A trip to the supermarket is not a typical way to build wealth. A trip to the supermarket in Neptune Beach, Florida, however, seems to have been just the ticket for one lucky shopper last month, who won one of the largest US lottery prizes in history, scooping a cool $1.58bn (yes, with a “b”) jackpot in the Mega Millions draw. These stories never fail to fascinate the public, and the life-changing possibilities that lie at the end of randomly chosen numbers will likely continue to entice players for centuries to come – after all, the earliest recorded lottery originates from the Han Dynasty in China over 2,000 years ago, and we’re still hard  at it[1].

Aside from providing great clickbait articles, lotteries are an interesting lens through which to view investing attitudes, particularly as they pertain to the right price to pay for the chance for growth. Consider the recent $1.58bn winning ticket: as with all Mega Millions draws, the ticket only cost $2 to play, netting the winner a 79 billion percent return (a good year by anyone’s standards). Whilst that is a fabulous outcome, it is easy to see that even $2 is probably too high a price to pay for such a ticket: the expectation, based on the likelihood of the outcomes, is that you will never win back your original stake (that is, after all, what the lottery operators rely on). This message seems intuitive to most people, who take part in the lottery usually because it is fun and amusing, and not as part of an overall financial plan.

Nonetheless, staying for a moment with the rational approach to lotteries and ticket prices, it is interesting to consider what price you would pay for the winning ticket, were it to be offered for sale once the numbers had been drawn. In such a scenario, paying even a dollar less than the jackpot is a way to guarantee effectively free money, as you have pre-paid for the winnings – though it is easy to understand that your returns will be nowhere near as good as the original ticket buyer[2]. By contrast, were you offered the chance to buy the winning ticket – after the draw had taken place – at the original $2 price, you would obviously jump at the chance, grabbing a sure-thing cash payout for an eye-wateringly attractive price.

The clarity of this example, however, seems to get lost in translation when looking at investment opportunities. Often – and, it seems to us, particularly today – investors buy companies that they believe to be future lottery tickets, expecting to earn the associated high returns, yet pay prices that all but assume a guaranteed win. As is easy to understand from the lottery example, paying full price for a winner might make sense, but (i) it won’t make you the same return as paying only the initial $2 ticket price, and (ii) it only makes sense if you already know the outcome of the draw. Paying $1bn for the chance to win $1.58bn, without knowing the final numbers, seems like a recklessly speculative way to spend your money. For companies, too, those investors buying at huge valuations are effectively paying in advance for a sure-thing winning ticket, without the associated guarantee of a bonanza payout – and, even if they do get the payout they expect, they will only earn an average return, since they have already paid for the winnings. This approach is difficult for us to understand. At the same time, the inverse phenomenon also makes little sense to us: today, there are some of what we would consider “sure-thing ticket” companies, with impenetrable balance sheets, track records of success and impressive cash earnings, priced at the original $2, as if they still have extremely unlikely odds of a payout that we see as much closer to guaranteed.

We find ourselves bumping up against this problem repeatedly in the real world, and one of our portfolio companies, Stellantis, provides a good example, especially when compared to the much more highly valued peer, Tesla. Stellantis is the corporation formed by the 2021 merger of Fiat-Chrysler and Peugeot, bringing together two storied companies with a formidable stable of brands – Alfa Romeo, Citroen, Chrysler, Dodge, DS, Fiat, Jeep, Lancia, Maserati, Peugeot, Ram, and Vauxhall/Opel – and strength in Europe, North America and South America. In the first half of this year, the company grew its shipments by 10%, revenues by 12%, and operating income by 31%, delivering €13.5bn of operating income and €10.9bn of net income[3]. With a €53.8bn market capitalisation[4], and €24.5bn of net cash on the balance sheet, the company is valued at a price to earnings of 2.5x[5], and an enterprise value to operating income of 1.1x. Given the long track record of the company, the brand strength of the group, the experience of the management team, and the sturdiness of the balance sheet, that price is simply staggering to us – like finding an unclaimed lottery ticket with last night’s numbers on them, selling for a mere $2.

At the same time, Tesla – another car manufacturer – appears to us to be the lottery ticket priced for a win, without having any certainty whatsoever as to the final outcome. Whilst we are not advocating for betting against Tesla and Elon Musk – with many great investors finding this experience to be particularly punishing – we would simply note that we believe the current valuation bakes in extreme growth assumptions. The danger of this approach, in our view, is that even if the lofty goals can be reached, the return earned by the investors will be, at best, in line with the market, and quite possibly much worse. After all, that is what can happen when you pay upfront for targets that have not yet been hit and is akin to paying $1.57bn for the $1.58bn ticket – only this time, doing so when the jackpot win is far from guaranteed. In the first half of the year, Tesla grew automotive and total revenues by 35%, whilst operating income declined by 17%, and net income fell by 6.5%, delivering $5.2bn of net income to shareholders[6]. At its current market capitalisation of $814bn[7], and with $20.7bn of net cash on the balance sheet[8],  Tesla sports a price to earnings of 78.3x, and an enterprise value to operating income of 78x[9]. These huge numbers indicate extreme optimism about the future trajectory of earnings for the company, and, importantly, mean that investors will only experience above-average returns if Tesla actually exceeds these lofty aims. Even though Tesla earned a little less than half of the net income figure Stellantis achieved this year, it would cost you fifteen times more to buy Tesla: that means that, for every $1 of net income available for you to buy, Tesla’s will cost you thirty-one times the price of the same $1 earned by Setllantis.

Both Tesla and Stellantis are auto manufacturers, experiencing the same industry churns and challenges, and navigating in a competitive, capital-intensive market. Which will grow faster, earn more money, or have a more beloved CEO, we do not know, nor feel any compulsion to predict. Instead, what we find instructive about this case study – with such an extreme valuation discrepancy between companies in the same industry – is the illustrative example that each company provides for different investor approaches: buying presumed future earnings for a fairly full price, or buying current cashflow for a bargain price.

A good mental model for thinking about which type of lottery ticket to buy was put forward by Warren Buffett in 1989, in his annual letter to shareholders (emphasis added):

“After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers” – Berkshire Hathaway Chairman’s Letter to Shareholders, 1989

Stellantis, in our view, is a one-foot hurdle: a well-run, conservatively financed company with attractive prospects and an absurdly low price for its impressive and growing earnings, all it needs to do to be a great investment at today’s price is simply more of the same. The seven-foot hurdle, meanwhile, is aptly represented by Tesla, who, in our view, will need incredible feats of corporate athleticism in order to grow into the price that investors are currently paying. We have no view on whether such a seven-foot hurdle will be cleared; where we have much greater confidence, however, is in the ease with which we believe Stellantis’ one-foot hurdle can be stepped over.

Sources:

[1] https://en.wikipedia.org/wiki/Lottery

[2] Leaving aside the complexities of lump-sums versus annuities, and assuming the headline jackpot is what you’d get on day 1

[3] Company reports, H1 2023

[4] Bloomberg

[5] Using the run-rate figures for the full year

[6] Company reports, 10-Q Q2 2023

[7] Bloomberg

[8] Including short-term investments, and excluding $184m of Bitcoin

[9] Again, using run-rate figures for the full year

[10] Market prices as at 07.09.2023, Company reports 2023