Over our 35+ years1 as investment managers, we have focused on investing in quality companies at attractive valuations. We have always defined the quality of a company by the following attributes: (1) at least a 10-year track record of above-average and consistent profitability, (2) evidence of sustainable competitive advantages, (3) financial strength, (4) opportunities to grow the business and (5) capable management.
The current continued low interest rates stemming from policy actions taken by governments around the world led investors increasingly into riskier assets through 2020. With increased demand for equities, particularly technology, health care and e-commerce, growth stocks’ valuations have surged uncorrelated for many, it seems, to fundamentals.
The uncoupling of equity prices from economic reality and corporate fundamentals is, in our view, epitomized by the seven-fold increase in Tesla’s market cap during 2020. As auto enthusiasts, we believe Tesla makes technologically innovative vehicles. As analysts and investors, however, we have watched the stock perform independent of many core fundamentals. One example from 2020: Tesla announced a 5-for-1 stock split on August 11th and by August 31st, absent other meaningful news or developments, Tesla stock increased 81% (compared to the S&P 500 gaining 5%).
In comparing Tesla to incumbent auto manufacturers, we appreciate that there are differences in product mix [100% battery electric vehicles (“BEVs”) for Tesla versus a mix of traditional and electrified (i.e. hybrid and BEV) for other global auto OEMs] and varying degrees of financial transparency. That said, reasonableness checks are achievable, as seen in Table 1.
Comparing market caps between Tesla and BMW, Tesla trades at more than 10-times BMW despite BMW delivering nearly five times the vehicles from Q4 2019 to Q3 2020 (the latest twelve months, or “LTM”). Illustrated differently, Tesla’s market cap exceeds by more than $150 billion the combined market cap of Toyota, Volkswagen, Fiat Chrysler, Daimler, GM, BMW, Hyundai, Honda, Ford and Nissan. Market Cap/Vehicles Delivered of $1.6 million for Tesla compared to $25,406 for BMW continues the theme of market exuberance of Tesla.
We view BMW (began covering, and first invested, in 1991) as a quality name given its 20 consecutive years of profitability and resiliency, driven in large part by a deeply loyal global customer base.
While Tesla investors may point to the recently achieved 6.1% EBIT Margin, it is noteworthy to recognize that in 2020 approximately $1.5 billion in revenues came from Regulatory Credits. (Tesla sells credits to other auto manufacturers who, unable to fully comply with various States’ emissions standards, must buy credits to generate the required offset). Industry experts believe Tesla’s profit margins would be reduced by some 200-600 basis points (likely generating break-even or a net-loss) without credits supporting their revenue. Furthermore, over its relatively short history, Tesla has demonstrated difficulty in effectively managing liquidity during phases of ramping up production capacity and could return as they pursue higher sales volume. Fundamentals struggle to support Tesla’s valuation.
Frothy growth stocks span the globe. Sticking with the auto industry, NIO is a Chinese EV manufacturer founded in 2014, generating net losses since inception and delivering fewer than 35,000 vehicles LTM. This volume is roughly 20% of BMW’s electrified vehicles delivered over the same timeframe (and only 1.5% of BMW’s total vehicle deliveries). Despite their relatively small scale and history of losses, NIO’s market capitalization of $76 billion is $17 billion more than BMW’s market cap. NIO’s valuation also appears to defy fundamental analysis.
Another reference point to gauge relative quality and valuations is Toyota (began covering in 1993 and invested in since 2006), the second largest global auto company and a leader in hybrid technology with approximately 45% market share (of electrified vehicles) worldwide. Of Toyota’s 9.4 million total deliveries, electrified vehicles represent 1.9 million, roughly 4.5 times greater than Tesla’s 430,806. Toyota’s competitive advantages of brand strength, scale, geographic diversification and product mix, combined with an attractive history of profitability and strong balance sheet demonstrate the quality we require in our investments.
We understand and recognize that for BMW and Toyota to maintain market leadership they must accelerate their migration to electric vehicles to satisfy increasingly demanding emission standards and goals worldwide. We believe that both have the financial resources and organizational commitment to achieve these targets.
Over our decades’ long history, we have consistently applied our fundamental, bottom-up investment approach recognizing there are only two aspects that we can control: the quality of the companies in our portfolios and the value implied in the price we pay for them. The relatively low valuations of many underappreciated quality names in 2020 have afforded us to the opportunity to add an unprecedented 12 new names to the portfolio in addition to increasing dozens of existing positions (including BMW and Toyota).
While we are not in the business of predicting investor behavior or the timing of a rotation away from growth to value, we believe the portfolio is well positioned for the future regardless of market dynamics and our auto exposure is an example of that.
1 Sprucegrove was founded 27 years ago by individuals who had worked together for 15 years previously applying the same investment philosophy and process throughout
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