To understand the challenges facing the automotive sales industry, it is often helpful to examine a particular company, as Roger Montgomery did earlier this month.

Autosports Group (ASX:ASG) operates car sales outlets in Sydney, Melbourne, Brisbane and the Gold Coast. Its share price has been on a rollercoaster ride since floating in 2016 and currently sits below the $2.40 listing price. ASG is profitable and reasonably priced, but investors should be mindful of the threats facing its business model.

Established in 2006, Autosports Group owns and operates 40 retail businesses, including 23 luxury and prestige motor vehicle dealerships, two used wholesale motor vehicle dealerships and two specialised collision repair facilities in Sydney, Brisbane, the Gold Coast and Melbourne. Autosports Group represents Original Equipment Manufacturer (OEM) brands including Alpina, Aston Martin, Audi, Bentley, BMW, Jaguar, Lamborghini, Land Rover, Maserati, McLaren Mercedes Benz, Mini, Rolls-Royce, Volkswagen and Volvo. ASG offers new and used vehicles, finance and insurance, and back-end parts and servicing, including collision repair.

Currently, car dealers are operating amid a veritable storm. Deliveries of new vehicles are hampered by a semiconductor chip shortage and the shuttering of manufacturing facilities due to COVID-19 associated isolation requirements.  Booming demand for vehicles however is undiminished, thanks to consumers unable to travel, and flush with cash (e.g., a booming construction sector lining the pockets of builders and tradies). The eroded appeal of public transport is also driving demand for private transport.

Unable to purchase a new car, buyers have turned to the used market where prices for many used vehicles have risen beyond their original purchase price of several years ago.

The agency threat

Meanwhile, in the background, the ever-present threat of OEMs moving to an Agency Model (Mercedes AG have already announced the change and are in court with dealers fighting for $650 million compensation) poses a revenue hazard to dealership revenues, putting investors on edge.

Under the current dealership model, a brand retailer buys a vehicle from the OEM as inventory at a wholesale price. Typically the vehicle is only paid for by the dealer when it is sold. A margin for the dealer to cover costs is added and the salesperson then negotiates a transaction price with a customer.

OEMs including Mercedes and Honda have expressed frustration with the traditional dealership/OEM relationship because dealer promotions including special offers, run-out deals, discounts and end-of-the-month sales all lower resale values and accelerates depreciation rates.

But it hasn't all been the dealers' fault. Dealers note they have had to pay for manufacturer 'mistakes', overproduction on their floor plan charges, incorrect build combinations and obsolescence. This is the reason for the "race to the bottom" on new-vehicle margins.

Under the Agency Model, dealers are paid a fee for a vehicle sale. For Honda dealers in NZ, this ranges from four per cent to seven per cent depending on meeting sales targets and customer satisfaction scores. Elsewhere, the customer places their order directly with the OEM and nominates a preferred delivery dealer. The price and dealership mark-up or commission is set by the OEM.

The positive spin put on the agency model by OEMs says dealers aren't limited to selling just the cars allocated to them. They are free to sell any vehicle model in the brand's stable on order nationally. Dealers have access with access to the full range without incurring floorplan costs.

The OEM owns all demonstration stock at the dealerships and all the new-car stock. New vehicles are held for sale at a national distribution centre and sales are made directly to the customer. The dealer therefore no longer finances an inventory of vehicles for sale, and all floorplan or finance costs are borne by the OEM. In Volkswagen's electric vehicle agency model in Europe, the dealer is offered a lease program for demos and loan vehicles.

Across the globe, the use of agency models is more widespread.

Mercedes-Benz has already introduced agency models in South Africa, Austria, Sweden and it will transition to one in Germany as well. Volkswagen is rolling it out for selling electric vehicles in Europe and Honda has been running the model in NZ since 2000.

Back to ASG

Navigating this tumult is a challenge attested to by a 30 per cent decline in ASG's share price since its high of $2.74 last June.

