Investing in stocks of auto parts makers is a wise move for many reasons. For example, the demand for automobile parts is stable during economic expansions and contractions. In fact during recessions demand goes even higher as consumers try to repair their existing vehicles and use them instead of buying new ones. During good times, the demand for auto parts continue as consumers replace worn-out parts in their vehicles or add accessories to even newer vehicles. As cars are a necessity for most Americans living in places other than the world-class cities of Los Angeles, New York,  Chicago, etc. there will always the need for  replacement parts for automobiles. I written about the auto parts sectors many times such as here and here and here and here over the years.

Recently I came across an interesting piece at Alliance Bernstein that discussed how auto suppliers are more profitable than auto makers.From the article:

Suppliers Are Highly Profitable

Auto suppliers are already much better businesses than perceived. Many of these companies streamlined dramatically after the 2008 global financial crisis because they weren’t propped up by governments like the carmakers. There was a wave of mergers and acquisitions in Europe and the US, along with drastic cost cuts and consolidation of production.

Today, the supply base is brimming with technology. This gives suppliers more pricing power than in the past because their products are more sophisticated. Combined with industry restructuring and investment in new products, suppliers have improved returns on invested capital to levels well above those of the automakers (Display)—which adds resilience to downturns.

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Barriers to entry are high. Since quality standards for car parts are very stringent, it’s not easy for an upstart with a sharp product to challenge an incumbent and win support from big auto manufacturers.

From an investment perspective, the authors note that European suppliers are now trading at n attractive valuation and have stronger balance sheets. In addition, their organic growth rate is higher than US auto parts suppliers.

Source: Does Volkswagen Fallout Taint the Auto Industry? by  Tawhid Ali, Andrew Birse, AB Blog, Nov 30, 2015

The above evidence validates my long-held theory that in order to profit from the rebound in the auto industry, it is a good idea to invest in auto parts makers instead of auto makers as part suppliers offer the “picks and shovels” to the auto manufacturers.

Some of the foreign auto parts makers to consider are: Continental (CTTAY), Michelin (MGDDY), Valeo (VLEEY), Autoliv Inc (ALV), Magna International Inc(MGA) and Bridgestone Corp. (BRDCY).

Major US-based car parts suppliers include Johnson Controls, Inc.(JCI), Genuine Parts Company (GPC), AutoZone, Inc.(AZO),  Lear Corp (LEA), Visteon Corp (VC), etc.

Disclosure: Long MGA

One of the advantages of holding foreign equities in a well diversified portfolio is that the performance of US stocks and international stocks tend to deviate from one another. This means while US stocks may perform well in one year foreign stocks may not and vice versa. So by holding both foreign and US stocks investors can benefit more.

The year-to-date performance of the US and major European indices are shown below:

S&P 500 Index: 1.59%

UK’s FTSE 100:  -5.0%
France’s CAC 40:  10.3%
Germany’s DAX Index: 9.7%
Spain’s IBEX35 Index:  -2.0%

So some European indices have performed much better than the US market so far this year.

For a long-term perspective, the following chart shows the performance comparison of US and international stocks from 1983 thru June 2015:

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Source: Why you may need more international stock, Fidelity Investments

In summary, it is always a good idea to diversify and own foreign stocks in addition to US stocks instead of putting all the eggs in one basket and completely avoiding equities outside of the US.

Equity investors have to ignore average returns reported for a short period of time like 3 years, 5 years, etc. This is because stocks are a very volatile asset class and and go up sharply as well as plunge dramatically from one year to the next. So simply taking an average over a very short-term like 3 years does not make sense for an investor. Basically when funds such as ETFs, mutual funds report a 3 year or 5 year average return it is simply useless information that investors should ignore. Instead it is better to look at the performance of a fund over the long-term such as 10 years or more. For example, in 2008 the S&P 500 declined by 38% excluding dividends. But in 2009 and 2010 it rose by 23% and 12% respectively. So taking average of these three returns to predict the average annual return an investor can expect from investing in an S&P 500 fund is wrong to say the least. This also shows how the S&P’s returns can be volatile from year over year.

Let us review this concept using the South Africa FTSE/JSE All Share Index returns from an research report by Mark Cliff at PSG Asset Management .

A closer look at historical returns

Chart 1 below shows the rolling 12-month total returns of the FTSE/JSE All Share Index (with dividends re-invested) between 1 June 1996 and 30 September 2015. Each dark dot on the graph represents a return for the index for the preceding year. The blue line shows what inflation was for the corresponding period and the red line shows the average annualised return over the period. The dotted lines are one standard deviation above and below the average.

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Calculations for the above chart show that the average 12-month return for the index was 17.24%. during the period shown. And the annualized standard deviation (variability) of these returns was 19.9%.

The author Mark noted the following observation:

So what we can see from this data is that while the average annual return was 17.24%, this occurred very infrequently. The reason for this is that the stocks which have made up this index over this period have been very volatile – as evidenced by a high standard deviation of nearly 20%.

When it comes to the more volatile asset classes – like equities – the variability of returns can be significant. The higher the volatility, the lower the probability that short-term returns will be near to average returns.