Even among those massive companies, these are companies like Apple, Microsoft, Google, Facebook and Exxon. Those types of companies and even consumer staple companies like Johnson & Johnson, the average 52-week high is 40% greater than the average 52-week low. So, those fluctuations obviously provide opportunity. 

Then, in terms of my approach to investing, I focus on good businesses. I’m trying to make investments in quality companies, when their stock prices are undervalued. I look for things like predictable earning power and high returns on capital, good management. Then, I try to just patiently wait until there’s an inevitable opportunity that the market offers from time to time. 

Sometimes these opportunities are in smaller companies, and sometimes they’re in some of the more mature larger companies that have predictable cash flow, and then just occasionally get mispriced by the market. 

I look for investments of all sizes. Some are large, some are small, but I probably prefer the smaller ones because there are more, I think, efficiencies there, but I’m just explaining these thoughts to try to demonstrate that just because a company is large, it doesn’t necessarily mean it can’t be undervalued. 

So with that background, I’ll discuss a large cap stock. It’s a well followed company and as I mentioned, that’s Tencent Holdings. Ticker is TCEHY. So Tencent is an internet holding company in China. We’ve got a variety of different businesses. All of which are benefiting immensely from the rapid rise of the Chinese consumer and the expanding middle class there. It’s a really incredible company. Tencent has got a lot of investments in many different areas. 

I categorize the largest businesses, or at least the businesses that are large right now and I think have a lot of potential going forward are video game publishing, mobile advertising, e-commerce, mobile payments, and music and video subscription. 

So collectively, these are great businesses. Most of them take very little capital to grow. Some take more than others, of course, but on balance, these are really high-returns on capital businesses and produce solid free cash flow, and they’re growing rapidly. 

The company did about $28 billion in revenue last year, and did about $10 billion in free cash flow in the last 12 months so it’s highly profitable. The top and bottom line are also growing at about 40% to 50% annually at the current time. So it’s an interesting company with a lot of great businesses in attractive markets, lots of growth potential. 

The company has aspects of numerous companies that we’re familiar with in the West. All under one roof. So, it’s got aspects of Facebook. It’s got aspects of WhatsApp, YouTube, PayPal, Apple Music. All rolled into one. 

On top of that, it’s the world’s largest video game publisher as well. So, a lot of great businesses. The crown jewel of the company, in my opinion is, and this is also the reason for wanting to own the stock, and it’s also one of the widest moats in the world, I think, and that’s WeChat. 

So many refer to WeChat as the super app. It’s one of the most powerful networks, as I said, and they are just under a billion users now. WeChat is primarily in China. Almost exclusively in China. It started to expand a little bit, but mostly in China. 

What’s amazing about that statistic is basically everybody in China is on WeChat. It’s really unlike anything that we’ve seen in the West. It’s used for just about everything in everyday life in China. So on the surface, what is WeChat? [It] is an app for your phone. But unlike most apps, it’s really a collection of different apps. It’s called mini programs that all exist inside of WeChat. 

So there are all these apps within WeChat that allow you to perform all different kinds of everyday functions like calls, text messages. People don’t send text via SMS, they send messages via Wechat. They don’t make phone calls. 

In some cases, they just call through WeChat. There’s a social network, really similar to Facebook, which is used for work communication. People don’t send email as much anymore, especially in the larger tier one cities. They just communicate via Wechat. 

WeChat started as a communication tool, but then it also blossomed into this monster app. What’s interesting is WeChat and the ability to make mobile payments. That really created a whole new [way]. It took the app to a different level. 

Now, people can use WeChat for everyday payments. You can help cabs on WeChat. You can pay for movies on WeChat. You can buy goods online. You can make payments in physical stores. Basically anything that involves a commercial transaction can be used through WeChat. 

WeChat Pay is actually now one of the larger global payments platforms in China. It is the second largest behind Alipay, and it’s rapidly taking market share. I think it’s up to close to 40% market share in China now. 

So WeChat is a really incredible platform that has a strong network. Billion users attract a lot of businesses. There are now I think 300,000 businesses that accept payments via Wechat. So it’s a very powerful network that continues to grow, and people spend a lot of time on the app. 

