In this podcast, Motley Fool host Ricky Mulvey and analyst Asit Sharma continue their conversation about expectations investing, applying the framework to four companies with different growth outlooks.
- Value drivers for mature automaker General Motors.
- A high-growth payment processing company experiencing a narrative shift.
- A railroad that just made an acquisition that will give it a rail network from Mexico to Canada.
- If Nvidia can maintain its moat over the long term.
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This video was recorded on Sep. 09, 2023
Asit Sharma: Their idea is that when you’ve got this nice return that’s well above your cost of capital, you actually attract competition and there is this finite time in which that edge dissipates and you’re driven to eventual returns that almost equal your cost of capital.
Ricky Mulvey: I’m Ricky Mulvey, and that’s Motley Fool Senior Analyst Asit Sharma. On today’s show, Asit takes the expectations investing framework to four companies. We go from General Motors all the way to Nvidia. In between, we’ve also got a uniquely positioned railroad company and a fast-growing payment processor that’s recently taken a hit. Asit gave us an introduction to expectations investing on Thursday’s show, so I’d recommend starting there if you haven’t, but this show will still make sense if you have not had a chance to listen to Thursday’s episode yet. Let’s get into the case studies and I think a good place to start is General Motors. Asit, if I told you a story about an electric car maker that now has fully self-driving cars on the road. They are licensed to give rides in multiple cities across the United States. You might guess that its stock price would be better than flat over the past five years. Investors have basically received nothing in terms of price appreciation and basically, a 1% dividend for you to wait. What do you think is the story that the market is telling about General Motors right now? It seems very disconnected to me.
Asit Sharma: I think the market is making some assumptions about General Motors cash flows that could be reasonable. Again, we’ll take this from an expectations investing framework or point of view. I think the market is saying that this company has some pretty big incremental investments to make. Those are going to decrease the potential of its cash flows to grow. Let’s say if revenue takes off, that revenue might be challenged by not as much operating margin as it potentially appears today on the books, and I think that the market may also be saying that the potential for revenue itself to grow from this technology may be overstated. If I didn’t know anything else, I would say perhaps there are some other worthy competitors in the space. Just talk through three of the big drivers of value that Mobison discusses with Alfred Rappaport in the book Expectations Investing. This is probably what the market is saying. Now you and I know a little bit more about General Motors so we can see where that fresh take could be off. What are your thoughts, Ricky?
Ricky Mulvey: I think you have to ask a very basic question if you’re a General Motors investor right now. This is something Mobison has encouraged, which is what is your basic unit of analysis? It could be cars sold. Maybe it’s self-driving car miles given to riders. Is this going to be maybe a legacy automaker with the growth component of full self-driving automobiles attached or is that a race to zero and you’re really investing in a very mature car maker? I think it’s an interesting question because they’ve been first in San Francisco. General Motors is allowed to offer 24 hours of self-driving car service. There’s been controversy around it. There’s been a social media post where a self-driving car rode basically into a construction site and into wet cement, which is an image that is attractive and you can understand why that’s gone viral. But I think the challenge for investors is what is your basic unit of analysis? If it’s in the case of self-driving cars, it looks like it’s performing very well right now. But in the case of cars sold, I think you may have a challenge, which is that Mary Barra, the CEO in the last earnings call said, for our future guidance, we are assuming that there will be no strike. I think you would have to ask a serious question of is that reasonable? Could this really put a dent in the cars sold over the next months or probably year? This might cause one of those supply chain disruptions for General Motors right now. In my opinion, at the time of this recording, it’s likely that there will be some United Auto Workers strike for the major car makers.
Asit Sharma: The exercise you went through just now is similar for both a traditional discounted cash flow model and expectations investing if you spreadsheet out that more. Because both are trying to get at something really fundamental. What are the inputs to build value in the form of those future cash flows that have this return above the cost of capital? Now, there’s a slight difference I feel between the expectations investor and the DCF modeler. The DCF modeler is going to do his or her best job to figure out those units of value and then start building the model from the ground up. The expectations investor is going to play around more with the determinant of value. Maybe brainstorm a bit more to see if there’s something that others are missing. Is there a value driver here? Whether it’s going to be sales acceleration or it’s going to be better margins or less investment than people expect in the future, less fixed capital investment and determine when that might hit the books and that’s the edge. What you mentioned about Mary Barra and the outlook that she and the management team are forecasting, I think is going to be captured by both types of investors. I think they’re both going to incorporate whatever their uncertainty is over that. She certainly is talking straight through those possibilities, maybe ignoring them, brushing them off, but I think both types of investors will be hedging their models for this probability. But in general, what you are doing, thinking through Ricky, how do we really understand what’s going to push the value here, is the fun part of expectations investing. You did it very well.
