An illustrative tale of why valuation matters … balancing growth with valuations today … the right approach, according to Eric Fry

Let’s start with a quiz …

The data below come from Eric Fry’s February issue of Investment Report, so the market has moved a bit in the last month. But it illustrates the point.

As a quick intro, when we buy a stock, there are many ratios we can use to evaluate our entry-price. There’s price-to-earnings, price-to-book, price-to-sales …

These are traditional valuation metrics. But we could get creative too.

For example, if we were to buy, say, an auto-manufacturer stock, we might look at how our purchase price translates into an effective “cost-per-vehicle-the-company-produces-each-year.”

On that point, here’s your first quiz question …

What’s the recent cost-per-vehicle-produced-in-a-year for German automaker, Volkswagen?

Got your guess?

It’s $11,000.

On to the second question …

What’s the recent cost-per-vehicle-produced-in-a-year for electric vehicle behemoth, Tesla?

You have to factor in Tesla’s explosive stock gains in over the last several years. But you’d also need to consider how, between July and December 2020, the company delivered nearly 320,000 vehicles, which was roughly 140,000 vehicles more than during the first six months of 2020.

Put it all together … maybe the multiple is five times higher, at $55,000 per vehicle?

Perhaps 10X, so $110,000?

Maybe we go all the way to 25X?

Not even close.

A recent Tesla stock purchase would have an investor paying about $1.7 million per vehicle … which is 149X more expensive than Volkswagen.

Now, let’s be blunt — who cares? Why does this matter?

Because, as Eric wrote in his latest issue of Investment Report, “valuation matters … eventually.”

Even though as the old (paraphrased) saying goes “stock prices can remain irrational longer than you can remain solvent” it appears that valuation is beginning to finally catch up with Tesla — and Volkswagen, for that matter (yet in a more-appealing way for investors).

Below, we look at the stocks of Tesla and VW over about the last month. As you can see, while Tesla is down 17%, VW is up 78%.

It turns out that Eric recommended VW to his Investment Report subscribers just weeks ago on February 12, so a quick congratulations on this 78%-gainer and counting. That’s a fantastic return — especially when considering the S&P has been flat over the same period, and the Nasdaq is actually down 5%.

But there’s a more instructive point here …

The recent divergence of fates between VW and Tesla suggests a solution to one of the biggest challenges facing investors today — how do you remain invested and exposed to gains from technology, while not taking on a reckless degree of valuation risk?

The answer is simple, though not easy …

You do your homework and find the VWs of the world.

In the end, valuations eventually matter. Gravity wins. Today, we’ll tap into Eric’s recent analysis to see why this is incredibly important to remember in today’s market.

 

***The agony and ecstasy of multiple expansion and contraction

For newer Digest reader, Eric is our macro specialist. He isn’t a household name like, say, Warren Buffett, but many finance industry insiders consider him to be one of the greatest stock pickers of all time.

In an industry where a stock picker is fortunate to have just one 1,000% gain to his or her credit, Eric has more than 40 such 1,000%+ winners.

But equally important is the slew of triple-digit winners that Eric has made his readers … which, had he held too long, could have been reduced to double- or single-digit winners … or even losers. Eric prevented this profit-slip by acting on a central tenet of investing …

Valuation eventually matters.

In his decades of experience, Eric has learned that selling when valuations grow too bloated (and potentially leaving some profits on the table) is often vastly better for your portfolio than holding out for the ultimate top (which nearly always means you’ll get caught in a major selloff when market conditions collapse).

(Regular Eric-readers will recognize his common refrain of “little pigs get big, big pigs get slaughtered.”)

It’s this topic of valuation that Eric dug into in his most recent issue of Investment Report. From the issue:

Multiple expansion is the term Wall Street analysts use to describe the boost a stock receives when investors award that company with a higher and higher valuation.

Imagine, for example, that “Acme Widgets” is a $10 stock that produces $1 per share in annual earnings. At that price, Acme would be trading for 10 times earnings — also called a “price-to-earnings (PE) multiple of 10.”

Now let’s imagine that investors become so enthusiastic about Acme’s prospects that they bid its price up to $20 a share, even though the company’s annual earnings haven’t budged from $1.

In this circumstance, Acme’s PE multiple would have expanded from 10 to 20. That’s “multiple expansion.”

Whenever a stock’s PE multiple is rising, that stock is benefiting from multiple expansion. Conversely, whenever a stock’s PE multiple is falling, that stock is suffering from the evil twin called “multiple contraction.”

