Value Column von Hans Peter Schupp

21 AUGUST 2024

Investing is a walk in the park

Hans Peter Schupp, Managing Partner of Fidecum AG and portfolio manager of the Contrarian Value Euroland Fund (ISIN: LU0370217092) on expectations and the mathematical challenges of high valuations.

On August 28, the AI company Nvidia will report its latest quarterly results. Expectations are very high. After all, the Group’s market value has risen by an incredible 2,000 billion US dollars in the past twelve months alone, while the company’s profit has “only” increased by 30 billion dollars.

Above all, share prices naturally have something to do with the actual earnings performance. But there is also another component – future expectations, which are reflected in the valuation. The legendary Hungarian investor André Kostolany described the relationship half a century ago as follows: ‚The stock market is like a dog on the leash of its master – the real economy – going for a walk together. The dog runs far ahead, then lags behind again. Ultimately, however, it returns to its master. Translated, this means that share prices can deviate from the long-term economic fundamentals. But at some point they will return to them. This applies to entire markets as well as individual companies.

The challenging math of high ratings

When analyzing companies, I find it always fascinating how long the leash can get. Of course, NVIDIA is a great company and its chips are currently at the heart of the AI revolution. But as an entrepreneur, would you really buy the company at its current market value of more than 3,000 billion dollars? After all, this is roughly equivalent to the gross domestic product of France, the seventh largest economy in the world.

Admittedly, the development is impressive. Since 2019, NVIDIA has increased its turnover sixfold from 10 to 60 billion dollars and reports 50% of this as profit. But investors are currently paying 50 times this fantastic turnover and 100 times the incredibly high profit of 30 billion dollars.

I did the math once. For a current investment in Nvidia to be amortized via the dividend, the Group would have to increase its profits by 30 billion dollars every year until 2042 and continuously distribute 50 percent of its earnings. Its turnover would then have to reach 1,200 billion dollars.

That is of course possible. But it will be very, very, very difficult. It is much easier to go from a turnover of 10 billion to 60 billion than from 60 billion to 1200 billion. After all, large investments are needed to build new chip factories. And fantastic, monopoly-like profit margins attract competitors. But even under these heroic assumptions, NVIDIA would only reach a price/earnings ratio of 18 after 5 years, which corresponds roughly to the long-term average of the US stock market. In this case, today’s investors would not have made any money. The dog would have just stood still and waited for the master. For an investment to be worthwhile, the extraordinary growth story would have to continue well beyond 2029.

Disclaimer: Past results are no guarantee for the future

However, this rarely happens. The more spectacular a company’s growth rates were in the past, the less robust they often proved to be in the future. Do you remember? At the height of the dot-com bubble in 2000, the global cell phone market leader Nokia grew rapidly, the prospects seemed great and the share was therefore priced at nine times turnover. Then technological developments changed. Competitors (Apple) emerged and the high expectations could not be met. The share price fell dramatically because both the profit expectations and the valuation were now reduced at the same time. A classic one-two punch. Could this also threaten Nvidia?

Value beats imagination

The dog comes back to its master. Always. That’s why we think differently about our investments. We focus on companies whose market value is – due to pessimistic market expectations – far below the level we consider to be fundamentally justified.

Vopak NV is a good example. The tank storage company based in the Netherlands. The company has been offering storage and handling services for chemicals and oil at its terminals worldwide for 400 years. Because oil production and consumption do not take place in the same place and usually not even on the same continent, this was a lucrative business for a long time. But then it was discovered by well-funded competitors. Storage capacities increased, profit margins collapsed and Vopak’s shares lost two thirds of their value in 2022.

This was an exciting starting point for us. The first competitors dropped out again due to the poorer conditions. Vopak also reacted and specialized in customers for whom the focus was not on pure storage costs, but on reliable delivery capability. Meanwhile, Vopak has returned to the old margin level and the share price has doubled. The dog had briefly lagged far behind its master and is now approaching him again.

Many value companies are trading well below their fair value

Many so-called value companies – especially in the small-mid cap segment – have yet to make this move. According to our calculations, their share prices are far below their fundamental value. For our Contrarian Value Euroland Fund (ISIN: LU0370217092), we have been investing in such opportunities – undervalued companies with understandable business potential – for more than 25 years. To paraphrase Kostolany, we look for dogs that run far behind their masters. The length of the leash defines the safety buffer of the investment. If it is large enough, we should achieve a reasonable return even if our expectations are not fully met.

About the author: Hans Peter Schupp, Managing Partner of Fidecum AG and portfolio manager of the Contrarian Value Euroland Fund.

Convenience translation only !