Ricky Mulvey: Thank you, I appreciate that. Two other things to note is that General Motors has had a very difficult time achieving a positive free cash flow which you would expect for a mature company. They’ve done it, I think, in one quarter since 2015. However, there is a very general upward trend to getting back to that place. Barra has implemented stealing from Zuckerberg, perhaps the year of efficiency, identifying two billion dollars in cost savings and then another billion in cost savings. She has called many of these fixed costs which are in some cases, early retirement offers to employees. In other cases, I would say costs that we have a dispute about whether or not they are fixed, which includes corporate travel and marketing expenses, but that’s two in the weeds to get into for now. I think it’ll be a very interesting company to watch moving forward. If I may Asit, let’s move on to our next company.
Asit Sharma: Proceed.
Ricky Mulvey: The next one which has a little bit of higher expectations from the market is a railroad company. It’s called Canadian Pacific. They just made an acquisition that will give them a rail network from Mexico to Canada. The only one that exists like that. There were a lot of questions about the acquisition, whether they would go through and some regulatory pressure, perhaps from the United States government. That didn’t happen, and the acquisition was completed. But the stock didn’t really react to that. I found that curious because this seems to be a huge win for the company. But what do you think the market is saying about this merger?
Asit Sharma: I think the market is still very positive on the merger. There was some compression on the stock price while this merger was under review by the various transportation safety boards, mostly in the US. It got approved at a time when the market wasn’t in a great shape. We suddenly had so much macro pressure. It’s almost got lost in the noise. But I will point out that Canadian Pacific, Kansas City has actually outperformed its peers over a year to date, a one-year, a three-year, a five-year period. But much of this out-performance is over the last year or so where the stock just hasn’t deflated as much as its peers, as the macro economy has gone bad. I think the investor enthusiasm is actually there, it’s not as visible. Maybe if we were still in a low interest rate environment, you would see more of a pop there. But I think the market does look favorably on this merger. We can get into those details if you’d like.
Ricky Mulvey: I would, because this company, Canadian Pacific, Kansas City, is significantly more expensive than its other railroad piers. Which forgive me, I’m going to use the price to earnings multiple, those trade at about a 16-20 PE multiple, and Kansas City is up in the 27 range. Do you think this higher multiple is justified?
Asit Sharma: I believe it is. There are a couple of things going on in that multiple. One is, of course, the efficiencies, the synergies that the company is talking up that it’s going to realize over time. We’re not more than a few months into the formal approved merger of these two companies. Investors are looking forward to that, and there are a number of pricing advantages that it has, being this now single company that can provide you with near shoring capability. It provides a route for automotive parts. All the way from the factories in Mexico, which received from their own ports, all the way up through the US supply chain then into Canada where we have a retail presence of a Ford Motor Company. You can see how valuable that is. The pricing power doesn’t really come from competing with other railroads because they don’t have those North South routes. It comes from offering a potentially cheaper transitive good versus trucking. If you’re going to ship something via truck all the way from Mexico to, let’s say Detroit, you’ve got some inbuilt pricing power there.
You’re not competing against other rails, you’re competing against freight on the road. But you’re making a higher margin than you might otherwise. If you are say, transiting Saskatchewan potash, which it does up in Canada going east to west. That’s one part of it. The second is the combined companies have a little bit higher operating ratio than they should. Operating ratio is the ratio that railroads use to judge themselves on efficiency. Lower is better. There’s some opportunity here to get more efficient. Anyone who follows railroads knows that precision scheduled railroading has been a big force in the industry. Reduce costs by putting locomotives into retirement, cutting down on labor, making it more flexible, speeding up trains, so many different parts of this. You could use one of these multiple point plans in this newly combined entity and bring those margins to a better place. It’s almost like investors are saying in advance, we see the opportunity for improvement here in the operating ratio. It’s going to be rolling at some point, so we’ll pay more today for these shares, as koki as it sounds.
Ricky Mulvey: This is a company with a revenue growth rate of about 30%, so 37% a return on invested capital of about 7%. It’ll be interesting to see how that changes as the merger unfolds. For investors that are watching this company, what would you recommend being the basic unit of analysis?
