Tesla’s recent launch of its luxury 3 Model, scarcely more than a decade after the launch of the business, has defied analysts’ predictions that its ambitions were impossible.
Excitement at the business’ potential briefly enthroned it as the world’s most valuable carmaker by market cap in April, narrowly eclipsing GM for a few hours.
While more sober heads rapidly prevailed, the giddy sense of the possibility reflects the rapidly changing sense of potential in battery technology. Major carmakers are increasingly phasing out research into internal combustion engines to focus on electric vehicles.
Legal & General Investment Management (LGIM) recently predicted that the sector was only eight years away from the tipping point of becoming the dominant automotive technology, as emerging nations begin to prioritise a transition, as they get serious about air pollution.
‘With the hardware and software improvements required to address efficiency issues now within reach, futuristic vehicles are on the horizon,’ said LGIM chief investment officer Anton Eser.
‘Much like Henry Ford’s original low-cost assembly line, these innovations are capable of redefining the future of transportation – with significant implications for investors as well as consumers.’
OEMs and ‘big auto’
‘What we don’t know is that once you start offering products that are much better than anything that is on offer, how quickly this will drive demand and change the market or how quickly this will speed up the process of change to lead to a revolution,’ said Tom Slater, joint manager of the Baillie Gifford Scottish Mortgage trust, which has owned Tesla holdings since 2013.
‘The good news is that we don’t have to predict this, we just patiently back the people who, like Tesla, are perusing this vision.’
However, despite Tesla making headlines this year after launching its third vehicle and meeting construction deadlines for its ‘giga factory’, LGIM sees other opportunities in the auto sector.
‘Original equipment manufacturers (OEMs) need to dramatically shift their manufacturing facilities to adapt towards electric or hybrid solutions. They will also need to become more tech-focused, going beyond their traditional roles as manufacturers,’ said Shaunak Mazumder a fund manager in LGIM’s inflation plus team.
‘Within car manufacturers, Mercedes-Benz, owned by Daimler, recognises the threats posed by tech companies such as Tesla, Google and Uber, and is now well placed to deal with the challenge head on.’
Tesla, while promising, combines execution risk with very high valuation, added Mazumder. Its lofty valuation is priced for perfection, while traditional OEM values are ignoring possible upsides.
In a recently published report, UBS pointed out that: ‘Consumer cost of ownership parity vis-à-vis combustion engine cars can be reached from 2018 (first in EU), creating an inflection point for demand.’
This cost parity is a boon for OEMs, as earlier cost parity means earlier and more visible returns on the current high research and development, the bank’s analysts argued.
Furthermore, the contribution of electric vehicles to CO2 fleet targets, particularly in Europe, will remove a key cost burden. The Swiss bank identified several companies that would be most affected either a positive or negative light from cost parity.
The biggest winners and losers in the electric vehicle revolution will be OEM suppliers, according to Mike Appleby, co-manager on the sustainable investment team at Liontrust.
‘The best example of how we are playing this in our portfolios is through Infineon, a German analogue semi-conductor manufacturer,’ he said.
‘The company is a beneficiary of both big structural themes happening in the autos sector, which will see an approximate trebling of semi-conductor content in cars. Semi-conductor content in a normal internal combustion engine (ICE) vehicle today is about £230 per car, which triples, on average, to £700 in an electric vehicle.’
He continued: ‘[There will be] negative impacts on incumbent supply chains into diesel (the big long-term loser in our view). This affects incumbent OEMs as well as specialist equipment manufacturers, the kit OEMs put in the cars to meet emissions and safety regulations, where we see further tightening.
‘There are also potential negative secondary effects for car financing and existing fossil fuel infrastructure (forecourts) as the oil and gas sector and refineries suffer slowing global growth from internal combustion engine.’
Being exposed to a structural trend and the rise of electric vehicles is not enough to pick winners in this industry, added Appleby. Quality in terms of profitable growth, as well as having conviction the stock will be worth significantly more on a three to five-year timeframe is key.
Some suppliers are benefiting from the transition today and represent good value outside of the auto industry proper, said Justin Winter portfolio manager at Impax Asset Management.
‘There are some things that might not be properly valued in the transition to electric cars, as companies like Tesla take the limelight,’ he said. ‘We think that component suppliers are the most attractive part of the value chain.’