Finding a Valuation Arbitrage - Why Porsche will outperform Tesla
Summary of the week
This week inflation printed at 7.5%, above an expected 7.2%. This, alongside the nonfarm payrolls beat last week, is yet more confirmation that the Federal Reserve will need to continue on its hawkish path of raising interest rates. Therefore, bonds and equities will move in tandem, so anyone seeking true diversification will need to hold alternative asset classes, such as gold and foreign currencies like the Swiss Franc. Due to this, we have seen an uptick in gold purchases into the new year, while bonds are selling off. Aside from gold, commodities more generally continue to perform well, and for this reason, I want to add a small allocation of capital to this sector, as momentum strategies have proven to work during times of market stress in the past. In addition, value stocks also tend to outperform in rising inflation and rising yields, and they are extremely cheap at present. They also offer inflation protection and I have no exposure to materials at present, so I believe this is a prudent decision. I will be adding 2% to Anglo American (AAL), one of the biggest miners in the world with operations involving many different metals such as Iron ore and copper. This will give me broad exposure to the continued rally in commodities.
For exposure to materials, you could look into other large mining companies such as Rio Tinto (RIO) or BHP (BHP). Vale SA (VALE) is also very attractively priced with a dividend yield of 11%, but be wary that this miner has high exposure to iron ore, so its share price will be highly-geared to movements with this metal. For investors with higher risk tolerance, then Ferrexpo (FXPO) looks good. FXPO operates one mine, located in Ukraine, so the ongoing tensions with Russia are weighing on the company’s share price at present. Finally, one small-cap stock which looks like a great opportunity long-term is Jubilee Precious Metals (JLP) – Full disclosure: I hold this stock personally. The company mines for copper and chrome, as well as a small amount of gold and silver. The interesting thing about this miner is that it obtains its metal from the tailings of other miners. Tailings are the residue/dirt that miners leave behind when they dig up huge holes in search of metal. These are expensive to remove and cause uproar with environmentalists. JLP helps solve this problem, so is huge on the ESG front. In addition, lithium-ion battery makers (used in electric vehicles) use a lot of chrome, benefitting JLP further.
In my mind, I see three potential scenarios playing out over the coming months.
Bonds continue to sell off, and inflation continues to print high numbers. If this occurs, I will continue to hold a bias toward value stocks, gold, and safe havens.
Inflation slows or reverses course (disinflation). If this occurs, I will sell down commodities and buy attractively priced growth stocks
The sell-off continues, and the contagion selling trickles through to commodities. I will reduce exposure to higher beta stocks and add to safe-havens. A continued sell-off early next week seems likely, however, the rising rates environment is priced in now, following the high inflation figure this week. The economy is still strong but going at a slower pace, therefore the biggest risk for financial markets at present is a Russian invasion of Ukraine and the implications for the global economy. This looks highly likely now.
For now, my conviction is aligned with scenario one, however I may add to some special situations in the near future, such as Meta Platforms (Formerly Facebook), as the valuation seems too attractive to pass up. I believe that we may see one or two more higher CPI prints, before we move to scenario two, as inflation moves downward to 3%-4%. I do not believe we will return to the 2% inflation the central bank had hoped for. The markets now seem to be pricing in too many interest rate hikes (seven at present), which means a relief rally may ensue at some point in the near future.
Action:
Adding 2% to Anglo American (LSE: AAL) at £35.79
Why Porsche will outperform Tesla
Since the COVID crash of March 2020, there has been a global push for more sustainable living, with one aspect of this involving electric vehicles (EV). This has led to a monumental rise in many growth stocks related to the car-making industry, such as Plug Power and Rivian Automotive. In addition, the cult following of Elon Musk, as well as the rise of Reddit investors during the GameStop pump and dump of January 2021, has led to holding on for dear life (HODL) on Tesla stock, which has risen from a low of $96 to a high of $1,114 a few weeks ago. Leaving aside the speculative froth within the EV industry, there seems to be a significant long-term opportunity with the major players in this field, so this week I will analyse one of the oldest car makers (Volkswagen) against one of the newest and most discussed (Tesla).