What’s interesting is people spend more time on WeChat than people spend on Facebook and Instagram combined. Also along those lines, one of the most incredible statistics, I think, is that over one third of WeChat users spend four hours or more on this single app. So it’s a really powerful app that has an incredible grab among users. And that, of course, attracts a lot of businesses that want to sell things to those users. 

One more statistic that I’ll point to try to demonstrate the growth potential… Facebook did about $2 billion in advertising, and we all know how good the economics are at Facebook. This past year, they did $27 billion in revenue and $10 billion in cash flow. 

In 2010, two years before they went public, they did about $2 billion in revenue. So, the company went from $2 billion to $27 billion in the last six or seven years. That’s almost all online advertising. A large portion of that is mobile advertising. So I think there’s an enormous potential for a platform like WeChat, which I think you could make an argument actually has more pricing power than Facebook has. 

All in all, I think it’s one of the best companies in the world. I think sizeable cash flow, really strong network effect, plenty of room for growth in industries like mobile advertising, mobile payments, e-commerce, and Tencent has, as I said, a small fraction of those markets. So, the stocks have a lot this year. It looks expensive on the surface at around 40 times earnings, as the 40 times the amount of cash flow that I think the company will produce this year.

However, I think it could actually still be undervalued. The reason is that if you forget about the size of the market cap, which usually becomes an anchor, at this size is $400 billion, and you just look at the company’s earning power. 

Also, you look at the returns on incremental capital that produces, and again, the growth potential that it has. I think you can make a case that the company will continue to grow its earnings and its intrinsic value. 

I think the stock price will likely correspond more or less to those gains in earning power and gains and intrinsic value over time. So sometimes 40 PE is expensive, usually it is and  I think it’s rare cases it can be cheap.

Stig Brodersen  12:02  

John, could you tell us more about the valuation? You mentioned that it looks somewhat expensive right now. We’re also talking about growth rates, top line, bottom line. Call it 40%. It’s aggressive to project that it has done so in the past. That looks like there’s a lot of earning power to be gained, especially in the digital marketing in China. 

How do you make a model? How do you make your projections of the future cash flows, whenever you justify the current valuation?

John Huber  12:28  

That’s a great question. I mean, the way I do valuation is usually back of the envelope. I don’t have any detailed spreadsheets or models or anything, but I just think about the company’s earning power now and the amount of cash flow that’s producing now and then I try to think about what the returns on capital look like. The company is a complicated beast. 

I mean, it’s investing in lots of different passive investments. It took a 5% stake in Tesla for example, it owns a piece of Activision which is a video game publisher here in the US and it has all different kinds of equity investments which are passive. So some of the capital gets diverted towards those investments. 

You then sort of have to make a view about how good you think the company is as a capital allocator.  That’s maybe a question mark. I’m not sure how good of an investor *inaudible* is the manager. But I think over time, the core businesses at Tencent are so good and the runways are so great that I think there’s a long potential ahead for the company to grow.

Preston Pysh  13:27  

Just as a note to the listeners, we first came in contact with John because I sent out a tweet. This was, I don’t know. Maybe three weeks ago, two weeks ago, or something. I sent out a tweet that says, “Hey, does anyone know much about Tencent?” which is the company we’re talking about. I think I had maybe 10 people reply to me in the matter of a half hour saying, “You need to talk to John Huber.” Everyone was throwing your name out there as the guy to talk to about Tencent.

Whenever I’m digging into this, initially, all of this because of all the reasons that you’re saying, I totally understand the WeChat argument. I think that it’s a much bigger moat than most people in America might give it credit for, because everyone’s so Facebook centric here in America. 

However, when you go over to China, and you see what everyone’s using, it is WeChat 1000 times over. I would argue that maybe it’s even stronger than Facebook is here in the US. So, I’m with you. I completely agree with that when I look at the financials, and I see the free cash flow on this thing. 