Asit Sharma: This one is interesting because the railroad industry already provides you with different looks into very minute types of measurement. I think looking at volumes, looking at train speeds is always fun, seeing how those increase, looking at network fluidity. There is so many stats that railroads provide you that would be so great. We saw the equivalent stuff out of software companies. I think pick your unit, it could be say revenue as an expression of volume is always fun. There are ton mile metrics that you can use. Pretty much what I’m saying here, you can get as minute as you want Ricky, and build your model from there. But I think some expression of the relationship between the revenue per something, whether that be a car load, whether that’s expressed as a mile or one of its different categories of freight, intermodal, we mentioned looking at whatever type of category you feel is most important. It could be chemicals, it could be potash. Choose that and start working up. It could be different for an expectation based investor. If you’re building that DCF model in a traditional way, you’ll arrive at a basic unit and only stick with that and see if the economy improves, how much more volume will this company have? Then you spread it up into your model. The expectations based investor is really going to key in on what could push the value. I’m going to look more at that intermodal volume than anything else because that’s where I think the edge for this business will come in two years.
Ricky Mulvey: You don’t want to try to guess what grain production will be in five years. I understand. Let’s move on to a higher growth company that’s taken a big hit recently and that company is Adyen. It’s a digital payment processor, and its stock fell about 40% upon its latest earnings release. This is a company that does payment processing for very large companies. It’s not like Paypal or Stripe where you see that at the point of transaction, they’re taking care of the entire payment process for companies like Meta and Uber.
Ricky Mulvey: With that understanding, how did the Adyen story change in its latest report?
Asit Sharma: Ricky, Adyen has been investing in its people for the last 18 months or so, and they have told investors that’s going to be part of our margin story. Margins are going to decrease temporarily, then they’re going to come back up once we have everyone on board. They only report twice a year. They’re not based in the US. I believe in the Netherlands is their home headquarters, and so twice a year we get this look. This quarter revenues, although they’re growing fast, 23% I believe, year-over-year, still demonstrably slower than in the past and the company talked about some rising competition in North America, an important new market to them in the digital payment space. The story changed a bit. Investors are a little antsy now because they’re worried about that growth cadence. They also see that the company is in investment mode, so they don’t like that the profits are slimmer because they’re loading up on really great skilled people as all other tech companies seem to be laying off these highly skilled workers. The narrative has shifted and you’ve got another half year to wait now before we can see some of the first results of this investment. But I do want to say Adyen has pulled this off before. It’s been through these cycles of hiring waves where then they come out with some innovation in their product suite.
Ricky Mulvey: They did exactly what they said they’re going to do. I see both sides of this debate. On the bare side, you could see folks saying, hey, what are you doing hiring so many people, that’s lowering your earnings and growth and it’s already slowing down. Versus the other side, hey, we’re making long-term investments and we need to get more people to grow this business even if it hurts margins in the short term. Where do you think you fall on that side of the debate?
Asit Sharma: I see both sides of it too Ricky, I think I lean on the side of those who say that the investments have a payoff. How Adyen is different. You can say Adyen, let’s agree to disagree on the pronunciation. You can look at this company as one that’s a little different from the stripes and PayPals of the world because it’s more focused on providing this unified platform. They have something they called Unified Commerce, which takes all your purchasing data across channels, whether it’s digital or point of sale. Someone coming into a physical store, not using a point of sale that they could even purchase on their mobile. But all the different ways that retailers and other companies pull in their payments, they seek to give the merchant this really insightful analysis, visual graphs, insights that they can use when they pull all of this data together. They have a different bent, I think, than other companies and part of it stems from what you said, that they are first and foremost a platform company. They like to go after big platforms and BV, sole provider of the payments processing. They had this strategic way of looking at things and the argument that management makes is, look, our solutions are actually cheaper than anyone else’s when you look at a total return on investment proposition in terms of the insights that the platform gives plus the total cost. Not really hyper-focusing on a fee structure. If you hyperfocus on a fee structure, then there are some competitors that look cheaper than Adyen at first sight, but they potentially aren’t in that total yearly stream of payments and all the associated activities going over the payments platform. I tend to agree with those who say that the investment is necessary. This is a company that’s really cash flow rich, the great free cash flow generator and I’m willing to be patient and spot them a little bit of slack here.
Ricky Mulvey: You can always correct my pronunciation on things. It is Adyen, and I was calling it Adyen, perhaps that is a consequence of growing up in southern Ohio, I’m going to blame that. But when I think of the Adyen story, it seems like this is the fate for many, if not all, high growth companies which is that there’s always going to be a bit of a return to the mean. I don’t know.
