Why you should invest in the car of the future

If you were asked to dream up the car of the future, you might create some sleek, high-tech vision with all manner of gadgets: self-changing tyres, in-car entertainment, maybe even an autopilot for those evenings when you want to stop for a pint on the way home from work. But in reality, the car of the future or at least, the near future is likely to be anything but sleek. In fact, it may have more in common with an old-fashioned Lada than a brand-new Mercedes.

The world's cheapest car

As with most economic shifts these days, the major driving force in the auto market is the rise of the Asian consumer. While the battlefield in the West is over emissions and who can produce the greenest car (more on that later), in the East, it's a straightforward slug out over who can win the biggest chunk of Asia's emerging middle class. According to

JD Automotive Forecasting, India's auto market is set to double to 3.3 million cars by 2014, with the Chinese market forecast to grow 140% in that same period. Having built 25,000 miles of expressways in the last 15 years, the Chinese might finally have cars to drive on them. The key word for this car market isn't luxury or speed, it's affordability. The main aim of the auto industry today, then, is to build the world's cheapest car one that "could do for autos what Southwest Airlines has done for travel", says Gail Edmonson in BusinessWeek. A recent study by Roland Berger Strategy Consultants predicts that, by 2012, 18 million cars priced at less than e10,000 will be sold annually. "Low-cost cars are the single most important trend in the automotive industry," says Vikas Tibrewala of Monitor Group consultancy.

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In pole position to produce the world's cheapest car is Tata Motors. The Indian manufacturer plans to unveil a car with four doors, a 33 horse-power engine and a target price of 100,000 rupees (£1,250) in the second half of 2008. The "one-lakh car", a reference to the Indian word for 100,000, has been a source of ridicule among competitors, with many calling it a "four-wheel bicycle", says Edmondson. But that's precisely the market that Tata is aiming at. Ravi Kant, managing director of Tata Motors, says they will target "people who are driving two-wheelers and carrying their entire families on them". In India, some 1.6 million of these motorcycle and scooter riders are likely to buy a car over the next five years, the Berger study estimates.

Tata's not the only company eyeing up this market. French manufacturer Renault has already got a headstart in the race to make the cheapest car with its bare-bones Logan Sedan. The company produced the first car from its Dacia plant in Romania in 2004, and has sold 450,000 of them in 51 countries since. In order to keep the price down to $9,700, Renault's engineers took the gearbox and engine from its Clio model, stripped out the sophisticated electronics and even saved $3 per vehicle by using identical mirrors on each side. But the biggest innovation was the use of digital imaging when designing the car, which cut out the need for expensive physical mockups. Renault plans to use similar techniques to produce a $3,000 version for Asian markets.

But despite Renault's efforts, Tata still holds a distinct cost advantage. After years of selling to the bottom of the market, Tata's engineers have made a speciality of trimming needless spending to the bone. Tata hopes to slash the cost of the engine to about $700, or 50% less than the Western equivalent. Even with the no-frills approach, the few industry insiders who have been allowed to see the car say it is no ugly duckling. Kant even claims that the car, which won't benefit from either airbags or anti-lock brakes, has stood up well in crash tests although you may not fancy its chances if it hits one of the many cows that wander onto the country's motorways. For such cheap vehicles to be profitable, manufacturers will have to sell an awful lot of them. With a BMW, for example, the profit margin is typically about $3,300 per car. On a Logan, it's just $400. But car firms will be hoping that, just as happened with Japan's first-time buyers in the 1970s, they will benefit as Indian and Chinese car owners trade up to dearer models in years to come. "Entry-level customers are the car industry's holy grail," say John Reed and Amy Yee in the FT.

That prize has attracted other big car firms, such as Nissan, Volkswagen and General Motors, to join the race for the world's cheapest car. "You don't want to be surprised when the $3,000 car arrives on the market," Nissan CEO Carlos Ghosn told Forbes this week, announcing that they too have plans for the market. However, we aren't convinced that the big global companies will be the ones making money out of no-frills cars. Instead, the spoils are likely to go to local companies. India, which has cheap engineering and design expertise in abundant supply, has a major head start in cutting costs, for example.

That cost advantage is even making the US auto industry nervous that Asian car makers will encroach on their territory. Chinese car firm Geely, which makes a $3,900 model, has said it is aiming to export to the US market by 2010.