I mean, it’s a freaking beast. When you look at the top line to the free cash flow, I mean, it’s a huge margin. I mean, it’s massive. So, this is the type of business that you know all of us really like to own. 

The issue that I have really goes to the heart of what Stig was getting at, which is, what are we using as the growth rate moving forward because that is what it all comes down to here as far as the valuation on it. When you look at the last 10 years, let’s just talk about the last 10 years, the free cash flow, not the top line, but the free cash flow grew at 58% annually for the last 10 years. Just in the last year alone, it was 44% free cash flow growth. So these are like massive numbers. 

So, when I’ve got my intrinsic value model here and I’m putting in some of these numbers, if I put in a 30% growth rate for the free cash flow into the next 10 years annually, 30%-30% for the next 10 years, I’m getting a 11.9% return. 

We’ll call it a 12% return, if you buy it at today’s price of $41 a share. But you have to get 30% every year on the free cash flow growth. If I adjust that down, let me just adjust that down to 20%, which I think is a much more conservative number. I think that is this in the realm of possible? Yeah, but I would probably put the probability, I don’t know… I definitely wouldn’t say it’s 100% that they’re going to get 20% annually for the next 10 years. 

Though let’s just see what we get for intrinsic value here. If I put 20% growth for the next 10 years, I’m now getting an intrinsic value of around 6%. So, a drastic difference in the intrinsic value. The return at the current price of $41. If you buy at $41, and you have 20% annual growth on the cash flow for the next 10 years, I’m estimating that you’re going to get an IRR of about 6.3%. 

So that’s where I guess I get a little concerned, especially as I feel like when we look at the global economy, and we see that we’re going to have a credit event here in the next 10 years. That’s going to happen within 10 years. I have close to 100% confidence that that’s going to happen in the next 10 years. If that happens, I just don’t see how they’re going to be able to hit a free cash flow growth rate as high as 30% plus. I guess I have such a hard time buying that. 

I really liked your comment, John, because you said this is one to watch. If you’re not comfortable with the price today. It’s something to watch because you know in a year or two or three years, you might be presented with an incredible opportunity to buy this company at a fantastic price because their economic moat is so huge. I totally agree with that. I just don’t know if I’m a buyer today, but I love the fact that we’re talking about this company, because this is a very high quality company.

John Huber  17:17  

Yeah, I think, obviously, the current growth rates, although they have remained high, in fact, in some cases, actually accelerated slightly in recent quarters. However, obviously, you can’t grow at 40% for very long, because the Chinese economy is only so large. But the Chinese economy is very large, and the industries that they operate in are so large. 

One of the things that Bezos talked about in his recent letter to Amazon shareholders was how important it is to focus on these big trends. He called them, I think, these big, external fundamental trends that are sweeping major economies, and I think he talked about artificial intelligence. 

But the way I took that is look for these broad, sweeping fundamental trends, because as he said, they give you a tailwind, and you don’t want to fight those trends. 

One of the trends that I think the company benefits from is the rapid rise of the middle class. If you look at the numbers, and the sheer volume of people joining the middle class in China each year, the numbers are really astounding. They’re going to add an entire US population to the middle class in the next four or five or six years or so. 

So, there’s a lot of buying power as those customers come into the middle class and get more connected to the internet, spend more time on their mobile phones, buy more things. Tencent is really well positioned to capitalize on that. 

The other thing I’d say is, I think you have to think about Tencent, and this is always a little bit, maybe it’s a red flag that I’m saying this, but I think you have to think about the company differently than we would analyze most traditional companies… 

Tencent is such a unique animal, because not only is WeChat unique and unlike anything that we’ve seen, but the company itself has its tentacles and all these different businesses. It has 118 million subscribers, the paying subscribers to various news subscriptions and online video and music. 

When you compare it to Netflix with 94 million subs, it’s that’s a pretty big business that’s tucked inside this massive conglomerate. Not many people know about it, the video game business is obviously producing a good share of the profit right now and a good share of the revenue. 