Asit Sharma: Yeah, you hit on something that Michael Robinson and Alfred Rappaport talk about in expectations investing. Their idea is that when you’ve got this nice return that well above your cost of capital. You actually attract competition and there is this finite time in which that edge dissipates and you’re driven to eventual returns that almost equal your cost of capital, then you’re very mature company. They believe that naturally, this has to be the eventual outcome, so what characterizes outperformers from middling companies is that they can just keep their edge for longer than the next company. The most innovative companies on the planet can sustain that success for a long time. But eventually, I think everything does revert to the mean. At least that’s what this sort of classical approach to valuation posits. I think it’s true unless of course, you’re Coca-Cola.
Ricky Mulvey: Adyen has about a revenue growth rate now in the ’20s, that’s down from 40. Their return on invested capital, I believe is in the ’20s. For how expectations investors should judge this company, where the growth could come from, do you think it’s customers acquired, is it the payment volume they’re transacting? What are some of the signals for this company?
Asit Sharma: I think the biggest signal is going to be the value driver of operating margin. We talked about in our intro session three drivers that main drivers, not all but main drivers that Mobison and Rapport identify. It’s your operating margin, your sales growth, and your incremental capital investment. For this company, management has been forecasting to investors that we’re going way back up to an adjusted margin that’s some 20 percentage points above where it is today. I believe that they’ll get there and I think that the market now is pricing in. Those who are doing their DCFs are pricing in something lower than the margins that management is saying Adyen can well achieve and that will be their stable state operating margin. If you’re an expectations-based investor, your job would be to say, OK, how does that work? What’s the lever here? If prices in North America and the digital payment space are getting a little commoditized because there’s competition and they’ve got some big platforms, how else are they going to drive that margin?
Asit Sharma: The answer would be in the innovation that is promised by the hire of so many talented people. It’s like expansion of the product suite, it’s introduction of new products. It’s going to be very innovation based and that’s a hard task with this company for those who aren’t willing to spend a lot of time on it. Because then you have to get your sleeves rolled up and learn more about where they’re investing, and if that has a payoff in your eyes. This isn’t always the easiest of models to use. The expectations based model. I think Adyen is one of the harder companies actually to try it on.
Ricky Mulvey: Fair enough. Let us move to the complete opposite side of the planet that General Motors is on, that is Nvidia. They make GPUs, design chips, operate data centers, and the stock price over the past 12 months is up about 250 percent. For those who may not know, why have growth expectations changed so much for this company?
Asit Sharma: Growth expectations have changed for Nvidia because of a breakthrough in the way that neural networks processed information that came in the years between 2013 and 2017. Some really smart people at Google put out a paper called Attention is All You Need. That showed that something called the transformer model was really great at processing language. Much better than the way it had done before, which is all linear. This model assigned weights to language and made its own decisions on what’s important in interpreting sentences and making predictions on what the next word in a sequence of words would be. Now, everything we know about ChatGPT, large language models, Generative AI, all of this good stuff really stems back to that development and it turns out that the best way to utilize computational power for this transformer model and for training large language models happens to be the GPU’s that Nvidia develops in conjunction with its libraries that accelerate its hardware and software. This want to punch by Nvidia is yet to be equaled by any other company that manufactures either GPUs or very focused chips, ASIX chips and they’ve got an edge, which means that everyone who wants to use these models, especially the large Cloud hyperscalers who will offer space in their clouds for us to try to use them, need to buy Nvidia’s chips. Lastly, Nvidia has been investing in the architecture on these chips for years and years and years, foreseeing the day that this would happen, and so they were able to meet this tremendous demand pretty well over the last year. We can break down more of that if you’d like or move on to your question. Next question regarding Nvidia.
Ricky Mulvey: I have a big question about Nvidia that I want to ask as we start to wrap up, which you described the edge that they have. For me, perhaps to my detriment, I’ve put Nvidia in the two hard bucket. Is it able to defend itself long term from other companies that make graphics processors, like AMD or other data center companies? Amazon Web Services offers data and it seems like they might have some smart folks working there. The revenue growth rate is over 100 percent. The return on invested capital is 30 percent. But should investors expect to see that Compress it’s other companies? Notice what Nvidia is doing.