Autosports Group reported its first half FY22 results recently noting the solid margins of the previous financial year continued, driving profit before tax to beat some estimates by more than 10 per cent.

The company however reported revenue of A$911 million, which grew 0.8 per cent year-on-year (yoy) but missed consensus estimates for $1 billion. Revenue was down four per cent when adjusted for acquisitions, which contributed $44 million.

EBITDA grew 27 per cent yoy to $48.6 million, beating some estimates by 10 per cent.  Adjusted profit before tax of $39.2 million was up 35 per cent on the previous corresponding period and beat consensus estimates for $33.8 million by 16 per cent.

Revenue for the sale of new vehicles was unchanged on the same period a year ago at $564 million, thanks to an inability to obtain sufficient stock. A combination of strong demand, and that inability to deliver new cars, has also resulted in the company's new vehicle order book doubling from a year ago. New orders written in the first half exceeded deliveries by 22 per cent.

Over in the used car department, vehicle revenue of $209 million was also flat yoy but strong growth in the final quarter of the calendar year was implied by the fact the first quarter was down 12 per cent yoy due to lockdowns.

The services department generated $59 million in revenue, which was nine per cent higher than the previous corresponding period and parts generated $60 million of revenue up 13 per cent yoy.

The growth in profit, which exceeded revenue growth, was the result of higher selling prices (on less stock) and therefore improved margins. Gross margins of 19.2 per cent was an improvement on the 17.8 per cent generated in in the second half of FY21.

The company's outlook remains clouded by a comprehensive lack of clarity about when deliveries will return to normal. Supply constraints are expected to last the remainder of the calendar year at least. Demand should therefore continue to exceed supply. The Used vehicle, Service and Parts divisions are expected to generate revenue growth of between six and ten per cent. Longer term the business model remains under the cloud of threats from OEMs moving to an agency selling model.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Economy-wide events dominate the headlines

Big inital swings are a typical reaction to a change in the macro-economic outlook and are not cause for us to react. This movement was primarily driven by the largest swing towards value stocks in over 20 years. 

As at the end of February, the 'value' style category fell -2.8% CYTD with 'growth' styles falling -12.5%, according to JP Morgan. The lesser known 'quality' style category where Insync resides is neither value nor growth, although we tend to hold stocks the market categorises as Growth. 2022 marked the 5th worst start for S&P 500 since 1927. Inflation fears have the market pricing in 5-6 interest rate rises this year, precipitating the heavy swing initially, with Ukraine's invasion by Russia creating price spikes in both energy and commodity prices as well. Markets hate uncertainty.

It's no surprise then that material and energy stocks were the best performers in February (Insync has zero exposure to these sectors due to their low ROICs through the cycle). It's highly probable that the negative macro factors will slow economic growth. This in turn, will then favour a move back to profitable growth companies (rather than growth stocks overall). These are the type of stocks we hold. Thus, we liken the current portfolio to a coiled spring. When investors soon refocus on company fundamentals, the share price performance of quality businesses then rebound quickly and sharply. This usually 'surprises' commentators and investors alike. Earnings growth across the portfolio continues to compound strongly despite macro shifts, with valuations becoming more attractive.

Governance factors are why Russia and its peers don't appear with Insync

Russia's invasion of Ukraine is one of the greatest tragedies of our lifetime. We have no direct exposure to Russian equities and virtually zero indirect exposure. The simple reason is that Russia is a Kleptocracy run by a ruler who has used his poitical power to systematically steal billions of dollars of its national treasure owned by its people. When there is no rule of law - and therefore no shareholder rights - valuations do not matter. The risk of near total loss of capital is too high. Companies with strong governance nearly always do the right thing and also deploy capital wisely.

Why we are confident that sustainable growth companies are poised to perform strongly

Almost every big slowdown in the past has been preceded by a rise in energy prices and Federal Reserve rate hikes.Going forward then, markets will likely start shifting focus to the prospect of weaker economic growth and refocus on investing in businesses with durable, sustainable earnings growth and profitability.

