The sparkling story of the auto sector

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A cursory look at the newspapers these days shows how optimistic people have become about India's auto sector. This optimism is not restricted to only us Indians though. Auto majors from all over the world are looking at the Indian market like never before.

This week saw many Indian auto companies release their sales figures for the month of August. Maruti, the largest passenger car company in the country reported a 33% YoY growth in domestic car sales. This is its largest ever in a month. TVS Motors too was similar. It saw its moped sales improve 32% YoY. Tata Motors, India's largest CV maker, witnessed a 32% YoY rise in total sales to 65,938.

These numbers tell the sparkling story of auto companies in India. They also speak about the kind of profitability these companies are witnessing currently as a consequence of this stellar performance. This phenomenon has also lead to many auto makers not being able to satisfy the entire demand. Mostly due to shortages of components and auto parts. Extended waiting periods for many models have become common place these days.

There is one problem though. Basic economics asserts that when companies in any sector are witnessing abnormal profitability due to high demand, it is only a matter of time that players in the industry increase their supply to capture that demand. The larger the profits being made by players, and the greater the demand-supply mismatch, the higher the aggressiveness with which new capacity is added in the industry.

This capacity is added in two ways. One, by way of capacity expansion undertaken by existing players. And second, by way of the entry of new players in the industry. Who are also looking out to get a piece of the action.

The Indian auto sector has been seeing some happy times off late. And just like the books foretell, it has indeed attracted a barrage of capacity expansion by companies. Not only that, it has also caught the attention of large auto companies from around the world. The environment in developed markets continues to be dull. Thus the attention on fast growing markets like India has further intensified.

Taking our economics lesson further, it is now only a matter of time that this capacity expansion begins to come on stream. And when that happens, depending on how much supply overshoots demand, the best case scenario is that the high profitability of auto companies will get tempered to more normal levels.

The worst case scenario though is that the growth in supply far outstrips the growth in demand. In that case, the resultant intense competition may have a devastating impact on the profitability of the auto sector. The auto industry as a whole will still keep growing at a fast pace even in this eventuality. Individual auto companies' profits on the other hand may not turn out to be a very pleasant picture.

Many auto stocks and their valuations today seem to completely refute the possibility of the latter. Not a very wise thing to do for the thoughtful investor.