But selling cars to established markets will be a trickier business for Asian manufacturers. To comply with strict safety and emissions control in the West, the price of an Indian or Chinese car would have to come up to $6,000-$7,000 which may not be bargain enough for developed world consumers to put up with the stripped-down nature of the emerging-market car'. Such regulations are only likely to become stricter, raising the bar even higher for emerging-market firms.

Why US consumers are going green

That brings us to the other major trend of the future: what will power our cars? The main battleground here is not Asia, but America the world's largest vehicle market. When it comes to saving the planet, US drivers have lagged behind their European and Japanese counterparts, owing to low fuel taxes, light motor industry regulation and an unwillingness to sacrifice what author PJ O'Rourke has called "the US divine right to consume".

But contrary to popular stereotype, many US consumers are keenly aware of environmental concerns and are becoming more so. Ten US states, led by Arnold Schwarzenegger's California, are planning legislation to lower CO2 output from passenger vehicles. If passed and all the signs are that Arnie means business the promised cut in gasoline use is a whopping 30% by 2016. This is a big deal for the car industry between them, these ten states represent around 30% of US vehicle sales. Even more remarkably, California's 13-page bill is being pushed through under the nose of a Bush administration officially opposed to regulating CO2 emissions. And if a Democrat president is elected, perhaps as early as 2008, then the move to green up' America's cars could progress even faster, with "some pundits predicting strict emissions regulations across the board", according to Automotive News.

How to build a cleaner car

There are two main ways to cut CO2 emissions, says engineering group Ricardo. You can improve fuel efficiency by cutting weight from existing vehicles, or you can change the way they are powered. The problem with the first option, slimming down cars using lighter metals and plastics, is cost and the length of time it takes an entire model cycle to implement. A more realistic solution is to refine the way the power is delivered, by installing hybrid or diesel engines.

Hybrid cars are well known for their green credentials, substituting petrol for an alternative power source, such as liquid hydrogen or an electric motor. But less well understood are the benefits of diesel. With the problems of air pollution (the emission of toxic particles, such as lead and nitrogen dioxide, rather than greenhouse gases) from cars largely solved (see box, below left), diesel is no longer the dirty' fuel of popular perception. And because both these sources are more fuel-efficient (offering roughly 12% more energy per gallon than petrol) and last longer (their engines work more efficiently), their overall CO2 emissions are far lower.

So which is most likely to come out on top? Perhaps surprisingly, investment bank UBS reckons that while hybrids will continue to gain market share, diesel will be the big winner. Why? Well, whatever the ecological merits of switching, US consumers will need persuading that a more fuel-efficient car makes economic sense. Given low tax rates on fuel in the US Texas, for example, has just voted to suspend its (hardly penal) 20c/gallon levy altogether this summer, this won't be easy. Ricardo estimates a consumer moving from a 25mpg to a 35mpg vehicle will save less than $700 a year based on 20,000 miles of driving. So it's vital that manufacturers produce fuel-efficient cars that are also competitively priced and it's here that diesel wins hands down.

Building a US-compliant, large (four litre or more) diesel engine costs around $3,000-$4,000 more than a standard US-emissions compliant petrol engine. For a hybrid the premium is more like $7,000-$8,000. So cost alone means that expensive hybrid cars, such as the Toyota Prius, are likely to remain popular only with high-income users unless costs fall dramatically. UBS also questions whether companies such as Toyota make any money from hybrids and concludes that profit margins are likely to remain pretty slim. Another point on diesel's side is that big manufacturers, such as General Motors and Toyota, already produce diesel cars that comply with regulations in 45 US states and are confident that the next batch of diesel engines produced in 2008 and 2009 will meet even California's draconian emissions standards. On top of this, even though hybrids are popularly seen as the greener' option, in reality, while a hybrid might deliver a 20% fuel saving over diesel while idling in city traffic, on the open road this fades and is even reversed.

What about other alternatives?