However, I guess my point is, I think there’s a lot of whitespace that people might under estimate. So, I think the growth is not going to continue at these rates. I don’t think for certainly not for 10 years, because the numbers would be astronomical at that point. Though, I think the growth can be 15% to 20% for a long period of time, and the valuation that the marketplaces on that might not be 40 times earnings. 

But this is a capitalist business that I think will be valued depending on where interest rates go, and general valuations go. I think it’s going to achieve a premium valuation because of the quality of the business. I do think that earnings can grow for quite a long time at not 40%. Maybe even half that would give you a pretty nice return over time.

Hari Ramachandra  20:17  

John, thank you for sharing your views on Tencent. Just to add to what Preston said, I was one of the folks who tweeted him in half an hour.

John Huber  20:28  

I appreciate you getting me on here.

Hari Ramachandra  20:31  

I’ve been a big fan and a longtime reader of your blog. I also want to highlight the fact that one of your bets, probably is one of your significant bets, is Apple. Your strike price might be in the 90s and today, it’s 165. For folks, John was very modest, when he was talking about his performance. 

A couple of questions regarding Tencent and WeChat, as you said, are phenomenal. I have seen that making inroads even into the US and Europe. However, from a risk perspective, a couple of things that I wanted to clarify is even though Tencent is making foray into mobile payments and advertising business to business and customer to business, B2C, one observation is that more than half of the revenue still comes from gaming. 

Gaming is a kind of a low mode e-business because the trends change, so that’s number one risk. Number two risk I would like you to address is the regulatory risk in China because of Tencent’s foray into payments systems like WePay or TenPay. 

Recently, I think in March 2014 or some time around that, the Central Bank of China suspended virtual credit cards and barcode scanning for mobile payments and stuff like that. So they’re kind of hostage to the regulations changing in terms of their payments. I wanted to get your thoughts on these two risks. How significant are they for Tencent and what are some of the steps Tencent is taking to address that?

John Huber  22:02  

One of the ways I think they’re addressing it is just recently, the Chinese government is an interesting [entity]… When you think about the competitor to Tencent in some ways, I think the Chinese government could be the biggest competitor it has, because it really has no equal when it comes to the platform that’s WeChat. I think, in a market economy, if it were a complete market economy as opposed to a planned economy, I think the growth would be much more certain. 

One of my questions is how big will the party allow this company to be? How much money will they allow it to make? One of the risks is that the government basically goes to guys like Tencent, Alibaba and JD, and say, “Look, you guys have benefited from all of these investments that we’ve made in IT and building out the infrastructure that allows you guys to provide your services to the users that you have. 

And so, we’re going to force you to invest in China Unicom,” for example, which is one of the state owned telecom companies that recently there was a deal announced. There’s some complications going on right now but it looks like Tencent, Alibaba, JD and a couple other tech companies and a couple other companies are going to basically make an equity investment in that company to help finance the 4H expansion and the potential 5G expansion and so forth. 

One of the risks is that they just go to these cash rich companies and use them as piggy banks to sort of finance the growth that the country will certainly need. There’s a lot of debt in China right now, there’s a lot of government debt, and there are potential issues there. 

I think there’ll be a lot of bumps in the road, but my overarching view is that China is trending from a planned economy toward more of a market economy. There are going to be bumps in the road and there might be kind of cycles that sort of work against that. 

Xi Jinping is in an election year in China and he is accumulating power. A lot of people are concerned about that and rightly so. I think so in some ways they might be temporarily moving away from that. But I think in general, the country’s getting more capitalistic. If you look out 20 or 30 years, that’s going to continue. 

I think these big companies are in some ways on the other side of the coin, viewed as national champions in China. China wants these companies to do well, they want Ali Baba to do well, and expand overseas, and they’d like to see a Chinese company, I think, I mean… I think they’d like to see Chinese companies make inroads into Europe and make inroads into the US market, potentially compete with companies like Amazon and others that dominate the rest of the world. 

So, I do think it’s becoming more globalized. I also think these companies will continue to do well, but you certainly outlined a risk and that is certainly a risk that you have to think about and address.