Macroeconomic Outlook
As I have written about on many occasions now, rising inflation and interest rates hurt growth stocks. The reason for this is that higher inflation/interest rates mean a higher discount rate is applied to future cash flows, reducing the present value of those future cash flows today. In plain English, investors don’t value a company stating it will make $1m in five years as much as companies that make $1m now. Below you can see a simple table that illustrates this point. The first row shows the present value of £100 today, in two years, and in ten years with a 2% inflation rate. The second row shows the same £100 with a 7% inflation rate. You can see that at 2% (every central bank’s target rate), £100 in 10 years is worth £82. In comparison, at a 7% inflation rate (inflation is currently 7.5% in the US), that same £100 is worth just £50.83. This shows the huge effect a high inflation figure can have on a growth company’s promise of future revenues and profits, as well as on our own money if it sits idle in a bank account. This reduction in the value toward a company’s future revenues and profits leads to lower share prices and valuation multiples for growth companies, as we have seen over the last few weeks.
The effects of high inflation on our money
For this reason, the current macroeconomic outlook of high inflation and rising interest rates favours Volkswagen over Tesla (TSLA). Tesla trades like a tech (growth) stock, meaning its valuation is far misaligned from other traditional carmakers such as Ford and Volkswagen. Looking back to 2000 (see below), speculative and over-valued internet stocks fell substantially during the crash while attractively priced quality and value stocks (represented by Berkshire Hathaway - Warren Buffet’s Investment company), performed well. I believe something similar is happening today with regard to renewable energy and other related stocks.
Berkshire Hathaway (Blue line) vs NASDAQ 100 (Orange Line) 2000-2007, Source: TradingView
The Electric Vehicle Market
Electric Vehicle (EV) sales tripled globally between 2019 and 2021, according to the International Energy Agency, painting a rosy demand picture while the industry struggles with supply-chain issues relating to semiconductors. The Society of Motor Manufacturers and Traders car data report for 2021 found that 224,000 – more than a quarter – of all vehicles emerging from UK car factories last year were EVs.
A range of factors – including tightening emissions rules, earlier bans on internal-combustion models, and consumer incentives – are driving EV sales faster than expected, especially in China and Europe. Morgan Stanley’s auto team now projects 40% of new car sales globally will be EVs by 2030 – meaning 36 million electric cars within 8 years, from around 4million as of 2021. China is already the world’s largest market for EVs with total sales of 1.3 million vehicles in 2020 (40% of global sales).
Looking deeper into the Chinese market, the CCP is very serious about its sustainable growth goals. Alongside regulation of technology companies and deleveraging of its property sector, China is expected to spend $46trn between now and 2060 on reaching net-zero carbon goals. Some of this should be focused toward EVs. We can see that the top four carmakers by sales in China are:
1. Volkswagen
2. Honda
3. Toyota
4. Nissan
Volkswagen is the leader home and abroad, being the largest in the UK ahead of Audi, BMW, and Ford, and the biggest carmaker by sales in the world, standing at $280bn. TSLA cannot compete with this powerhouse.
The Arbitrage
Before I go any further, I am sure you are wondering why the title mentions Porsche, but I am writing about Volkswagen. This is where it gets interesting.
Volkswagen has two share listings, under the tickers VOW and VOW3. The difference between these two share classes is that VOW3 is more liquid (has more shares in circulation) and has a bigger dividend but has no voting rights. In contrast, VOW is less liquid but does have voting rights. The biggest owner of the VOW shares is Porsche Automobil Holdings (PAH3), owning 53% of the total shares outstanding.
PAH3 is a holding company (has no productive assets) but purchasing this company rather than Volkswagen shares gives you a margin of safety (MOS) of around 50%. Why? Because Porsche’s shares in Volkswagen are valued at $45bn, but its enterprise value (value of the entire business) is only $29.5bn. This margin of safety is something investors will seek in the uncertain environment we now face. As you can see below, during 2020 VOW outperformed PAH3 as investors looked for riskier assets as the central banks printed huge amounts of money and kept interest rates pinned at 0%. However, with the restrictive policy being priced into markets today, investors want the comfort of the MOS seen in Porsche, and PAH3 has now started to outperform. Porsche’s stake is the reason I focus on Volkswagen in this article, and the valuation arbitrage is the reason PAH3 is a more attractive opportunity than buying VOW outright.