Asit Sharma: I think they’re going to have some competition at the margins. Undoubtedly, there’s so many worthy competitors who want a piece of this very lucrative market. The edge that they have is really tied in with their technology called Kuta, which basically is tied into the acceleration of its GPUs. As I was mentioning forward, there’s no other company that has a complete solution that offers the GPUs or ASIX chips, and also acceleration libraries to the extent that Nvidia does. Many of them industry specific that are also primed to work with data centers that are now being optimized by Nvidia’s own software for data centers, its own networking equipment for data centers, and its own standards that compete with Ethernet. It’s become what Jensen, Huang, CEO of Nvidia, often talks about, a full-stack company and that’s what’s going to be really hard to crack. While they’ll see competitors chipping away and eroding some of that lead at the margins, for a while, they’re going to enjoy a lot of demand. Now, what we have to understand about Nvidia though, it is a cyclical company. At some point, this demand will level off. People will wake up one day and say, what kind of return am I getting on all these chips I bought? Maybe I’m not going to buy so many next year, and it’s cyclical in that sense. We’ve seen this story play out before. The important thing to remember though is that they work on their architectures in advance of the use cases. It’s not like Jensen Huang dreamed up an explosion in gaming, an explosion in Crypto, an explosion in generative AI. He knew that stuff like this would come along and he designed or had his engineers design the architecture to be able to be ready when those novel use cases emerged. I think they’ll continue to do that. Now, will the stock race ahead of itself at some points in time? Yeah.
Ricky Mulvey: Is there anything else you want to say or maybe some takeaways for an investor who wants to start applying the expectations investing frameworks to their personal decision-making?
Asit Sharma:Yeah, sure. We’ll stick on Nvidia to wrap up in terms of how you might use this. There was a time, just a few months ago when many investors were focused on the fact that Nvidia was trading at 37 times sales. That was very backward-looking. If you had the time to roll up your sleeves and I agree Nvidia is one of those companies that its easily put in the two hard pile. I’ve spent a lot of time studying and still feel like I’m scratching the surface on a lot of things. But let’s just suppose you had the time to understand if the demand that was being whispered about was real and you studied generative AI, and you studied the needs of the big hyperscalers in other companies. You could arrive at your own assessment that the market’s looking backward. It’s not looking forward at a company that’s actually going to have an explosion in its operating margin and an explosion in its sales potentially.
I actually can see a case where this company could be worth more than all those who are plugging in the inputs in their DCF models. Because I understand the value drivers, it’s going to be operating margin for this company. It’s going to be sales. It’s going to be how much they can reinvest in their capacity. The relationships with TSMC to get the product in the door and you could have bought shares. This is a classic case of that. Now, it’s a really complex company to give that bird’s eye view on, but you could apply this thinking to other companies. That’s my message here. It doesn’t have to be in Nvidia. It could be a much simpler company to understand, and that’s what I like about it. This is geared toward folks like you and me, Ricky, who want to be a little more lazy, who want to be a more big picture, who are interested in innovation, who want to find an edge and place our best thoughts behind it and buy some shares of a company. We don’t want to get lost in our DCF models and be paralyzed by indecision. Because we don’t understand if our assumptions are right or not. I highly recommend this book. It’s something that the entire investing team at the Motley Fool was given by our management, Expectations Investing once more by Michael Mobison and Alfred Rappaport and I highly recommend anyone who wants to just even conceptually use this. You don’t even have to use a spreadsheet.
Ricky Mulvey: This is the first time we’ve tried this concept where we introduce a topic during the week and then take a deeper dive during the weekend. We’re always looking for feedback on the show and take your questions about investing. The best place to reach us is firstname.lastname@example.org. That is podcasts with an S at fool dot com.
As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don’t buy yourself stocks based solely on what you hear. I’m Ricky Mulvey. Thanks for listening. We’ll be back tomorrow.
Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Asit Sharma has positions in Amazon.com, Canadian Pacific Kansas City, Coca-Cola, Nvidia, and PayPal. Ricky Mulvey has positions in Adyen, Meta Platforms, and PayPal. The Motley Fool has positions in and recommends Advanced Micro Devices, Adyen, Amazon.com, Canadian Pacific Kansas City, Meta Platforms, Nvidia, PayPal, Taiwan Semiconductor Manufacturing, and Uber Technologies. The Motley Fool recommends General Motors and recommends the following options: long January 2024 $47.50 calls on Coca-Cola, long January 2025 $25 calls on General Motors, and short December 2023 $67.50 puts on PayPal. The Motley Fool has a disclosure policy.