Stig Brodersen  24:57  

I know that soccer is probably not a big sport there for my American friends, but soccer is a huge deal here in Europe. One of the interesting things that had happened since Xi Jinping, the Chinese President, came into power is that a lot of money is flowing into Chinese soccer at the moment. 

So many of the best players, they’re just simply going to China because they can make more money. If you track where the money is coming from, it’s not coming from the government. It’s coming from its massive corporate investments. When I saw that, I was thinking this doesn’t make any sense. Why would corporations pay so much to see a soccer player? I mean, what’s that all about? 

It’s simply such a huge prestige project for the President to have a really good football league because they want to do good at the World Cup. So what the corporations are doing is that they are buying these players, not so much just so they can enjoy them play, but simply to gain favor with the government. 

It just tells me something about the culture and the unpredictability, not so much in the sense that the Chinese system works, because typically, when you’re president or your Secretary of the Communist Party, you will be sitting there for a long time… The underlying basis of unity is the same in China. 

However, each president has his own prestige projects that they’re just throwing so much money after. So my question to you for the political consideration would be, what’s the relationship and what can you see go wrong specifically about this company? Is that something we should be worried about? Or is this some kind of history? This is very important in the Chinese culture that can give you more stability than otherwise would.

John Huber  26:39  

That’s a good question. I mean, I think the relationship between Tencent and the government, from what I can tell, has been good. I think Tencent has, for the most part, done things to try to certainly abide by the rules but abide by the spirit and the preferences that the party has. There have been some bumps in the road and there probably will be in the future. 

I mean, just recently there have been some censorship questions. Weibo, which is kind of the Chinese version of Twitter, had some real issues. There are some potential censorship issues there. WeChat has been named as one of the entities along with Weibo and others that the Chinese government is now investigating to crack down on, I guess, slander against the party and other issues that just occur on social media that the Chinese government doesn’t like. 

Certainly, criticism of the Chinese government isn’t tolerated there. All of those things, I think, are there things I’ve thought about myself, they’re difficult to handicap and I don’t think you can really place precise odds on how those things will work. 

But I have gained a comfort level that I think Tencent’s position in that economy and its importance via the assets that it owns, specifically WeChat, are so crucial at this point to the actual economy and consumer culture that I think in general, the Chinese government understands that. I think a lot of the incentives are aligned there. You don’t want to upset the applecart too much when it comes to WeChat, because you’re going to have a billion people that are really upset. 

Now, there’s some things that the Chinese government can do outside of shutting down WeChat or limiting WeChat or censoring WeChat somehow, and they’re doing censorship right now on certain platforms. 

But there are economic things like I talked about the China Unicom investment. They can go to these guys and basically extort them for money, if they want to in certain ways, or force them to make investments that they wouldn’t make… if they had their own complete freewill. So all of those things are things that you have to consider and those are things you just kind of have to handicap on your own, but they are risks. 

Preston Pysh  28:50  

Stig, when I think through your question, which I think is a really good question, because we’ve seen so many Western companies try to go to China, and it just always turns out to be a disaster. 

When I look at this, the fact that the origin of the company is Chinese, and that it’s grown from that foundation, I think says that brings a lot more comfort to me personally, if that was a risk that I was concerned about. 

I have a lot more confidence knowing that it originated as a Chinese company, and it’s grown into this large holding company than if it was Yahoo that went over there with a new product and had competed really vigorously and done well. I’d be much more concerned about that, because the roots were tied back to some Western or some other country outside of China. So I guess for me personally, that’s how I’d be looking at it. I don’t know if John would agree with that.

John Huber  29:39  

Yeah, I mean, the other thing, Preston, is the Chinese firewall, I mean, basically, Internet companies, in large part haven’t been allowed to come into China. Some have tried and gotten kicked out or some have tried and failed. 

Even retail companies like Amazon have, I think, 1.5%  market share in China. So it’s very difficult for outside companies to do business there. There are laws that basically restrict foreign ownership of certain companies, which has resulted in the corporate structures that some of these companies have. 

Basically, I would agree that I think the government would certainly prefer it when it comes to IT, banking, mobile payments, probably e-commerce. These are industries that the government wants Chinese homegrown companies to dominate the market there.

