More room to run. China’s auto sector has been on a tear since March, driving up valuations and market expectations. Is there room for more? In this report we set out to answer why we believe there is. For starters, demand is flooding back. We significantly raise our car demand forecasts and expect to see 10% industry growth in 2021e (2.5% previously). And while valuations have risen, propelled by the market pricing in stronger earnings and because of the high operating leverage (2x-5x) in the sector, we don’t see these at alarming levels yet. PB multiples for H-shares are now at 1.68x vs.1.0x as at the end of July 2020, still far from their peaks reached in 2017.

Lifting TPs by an average of 52%. Given our renewed optimism, we lift our earnings estimates by 1% in 2020e, 8% in 2021e and 7% in 2022e, on average. Our valuation multiples are lifted amid the improving demand outlook. All this drives an increase in our TPs by an average of 52%. This leaves only 12% implied upside on average, given the run-up in the market.

Rising risks. While we are largely positive on the sector, and in particular see 2021 as the year EV sales take off, we acknowledge there are risks too. These include lower-than-expected car demand, price erosion, slowing economic growth, falling consumer confidence and a drop in liquidity, a major factor for auto stocks.

Five Buys. We upgrade Changan A to Buy (from Hold) as we see its new partnership with Huawei as able to raise its brand profile and product strength of its vehicles. We also keep our Buy ratings on four other stocks − BYD H, Geely and Great Wall H/A −as we see these market leaders as benefitting from a strong product cycle as well as their electric vehicle (EV) and autonomous driving (AD) capabilities.

Initiate on SAIC at Hold. SAIC is China’s biggest auto maker, but despite its strong brand and product portfolio, we see its overall product cycle as muted and it is losing market share. It needs to spend more to stay competitive in EV and AD, but that could challenge its payout sustainability. We see current valuations as fairly reflecting its growth profile. Our target price is RMB27.50, based on 11.6x 2021e PE. Key risks: stronger/lower-than-expected volumes; better/worse-than-expected EV and AD capabilities.