Electric cars take current hybrids, such as the Toyota Prius (which recharges the battery driving its electric motor by running a separate gasoline engine), a stage further. By plugging into an electric power outlet and charging a sufficiently large battery, the car can be run during the day mainly on electric and then powered up overnight. On low mileage (currently no more than ten per day), these cars can run entirely on a battery, making them the perfect eco-friendly city runabout. But major downsides include the size of the battery forget about boot space and the prospect of being stranded without power. They are also expensive. A tiny new G-Wiz will set you back around £8,500. There are some other fringe alternatives, but none that look commercially viable as yet. The Economist reports that Montana's Democratic governor drives a Volkswagen Jetta that runs on biodiesel, but keeping such cars on the road for any great distance is tricky, unless you happen to be him. "Everywhere I go, people give me a jar of local hooch to power it," he boasts. Not the kind of help most could take for granted stranded on the M25.

So for now, the future of green motoring seems to lie with the diesel engine and, behind it, the hybrid. Both UBS and Ricardo expect sales of diesel-powered vehicles to near-triple from 545,000 units now mainly installed in pickup trucks to 1.5 million in 2012, while hybrid sales will reach 1.2 million. And that still leaves plenty of growth potential in a total US market of around 18 million vehicles, that would give diesel an 8% market share, compared to more than 40% in Europe. So how do you play the boom? Take a look below to find out.

Where to fill your tank

If you are looking to take part in the race to build the world's cheapest car, then Tata Motors (NYSE:TTM), India's largest commercial vehicle maker, is almost certainly the best way to do it. Its as-yet unnamed car has achieved legendary status in the industry, says Gail Edmondson in BusinessWeek, and if plans to launch next year are successful, it would herald the emergence of Tata Motors as a major player on the global auto scene. But even without a no-frills bonanza, Tata is an attractive company. It controls 65% of the Indian commercial vehicle market and 19% of the passenger car market. It has just launched two new passenger vans targeting the rural and inter-city markets, which will be sold across the country, notes Ruth David on Forbes. This week it also raised $490m on the Singapore exchange to fund its expansion into the passenger car market. Valued on a forward p/e of 11 for 2008 by Thomson Financial, Tata Motors looks like an absolute bargain.

Although Tata's rival, Renault, has had success with its Renault Logan Sedan, sales of the French car manufacturer's other vehicles have been sluggish. A far better way to play its involvement in India's auto industry is through its production partner in the country, Mahindra & Mahindra (MHID). The company is helping Renault and Nissan to produce cars

to rival Tata's offering. The company's shares trade on a p/e of 15.5 and are available as global depository receipts on the London Stock Exchange.

As for America's conversion to greener' cars, investment bank UBS tips both BMW (XETRA:BMW.DE) and DaimlerChrysler (XETRA:DCX.DE) as good bets. BMW is currently trading on an undemanding p/e of 12, having suffered falling returns in recent years, but it is well placed to revive profits with the launch of fully US-compliant five and seven series diesel engines in 2008. In addition, management is expected to cut costs, which should boost profits. Meanwhile, DaimlerChrysler's US diesel sales rose 60% in 2006 and the Mercedes range is being expanded with plans to launch fully emissions-compliant "Blue Tech" diesels by 2009. Its expertise in trucks makes it a natural leader in the diesel market. Currently trading at e66, UBS expects earnings growth to take this to at least e75.

Then there are the companies that supply diesel components. Of these, Denso (6902.JP) and Continental (XETRA:CON.DE) look like strong bets. Denso is the second-largest supplier of diesel engine parts to the likes of Toyota, Mazda, Nissan and European Ford, as well as supplying some hybrid parts to Toyota. Continental is an established tyre and car systems maker with only limited diesel exposure, but this would increase with its proposed acquisition of Siemens VDO UBS sets a price target 20% above the current share price of e100, with earnings growth reasonably priced on a price to earnings growth ratio of 1.2.

For those wanting to play the hybrid boom, Toyota (7203.JP) is the number-one firm, with cumulative global sales of 870,000 units at the end of 2006, while Honda's (7267.JP) aggressive North American growth strategy should pay dividends. But given UBS's view on profit margins for hybrid cars, we'd be more keen to stick with the diesel plays.

Did you know?

• A modern car emits fewer pollutants while running than a 1970s vintage car turned off? The reason for this extraordinary anomaly is that the older car will typically release unburned hydrocarbons into the atmosphere from its leaky fuel system.
• More volatile organic compounds are released by painting a typical room in an average family home than through driving the hybrid Toyota Prius for 150,000 miles.
• On a warm day in Los Angeles, a Honda Insight hybrid releases cleaner air than it takes in.