Preston Pysh  30:25  

Alright guys, so we got through one company and so we’re doing well here. Stig, did you want to go next?

Stig Brodersen  30:32  

Sure. So, my stock pick is Fiat Chrysler, and the stock ticker is FCAU. This stock first came on my radar because it was one of Mohnish Pabrai’s picks, and he bought the stock at around $3. Now, it’s trading around $15. 

As you can see, I’m a very, very slow learner. When I saw the company, it was kind of doing a turnaround. It has its structure that it has now since 2014. The brands that most people are probably familiar with are Alfa Romeo, Chrysler, Jeep, Dodge, Fiat, obviously, Maserati, more expensive cars, and then also, Ram Trucks. 

Since they have the new structure, they also have been spinning off Ferrari back in 2015. That was settled in early 2016.

If you look at how the company is making money, where they make the revenue 80% of the revenue is in NAFTA. Then also, in Europe. In NAFTA, they are the fourth biggest with the 12.6% market share after GM, Ford, and Toyota. Europe is somewhat smaller, only 6.5% market share, when they’re trailing Volkswagen. 

It’s a very competitive industry. It’s characterized in general by somewhat smaller margins. It’s typically an industry you wouldn’t like. It’s capital intensive, unionized labor, a lot of bad stuff for many value investors, when they look at this. If you dig even deeper into where the money is made, not just the revenue, almost all the money or the income they’re making in NAFTA. They’re expanding. They’re big in Europe, but they’re also expanding into other continents, but they’re really not making any money there. 

So we’re recording this at the end of August. As people probably already know, there’s been a lot of rumors about Fiat Chrysler, about perhaps selling off the jeep division to Great Wall Motors. There’s also rumors about Maserati and Alfa Romeo brands being spun off. So, a lot of things are happening right now and there’s a lot of noise. 

Right now the stock has been soaring lately. I’m really sorry that we have to do the discussion now and probably not just a quarter ago when the stock was a lot more attractive. If we look at the valuation, we are looking at a market cap of around $29 billion. 

I always like to compare this to Tesla every time we talk [about] cars on the show. Preston and I always talk about Tesla, which is sort of weird, because Preston and I are huge fans of Elon Musk and Tesla cars. We just always pass the valuation. 

So, $29 billion for Fiat Chrysler. $58 billion for Tesla. If you look at how much money they’re making, for instance, Fiat Chrysler, they’re making $3.3 billion, trailing 12 month and Tesla. They’re making negative $766 million, so they’re definitely valued differently. 

A lot of good reasons why they’re valid differently. I think a lot of people would say Tesla is the future. A red flag with Chrysler is that they really haven’t seen a good plan for the electric car division. What are they going to do about that? It’s another concern that we can address later.

In general, the industry has just had a really rough time. I mean, you can also look at something like GM. GM is a good example; bankrupt in 2009. I mean, so all the competitors, the traditional competitors, their trading in low margins. I don’t necessarily see a lot of top line growth, even though I expect some, because it really also depends on how much is the business selling off, how much is perhaps spinning off. 

I see a lot of the value also coming from improved margins, so I still see the company as significantly undervalued, perhaps, if you aggregate all the different factors, and then shrink the value in the range between $25 and $40 in this current structure. So before I give the rest of my pitch, I’m very curious to hear what the group has to say.

Preston Pysh  34:40  

I guess I’m just looking at the valuations on this one a little bit different than Stig. So my big concern with the whole car industry is the inventory levels are just through the roof. I mean, they’re sitting on so much inventory. It’s absolutely insane when I’m looking at this company in particular and you were talking earlier, when we were talking about John’s pick, you’re talking about these tailwinds saying, “Hey, what’s the next 10 years going to look like?”

Well, I think the driverless car thing is going to be huge and absolutely massive. If you go on and you do a Google search for Fiat Chrysler, driverless car technology, anything, you practically get nothing. They’re just sitting back and watching this thing go completely by. I guess they did some teaming up with BMW for whatever that means but for the most part, from what I can understand is they’re so far behind this, this learning curve, it’s not even funny. 