This economic backdrop propels precisely the kind of stocks we hold. Overlaid with identified megatrends, it enables these companies to thrive irrespective of higher rates or slower growth.

Meantime, in the near term expect ongoing volatility in markets and most equity funds as well including our own. 

Indicators suggest that the market may be surprised on the upside

We have often discussed the difficulty and danger of market timing. The probability of getting it right more often than wrong is extremely low. Right now, investor sentiment is very bearish with the AAII investor sentiment survey at its lowest point since April 2020. Fund managers overall reflect this view, holding the highest level of cash since the covid lows and at the bottom of the GFC.

This is why we remain fully invested when markets swing wildly as one would expect in these moments of macro-economic uncertainty. For good reason we didn't react in previous occasions such as now, and we won't in future ones either.

This is also why we remain fully invested unlike many of our peers. Should timing be desired in the hope of avoiding the dips and riding the peaks, then we believe this is a decision for the investor and their adviser. 

We continue with our usual rifle-like approach of investing in the most profitable companies with a long runway of growth fuelled by megatrends. We refrain from trying to time these shifts, as this lowers risks and, longer term, aids returns. 

Do valuation multiples matter? There's broadly two schools of thought - one that purchase price dictates your future return and the other that good companies will deliver growth in time to drive value higher, whatever the current price is. 

Buying a stock on low multiples is no guarantee of either future multiple expansion or earnings growth. Outside times of panic you can expect there is some logic driving the sellers of those low multiple stocks.

But an excessive price today can burden a company with implied growth expectations that it just can't meet. In a different era, former dot-com darling Sun Microsystems' CEO, Scott McNealy, expressed it well:

"At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate."

Size is an important factor  - Sun was "at scale" with >$US10 billion of dollars of annual revenue and its ability to grow into its valuation was limited. A microcap today on 10x revenue that is just beginning to penetrate its market with a competitive advantage may well be able to prove it was a bargain retrospectively. So multiples only mean something with context and analysis.

War in Ukraine

The unprovoked conflict in Ukraine has unleashed a human tidal wave of misery, dislocation and death, the scale of which has not been seen since World War II. A columnist for the New York Times referred to the war as "the most dangerous confrontation for the world since the Cuban missile crisis (of 1962)." 

Just one month ago, we wrote of the onset of higher interest rates and inflation as major factors influencing markets, having considered but not believing that Putin would be so irrational as to start a war. 

This is not the correct forum to deal with the human and geopolitical consequences of this, so we won't. But it is appropriate to ask: How will the war in Europe affect investors globally? The broadest economic sanctions ever enacted have resulted in the collapse of the ruble (by 50%), the delisting of Sberbank (one of Russia's largest) on some European exchanges, and a well-advanced movement by some countries to source oil and gas from places other than Russia. 

This is forcing up the price of energy, at the pump and the meter, which will likely drive inflation even higher than its current levels, spurring the US Federal Reserve to continue its tightening policy. But the Fed will also consider the possibility that higher energy costs could suppress demand, thus reducing the need for more serious interest rate rises - an unscripted but possible outcome. 

Separately, we are of the view that now that Russia is considered an unreliable energy partner for the Europeans, the impetus to de-carbonisation will accelerate.  

Portfolio positioning

We do not know how this will end, but last month we wrote highlighting the quality of the portfolio. "Irrespective of macroeconomic conditions, this (quality) has always been an integral part of the portfolio construction process, and was a decision informed by the numerous corrections and crashes witnessed by the investment team over their lifetimes.

"It is for this exact reason that a majority of Loftus Peak's holdings are in quality companies - those with established business models, strong balance sheets and cashflows, with a much lower allocation to 'riskier' companies. This has always been the case, but in more recent months we have increased the tilt to quality even more than usual."