VOW (Blue line) vs PAH3 (Orange Line), Source, TradingView
Valuation and Outlook
Before I compare valuations on Tesla, I would first like to mention that unlike many I have not been a permabear on Tesla. Many have called the company overvalued since it began trading because it is a car maker which trades at a higher multiple than its peers. If we look at the chart below of Tesla’s EV/EBITDA since 2014 (when EBITDA first became positive), we can see it was grossly overvalued then at 100x EV/EBITDA. Because of this, the company’s shares went nowhere for 4 years, as it grew into its valuation. But by 2018 it was extremely cheap at only a 16x multiple, with revenue growing at 20-50% per year and it would have been a great time to purchase the company. Since then, the share price has gone ‘to the moon’, as many Redditors and cult followers of Elon Musk would say.
Tesla’s Historical EV/EBITDA ratio, Source: Tikr Terminal
With that said, looking at the valuation today there is no comparison between Volkswagen and Tesla. Tesla trades at a forward multiple of 44x compared to VOW trading at a 7.5x EV/EBITDA ratio. Volkswagen has been a car-making powerhouse for the last 100 years and it continues to dominate being the top manufacturer in the world. Its cars are more affordable than Tesla’s and it is continuing to increase capital expenditure to keep up with all the new innovative EV producers. It also has a huge amount of infrastructure which VOW can leverage to scale up the manufacturing of new cars, an issue TSLA has struggled with in the past.
A fair multiple for Volkswagen seems to be around 12x EV/EBITDA. With an estimated $40bn in EBITDA in 2023, this gives a total enterprise value (TEV) of $480bn EV, a 70% upside for VOW from current prices. However, if we then apply this 70% upside to PAH3 stake in VOW, we get a far better result. A 70% upside in PAH3 stake of $45bn is $76.5bn. Dividing this by Porsche’s current TEV of $29.8bn gives a potential 155% on the upside by the end of 2023 (€225 share price), should the market remove this arbitrage as investors seek safety, as I have written about above.
Tesla is expected to have a cyclically adjusted sales growth rate of 30% into 2026 compared to VOWs 6%, and TSLAs margins are a lot higher at around 15%. I think a 25x-30x EV/EBITDA multiple would be fair for this company, implying a share price of between $490 and $585.
Looking at the revenue of Tesla, it not only generates income from car sales but also through the sale of carbon credits. Because the company is committed to keeping emissions down, the government pays it credits as a way to subsidise costs. One potential negative implication for TSLA is that more and more companies are becoming environmentally friendly, meaning these companies will no longer need to buy TSLAs extra carbon credits. This may lead to a downward revision in the company’s revenue growth in the future.
One negative which hangs over VOW is its huge amount of debt, standing at €160bn at present. However, the company produced €11.3bn in annual free cash flow for 2021 (10% yield) and has plenty of revolving credit facilities to service the debt, a lot of which is not due for many years into the future.
Risks
In the electric vehicle space more generally, these vehicles are less profitable than internal combustion engines, which may weigh on both companies EBITDA and net income margins into the future. EVs also need twice the number of semiconductor chips as a combustion engine car, so a sustained increase in the price of these products could compress margins further and any shortages could lead to lower production outputs.
In addition, reduced consumption in China following the recent property crisis could be a problem, as around 70% of private Chinese wealth is held in property. With that said, the recent move of the CCP to make reserve requirement ratio (RRR) cuts will hopefully stoke the economy, and Chinese credit impulse is reversing (see below), which has been a leading indicator of a positive outlook for the Chinese economy in the past.
Chinese Credit Impulse, Source: Bloomberg
Conclusion
Overall, I believe there is a major valuation risk in holding Tesla at present, and as mentioned above the last time the shares were overvalued the share price went sideways for four years. In contrast, Volkswagen is the most popular carmaker in the world, offers a strong free cash flow, and purchasing Porsche AutoMobil offers a great valuation arbitrage. Back in 1999, Jeff Bezos (founder of Amazon) won man of the year. Less than two years later Amazon fell more than 95%. Elon Musk was awarded Man of the Year for 2021 and Tesla’s shares have wobbled recently from its all-time high. I wonder where its shares will be trading by the end of 2022.
Final thought
Many of you may be wondering why I am still cautious about markets when the buy the dip mentality has proven to be very profitable over this extended bull market since 2009. Please read this article by a great investor for a summary of the issues facing the financial markets today, written in a far better way than I ever could. With this said, the huge amount of negative sentiment in markets today makes me wonder, is it time to go against the crowd?
Portfolio Return Year-to-date: 2.3% vs S&P500: -7.88
Total Return: 8.4% vs S&P500: 1.36%
If you have any questions email me at: thesparknewsletter@gmail.com
Until next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.