TX Group

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Sergey Basalyga

Hedging The Automotive Industry: The Cyclicality Issue

Ways to solve the issue

As we mentioned several times in our analyses, the automotive industry has cyclical nature with greater volatility than the broader market. While the sector provides investors with great returns when the market is up, its losses are worse than average during market downturns. At times like these, effective hedging can offset some of the damage to an investor's portfolio caused by exposure to automotive and other cyclical sectors. Classic techniques for hedging exposure to cyclicality of the the automotive industry include investing in non-cyclical industries, such as banking, and locking of portfolio space for counter-cyclical investments, such as precious metals and companies, exctracting them.

With a beta of 1.1 (according to Damodaran.com), the automotive industry, composed of automakers and automobile parts manufacturers, gains on average 10% more than the broader when the markets are bullish and looses 10% greater when the markets are bearish. Because the broader market has historically trended upward in the long-term, people who invest heavily in the automotive industry and in other industries with high betas tend to enjoy excellent portfolio growth over time. However, heavy exposure to volatile sectors makes for unsteady portfolio growth.

Banking and utilities are popular stable, or non-cyclical, sectors. Only during major crises (such as one of 2008 or the Great Depression), when the whole economy is broken. With a beta of 0.3-0.5, its volatility is hardly half that of the broader market. The bank's stability derives from its composition of giant firms with a huge amount of capital. The utilities sector offers excellent stability as well, carrying a beta of 0.42. Customers do not greatly vary their consumption of the essential goods and services (electricity, water, etc.) during economic recessions, ensuring that the utilities sector remains fairly stable even in the face of wild market oscillations.

The companies that exctract precious metals, such as gold and silver, stand in even more sharp contrast to cyclical sectors such as automotive. These investments are completely inverse to the broader market and perform their best during bear markets. Therefore, we consider them significant and picking them as a hedging strategy to the abundant automotive stocks that we have in our porfolio. Because precious metals tend to fall out of favor when stock markets heat up, most investors limit their total exposure or rotate in and out of metals based on the economic cycle.

Hedging Tata Motors, Tenneco, GoodYears

Analyzing our portfolio, we conclude that the most volatile stocks in it are Tata Motors with annualized volatility of 38,2%, Tenneco (annualized volatility - 40,3%) and GoodYears (annualized volatility - 38,7%). Though we consider them top-performers in close future, one can never be 100% sure about the possible ups and downs of the stocks.

Volatility of the picked stocks

Additionally, we analyzed the companies with a weaker correlation with respect to the hedged companies. Meanwhile, they should not correlate significantly with other stocks in our portfolio. We picked Randgold Resources Limited amd Goldcorp Inc., which meet our criterion.

12-month correlation

5-year correlation

These companies have weakly correlate with the companies of our portfolio and perform inversely with respect to the picked companies.

5-year Randgold Resources Limited performance

5-year Goldcorp performance

As we can see the stocks of gold mining companies have been bearish for almost 5 years, while the automotive stocks have been performing inversely. The automotive stocks, over their 5-year performance, suffered the most only from the expectation of the decreasing Chinese demand.

5-year Tata Motors performance

5-year Tenneco performance

5-year GoodYears performance

Source: Yahoo Finance

Hedgind will be implemented by purchasing call options on the stocks of Randgold Resources Limited and Goldcorp Inc, corresponding to the weight of Tata Motors, Tenneco and GoodYears respectively.

Conclusion

Hedging by purchasing call options on the stocks of the 2 companies extracting gold will allow us to avoid risks significantly as gold mining companies perform well during bearish automotive markets and have weak correlation with the companies of our portfolio. We wouldn’t recommend hedging these positions for risk-takers as these comapnies may and should perform better then the broader market (and our hedging strategy is not cheap).