Eric explains that in extreme trading environments, these expansions or contractions can dominate the entire stock market and become the only influence that matters. We call moments like these “buying panics” or “selling panics.” They’re when valuations take a backseat to raw passion.

So, where are we today?

Back to Eric:

… signs of extreme optimism and frothiness have been popping up like mushrooms at a music festival. One of those signs is the lightning-fast pace of multiple expansion that’s taking place in various sectors …

Perhaps no sector has benefited more from multiple expansion than the electric vehicle complex.

According to calculations from FT Alphaville, a representative selection of 23 EV manufacturers, nine battery/cell producers, and nine charging station businesses recently reached a combined market value of $1.6 trillion.

That gigantic number is about three times the combined market values of the world’s 10 largest auto companies.

Incredibly, only six of these 41 EV companies managed to generate a gross profit over the last 12 months. The other 35 were money losers.

Eric points toward Tesla, noting how this “poster child” of the multiple expansion phenomenon was recently trading for more than 1,000 times earnings.

With that valuation as our backdrop, consider this …

During the last 12 months, Tesla booked $1.58 billion of revenue from selling environmental “regulatory credits” to other auto manufacturers. But if not for that windfall, the $721 million profit Tesla reported in 2020 would have been an $860 million loss.

Volkswagen is in an entirely different position.

Back to Eric:

While it’s true that Tesla sells about twice as many battery-electric vehicles (BEVs) as Volkswagen, the company trails far behind its German counterpart on all other relevant metrics. The differences between the two automakers are enormous.

Essentially, the only true comparison between Tesla and Volkswagen is no comparison whatsoever.

— Tesla built half a million cars last year. VW built 18 times more than that.

— Tesla spent $1.5 billion on research and development (R&D) last year. VW spent 10 times more than that.

— Tesla generated $31 billion in revenues last year. VW generated eight times more. VW also produced about eight times the net income Tesla produced.

At some point, these differences will matter. Gravity will return. Based on the last month of market action, it’s possible that point is arriving.

 

***Looking beyond Tesla, how do we balance our belief that hypergrowth stocks will make investor huge returns this decade with the reality that many tech stocks have nosebleed valuations?

Three points …

One, nowhere have we written that hypergrowth stocks can’t, or won’t, experience big losses.

That’s a very real possibility — one that investors need to include in their planning.

It’s just that with a longer investment timeframe, we expect these losses to be dwarfed by subsequent gains.

Take Enphase (ENPH), a high-flying solar stock.

In the summer of 2018, the stock crashed 48%.

However, if an investor had held through today, he/she would be up more than 2,000% — even with that painful 50%-chop.

Now, to be clear, this example of a recovery is not a license to ignore your personal financial realities.

If your investment situation and timeframe doesn’t allow room for a potential crash/recovery period, then high-valuation tech stocks may not, in fact, be appropriate for you today.

Even if you do have a lengthier investment horizon, if you can’t stomach a significant pullback, then volatile stocks might not be right for you. We tend to believe we can handle losses far better than we can in reality when those losses actually hit our portfolios.

(“Down 20%” doesn’t sound so bad, until you watch it crushing your portfolio. For example, imagine seeing your $435,000 nest egg losing $87,000 … and futures are down another 2% tomorrow.)

To this end, make sure your investment choices reflect your investment temperament.

Two, as we’ve noted many times in the Digest, it’s not so much a “stock market” as it is a “market of stocks.”

In other words, resist the temptation to think that all highly valued tech stocks will suffer similar fates. For example, Company A’s P/E ratio of 100 is egregiously high, and could precipitate a crash, while Company B’s 100-P/E ratio is reasonable.

This isn’t inconsistent. It’s reflective of different growth rates and growth prospects. Your challenge as an investor is make the distinction between the two (or follow someone like Eric who you trust to do it for you).

The final point blends the best of both worlds …

Find an innovative tech company with a reasonable valuation, then simply hold on. That’s what Eric has done with Volkswagen.

On this point, here’s Eric:

High-flying stocks that fail to live up expectations usually become low-flying — or crashing — stocks.

On the other hand, reasonably priced stocks that deliver strong and sustainable growth can thrive … no matter how poorly the overall stock market might be performing.

The key is to invest selectively in powerful long-term megatrends … and then hang on.

Wrapping up, another congrats to Eric’s subscribers on Volkswagen.

Looking broader, valuation multiples keep expanding. But this will eventually turn. Gravity remains undefeated.

Make sure you’re factoring this reality into your stock-selection today.

Have a good evening,

Jeff Remsburg