 18 Morningstar 500 funds suffered outflows of at least 40% of assets under management in the trailing 12 months ended February 2016, 61 shed 25% or more, and 168 had outflows of 10% or more. On the other hand, exchange-traded funds have increased their inflows. For an investor this means that the market is becoming more passive, thus thinks less and is more prone to high diversification by buying small amounts of each component of an asset class like ETFs do. This confirms the previous analysis and makes the detachment from fundamentals and the uncorrelation of the market to the earnings decline easier to understand. As most of the investors holding ETFs are not sophisticated and might easily panic in a stronger market decline the above mentioned potential market decline of 39% due to fundamentals might be even greater due to the investors’ weak hands and forced asset sales by ETFs.


By looking at the corporate earnings investors should expect returns of about 4.35%. The potential negative influence of increased interest rates on corporate profits has not been taken into account in the above return. Any increase in the base interest rate would increase the corporate interest expense and consequently lower corporate earnings. On the other hand, a potential market decrease of 39% makes the risk/reward very unattractive for investors looking for stable long term returns from the stock market.

Seeing that the market has not grown in the last 14 months there can’t be talk about a boom or bubble that would justify the potential downside in the risk reward analysis. The best thing to do could be “Sell in May and go away” or go for the more defensive stocks that have stable dividends and can easily weather higher interest rates, market and economic downturns. The ETF strategies and the trend of investing in them creates possibilities for stock pickers. And last but not least, several markets have been strongly beaten down in the last period and might conceal some long term value. Examples of that are commodities markets, some emerging markets, or for the more risk loving investors a good strategy in this markets could be a short one, but more about that in the next newsletters.