Motley Fool Hidden Gems Investing - Expectations Investing Part 2: General Motors to Nvidia

Episode Date: September 9, 2023

What does an investor have to believe for today’s share price to make sense?  Ricky Mulvey and Asit Sharma continue their conversation about Expectations Investing, applying the framework to four companies with different growth outlooks. They discuss: - Value drivers for a mature automaker. - A high-growth payment processing company experiencing a narrative shift.  - If Nvidia can maintain its moat over the long-term. Companies discussed: GM, CP, ADYEY, NVDA Host: Ricky Mulvey Guest: Asit Sharma Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

When WestJet first took flight in 1996, the vibes were a bit different. People thought denim on denim was peak fashion, inline skates were everywhere, and two out of three women rocked the Rachel. While those things stayed in the 90s, one thing that hasn't is that fuzzy feeling you get when WestJet welcomes you on board. Here's to WestJetting since 96. Travel back in time with us and actually travel with us at westjet.com slash 30 years. their idea is that when you've got this nice return that's well above your 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 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. 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. And those are sort of going to decrease the potential of its cash flows to grow. Even, 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 this space. So, 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's 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? So, I think you have to ask a very basic question if you're a General Motors investor right now. And this is something Mobison has encouraged, which is, what is your basic unit of analysis? It could be cars sold. You also might want to add, 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 while 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 Barr, 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 sort of united autoworkers strike for the major car makers. so the exercise you went through just now is similar for both a traditional discounted cash flow model and expectations investing if you if you spreadsheet out that all because both are trying to get at something really fundamental so 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 determinants 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 were 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. Thank you. I appreciate that. And 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. And Barra has implemented, stealing from Zuckerberg perhaps, the year of efficiency, identifying $2 billion in cost savings and then another billion in cost savings. She's 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. And if I may, Asit, let's move on to our next company. Proceed. All right. 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 Asit, the stock didn't really react to that. And 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? I think the market is still very positive on the merger. So there was some compression on the stock price while this merger was under review by the various transportation safety boards, mostly in the U.S. It got approved at a time when the market wasn't in a great shape. We suddenly had so much macro pressure. So it was almost like it 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 outperformance 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. I would, because this company, Canadian Pacific, Kansas City, is significantly more expensive than its other railroad peers, which, forgive me, I'm going to use the price-to-earnings multiple. Those trade at about a 16 to 20 PE multiple. And Kansas City is up in the 27 range. Do you think this higher multiple is justified? 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. 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 receive from their own ports, all the way up through the U.S. supply chain, then into Canada, where we have a retail presence of a Ford Motor Company. So 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 transit of goods 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 were, 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's reduced 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 kooky as that sounds.

This is a company with a revenue growth rate of about 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? This one is interesting because the railroad industry already provides you with different looks into very minute types of measurements. So I think looking at volumes, looking at train speeds is always fun. Seeing how those increase, looking at network fluidity, there are so many stats that railroads provide you that would be so great if 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. You can, 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 carload, whether that's expressed as a mile, or one of its different categories of freight, so intramodal. 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. This is, again, how it could be different for an expectations-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, okay, if the economy improves, how much more volume will this company have? And then you spread that up into your model. The expectations-based

investor is really going to key in on what could push the value. So 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. 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. So 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.

So with that understanding, how did the Adyen story change in its latest report? 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 margins 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 U.S. They're based, I believe, in the Netherlands, is their home headquarters. 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. 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. 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. So 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.

They did exactly what they said they're going to do. And I kind of see both sides of this debate. on the bear 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? 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, or 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 call unified commerce, which takes all your purchasing data across channels, whether it's digital or point of sale, someone coming into a store, 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. So they have a different bent, I think, than other companies. And part of it stems from what you said, that they're sort of, first and foremost, a platform company. They

like to go after big platforms and BV, sole provider of the payments processing. So they have 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 hyper-focus 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

it's really cash flow rich, a great free cash flow generator. I'm willing to be patient and spot them a little bit of slack here. You can always correct by 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. When I think of the Adyen story, it seems like this is sort of 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. Yeah. You hit on something that Michael Mubison and Alfred Rappaport talk about in Expectations Investing. 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. Then you're a very, very mature company. And so 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, 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. So, Adyen has about a revenue growth rate. Now in the 20s, that's down from

from 40. Their return on invested capital, I believe, is in the 20s. 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? I think the biggest signal is going to be the value driver of operating margin. We talked about, in our intro session, three main drivers, not all, but main drivers that Mobison and Rappaport 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

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 Audion can well achieve. And that will be their stable state operating margin. So if you're an expectations-based investor, your job would be to say, okay, how does that work? I mean, 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? And 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 sort of 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. So this isn't always the easiest of models to use, the expectations-based model. And I think Audion is one of the harder companies actually to try it on. Fair enough. Let us move to the complete opposite side of the planet that General Motors is on, and that is NVIDIA. They make GPUs, design chips, operate data centers, and the stock price over the past 12 months is up about 250%.

For those who may not know, why have growth expectations changed so much for this company? So growth expectations have changed for NVIDIA because of a breakthrough in the way that neural networks processed information that came in years between 2013 and 2017. Some really smart people at Google put out a paper called Attention is All You Need, and 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 chat GPT, 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 GPUs that NVIDIA develops in conjunction with its libraries that accelerate its hardware and software. So, this one-two punch by NVIDIA is yet to be equaled by any other company that manufactures either GPUs or very focused chips, ASICs 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. chips. Lastly, NVIDIA has been investing in the architecture on these chips for years and years and years, sort of foreseeing the day that this would happen. And so, they were able to meet this tremendous demand pretty well over the last year. And we can break down more of that, if you'd like, or move on to your next question regarding NVIDIA.

I have a big question about NVIDIA that I want to ask as we start to wrap up, which is, you described the edge that they have. For me, perhaps to my detriment, I've put NVIDIA in the too 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, data. It seems like they might have some smart folks working there. The revenue growth rate is over 100%. The return on invested capital is 30%. Should investors expect to see that compress as other companies notice what NVIDIA is doing? 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 CUDA, which basically is tied into the acceleration of its GPUs, as I was mentioning, Ford. There's no other company that has a complete solution that offers the GPUs or ASICs 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, its own standards that compete with Ethernet. So it becomes 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. So while they'll see

competitors chipping away and eroding some of that lead at the margins, for a while they're they're going to enjoy a lot of demand. Now, what we have to understand about NVIDIA, though, it is a cyclical company. I mean, at some point, this demand will level off. People will wake up one day and say, okay, 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 sort of 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. And I think they'll continue to do that. Now, will the stock race ahead of itself at some points in time? Yeah. 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? 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 it's easily put in the too-hard pile. I've spent a lot of time studying it. I still feel like I'm scratching the surface on a lot of things. But let's just suppose that 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, an explosion in its sales potentially. And so, 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, their relationships with TSMC to get the product in the door. And you could have bought shares. So this is sort of 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 NVIDIA. It could be a much simpler company to understand. And that's what I like about it. This is geared towards folks like you and me, Ricky, who want to be a little more lazy, who want to be 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. So 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. All right. 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 podcasts at fool.com. That is podcasts with an S at fool.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 or sell stocks based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow. Thank you.