By Shaul Rosten, part of the Redwheel UK Value and Income team which manages the Temple Bar Investment Trust
A trip to the supermarket in Florida proved life-changing for one lucky shopper last month who scooped one of the largest US lottery prizes in history. The $1.58bn winning ticket, costing $2 to play in the Mega Millions draw, net the winner a 79 billion percent return.
Whilst that is a fabulous outcome, $2 may be seen as too high a price to pay for such a ticket: the expectation, based on the likelihood of the outcomes, is that you will never win back your original stake.
Nonetheless, staying with the rational approach to lotteries and ticket prices, it is interesting to consider what price you would pay for the winning ticket, were it to be offered for sale once the numbers had been drawn.
In such a scenario, paying even a dollar less than the jackpot is a way to guarantee effectively free money, as you have pre-paid for the winnings. By contrast, were you offered the chance to buy the winning ticket – after the draw had taken place – at the original $2 price, you would obviously jump at the chance, grabbing a sure-thing cash payout for an eye-wateringly attractive price.
Why do investors buy at high valuations?
The clarity of this example, however, seems to get lost in translation when looking at investment opportunities. Often investors buy companies that they believe to be future lottery tickets, expecting to earn the associated high returns, yet pay prices that all but assume a guaranteed win.
As is easy to understand from the lottery example, paying full price for a winner might make sense, but (i) it won’t make you the same return as paying only the initial $2 ticket price, and (ii) it only makes sense if you already know the outcome of the draw.
For companies, too, those investors buying at huge valuations are effectively paying in advance for a sure-thing winning ticket, without the associated guarantee of a bonanza pay-out – and, even if they do get the pay-out they expect, they will only earn an average return, since they have already paid for the winnings. This approach is difficult for us to understand.
At the same time, the inverse phenomenon also makes little sense to us: today, there are some of what we would consider “sure-thing ticket” companies, with impenetrable balance sheets, track records of success and impressive cash earnings, priced at the original $2, as if they still have extremely unlikely odds of a pay-out that we see as much closer to guaranteed.
The case for Stellantis vs Tesla
We find ourselves bumping up against this problem repeatedly in the real world, and one of the UK Value and Income team’s portfolio companies, Stellantis [Euronext:STLA], provides a good example, especially when compared to the much more highly valued peer, Tesla [NASDAQ:TSLA].
Stellantis is the corporation formed by the 2021 merger of Fiat-Chrysler and Peugeot, bringing together two storied companies with a formidable stable of brands – Alfa Romeo, Citroen, Chrysler, Dodge, DS, Fiat, Jeep, Lancia, Maserati, Peugeot, Ram, and Vauxhall/Opel – and strength in Europe, North America and South America.
In the first half of this year, the company grew its shipments by 10%, revenues by 12%, and operating income by 31%, delivering €13.5bn of operating income and €10.9bn of net income. With a €53.8bn market capitalisation, and €24.5bn of net cash on the balance sheet, the company is valued at a price to earnings of 2.5x. Given the long track record of the company, the brand strength of the group, the experience of the management team, and the sturdiness of the balance sheet, that price is simply staggering to us.
At the same time, Tesla – another car manufacturer – appears to us to be the lottery ticket priced for a win, without having any certainty whatsoever as to the final outcome.
Would you bet against Tesla?
Whilst we are not advocating for betting against Tesla and Elon Musk – with many great investors finding this experience to be particularly punishing – we would simply note that we believe the current valuation bakes in extreme growth assumptions. The danger of this approach, in our view, is that even if the lofty goals can be reached, the return earned by the investors will be, at best, in line with the market, and quite possibly much worse. After all, that is what can happen when you pay upfront for targets that have not yet been hit and is akin to paying $1.57bn for the $1.58bn ticket – only this time, doing so when the jackpot win is far from guaranteed.
In the first half of the year, Tesla grew automotive and total revenues by 35%, whilst operating income declined by 17%, and net income fell by 6.5%, delivering $5.2bn of net income to shareholders.
Even though Tesla earned a little less than half of the net income figure Stellantis achieved this year, it would cost you fifteen times more to buy Tesla: that means that, for every $1 of net income available for you to buy, Tesla’s will cost you thirty-one times the price of the same $1 earned by Stelllantis.
Valuation discrepancy between companies in the same industry
Both Tesla and Stellantis are auto manufacturers, experiencing the same industry churns and challenges, and navigating in a competitive, capital-intensive market. Which will grow faster, earn more money, or have a more beloved CEO, we do not know, nor feel any compulsion to predict. Instead, what we find instructive about this case study – with such an extreme valuation discrepancy between companies in the same industry – is the illustrative example that each company provides for different investor approaches: buying presumed future earnings for a fairly full price, or buying current cashflow for a bargain price.
A good mental model for thinking about which type of lottery ticket to buy was put forward by Warren Buffett in 1989, in his annual letter to shareholders (emphasis added):
“After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers” – Berkshire Hathaway Chairman’s Letter to Shareholders, 1989
Stellantis: a one-foot hurdle
Stellantis, in our view, is a one-foot hurdle: a well-run, conservatively financed company with attractive prospects and an absurdly low price for its impressive and growing earnings, all it needs to do to be a great investment at today’s price is simply more of the same. The seven-foot hurdle, meanwhile, is aptly represented by Tesla, who, in our view, will need incredible feats of corporate athleticism in order to grow into the price that investors are currently paying. We have no view on whether such a seven-foot hurdle will be cleared; where we have much greater confidence, however, is in the ease with which we believe Stellantis’ one-foot hurdle can be stepped over.