Despite the short-term volatility and underperformance of a select few names, we believe the Fund is well positioned for a period marked by slowing economic growth and rising costs of capital because of the inherent characteristics of the big disruptive companies, which are amongst the strongest in the world.

Further, earnings growth in the majority of the Fund's holdings continues to be strong, adding to the conviction we have in the long-term secular trends to which we are exposing our clients. Although the short term might remain volatile and uncertain, we believe that over the medium and long term the safest place to be is in quality companies riding secular tailwinds. 

Disruption no longer implies excess risk

During the early days of disruption, between 1995 and 2005, there was considerable investment risk as typically the mechanism was via start-up companies, which mostly were light-on for profits, let alone cashflows and balance sheets. It was by no means clear, for example, that classified advertising would migrate on-line, that cars would go electric, movies would be shown on mobile phones or that taxi services would be replaced by Uber and the like.

Investors who bought before the bursting of the 2000 bubble did not do well… for a while. But those that understood what Apple, Amazon and Google were doing on the global stage - and that part is very important - made simply stellar returns.

Fast forward to today. The word disruption, for reasons related to its investment history as well as its more general meaning, still has a negative connotation. It is not unfair to prefer the safety of an 'undisrupted' world to the uncertainty that disruption implies.

But it is time to move on. Some of those early-stage disruptive companies are listed in the top ten by value in the world today, including Amazon, Nvidia, and Taiwan Semiconductor Company. Properly managed, disruption no longer need equate to excessive risk.

With rising global inflationary pressures mounting, a range of factors are converging to create a new inflationary era. From the demand distortions and supply dislocations associated with the COVID-19 pandemic, geopolitical risks, as well as monetary and fiscal tightening, these factors are expected to increase volatility across financial markets in 2022.

The reality of higher inflation and interest rate hikes has prompted asset owners to review their current defensive fixed income allocations and assess the level of risk protection required in order to earn the investment returns needed to meet their targets. 

Income generated by traditional fixed income sources such as fixed rate bonds are now harder to find. Strategies across private markets, in particular private debt, may be well equipped to deal with the ongoing market volatility and changes to interest rates. In periods of higher inflation, private debt can offer investors a level of protection - being a floating rate asset class means the underlying yield increases as inflation and interest rates increase. Additionally, the long term, patient capital nature of private debt, and the ability to absorb and pass on rising costs mean these strategies can actually benefit from inflation.

But senior secured private debt can offer more than that. 

It's a defensive allocation that can help to preserve capital and provide genuine diversification and yield, whether through the right sub-sectors of private debt or the underlying assets well-positioned to flourish during an inflationary environment.

The Australian investable private debt universe is large, and we believe the most attractive sub-sectors include leveraged buyout and private company debt - in businesses with brand and customer strength operating in non-cyclical industries; private and public Asset Backed Securities such as floating rate quality mortgages; and loans to stabilised commercial real estate assets with annual contracted rent.

Risk mitigation in senior secured private debt also relies heavily on strong credit discipline. A proactive approach to risk management can help build greater resilience in changing market conditions such as inflationary environments.

Revolution Asset Management believes the outlook for private debt remains positive. With a robust deal pipeline, deployment into 2022 is set to be strong. In private company and leverage buy-out loans, the M&A boom of 2021 drove three times the level of activity vs the prior year and 40% higher vs the five year average, and with international borders reopening, this is expected to fuel activity in 2022. In private Asset Backed Securities, warehouse funding is reaching A$10 billion and continues to offer very attractive relative value compared to public Asset Backed Securities. In the current market, we are witnessing significant growth particularly in non-bank lending activity in Australia and New Zealand, which continues to provide attractive opportunities for our portfolio and helps quality non-bank lenders realise their growth plans.

Allocating more to higher-yielding, floating rate assets such as private debt could be one strategy to minimise interest rate sensitivity of fixed income portfolios and guard against inflation risk, while at the same time increasing and diversifying sources of return.

Author: Bob Sahota