When I think about the margins that are going to happen in the auto industry in the future, I think that all the money is going to be on the software side, not on the hardware side. I think that there’s going to be a very massive delineation of that moving forward into the next 10 years where you’re going to have these car companies that have tons of software that is adding huge amounts of value. 

We could get into the whole argument of time sharing cars 10 years from now. I don’t find it to be that too far fetched to think that you might be able to get out of your car and then the car can go and perform a service for the rest of the day. 

I did a little research on this one for the stats here. The average person uses their car for 46 minutes in a day. That means that you’re paying for a vehicle. You’re paying for maintenance, the liability, the storage, the fuel cost, the insurance. All that stuff. 

The depreciation that happens at 60% over a 5-year period, you’re paying for all that to use something for 3% of the day. I think that that’s all going to change. I think in 10 or 15 years that’s all going to change, and I think you’re going to have timeshares with cars and all that kind of stuff. 

Where is that going to happen? Which companies are going to be on the tip of that? When I look at that, I think Apple they’re sitting on just ridiculous amounts of money to invest. Google ridiculous amounts of money to invest. 

When you think about the technology that a company like Fiat Chrysler brings to the table, what technology are they bringing? Like technology from 50 years ago? Is that what they’re bringing to the table because that’s how I see it, which is completely a commodity. Whenever I’m looking at this, I think the best case scenario for me when I’m talking valuation is a zero percent growth in their free cash flow. Then, into the next 10 years, I would say zero percent growth. 

With zero percent growth, the numbers I’m getting is a 6.4% return. I think that’s being nice to say it’s a zero percent growth. If I was going to really kind of hit it with a much more conservative number, I would say, negative 10% annual growth on the free cash flow. If we’re using that as the number here for the projection, we’re now below 1% return on the company. 

So let’s just ballpark it. We’ll say it’s between the first number and the second number. We’re looking at a 3% return, which is similar to the S&P 500. For me, I’m not willing to go into individual stock picks. That seems like they’re going against the headwind. My risk isn’t distributed across 500 picks, if I would just invest in the S&P 500. I’m not, if this one at all, Stig. I’m seeing it completely different than you.

Stig Brodersen  38:18  

That’s great. I need to know why I’m wrong. That’s why we have these Mastermind discussions. Hari, I’m curious to hear what you have to say about Fiat Chrysler, do you think is a good pick?

Hari Ramachandra  38:29  

I just wanted to clarify and I also had a follow up question, Stig, on this one. So you mentioned that Mohnish Pabrai bought the stock back in 2012 or 2013, I believe, and his strike price was $3.

Stig Brodersen  38:46  

Yeah. He said that he bought into the stock when it was less than a market cap of $5 billion, and right now, it’s trading around 30. That was before Ferrari was spun off.

Hari Ramachandra  38:57  

What was the intention or what was his thesis to buy? I don’t think Mohnish is betting on the long term prospects of this company when he’s buying the stock. It’s a value pick. The stock has grown a lot in the last four years at an annual growth rate of around 50%. If you look at the growth rate, whereas the revenue…

Preston Pysh  39:16  

Hari, sorry to just to interrupt you, you’re talking the price has grown at 50%? 

Hari Ramachandra  39:19  

Yes. Sorry. Yeah, the price of the stock has grown at annual tech from $3 to $15 [in] 4 years. It’s 50% annually, whereas the revenue has grown around 7% per year from $83, $84 to $111 billion, I guess. 

So, my question to you is so based on your analysis, what’s the catalyst that has driven the price increase? Is it just the earnings expansion? Is it just a multiple expansion like the P/E multiple expansion? Or was there something fundamentally that changed in the past 3, 4 years due to what the management did or due to certain conditions in the industry in the short term?

I agree with Preston on the long term past prospects, it’s really hard to say how Fiat Chrysler will do. But in the short term, I want to know what changed in these 3 to 4 years. 

Preston Pysh  40:14  

Hari, I’m jumping in here because you asked this to Stig, but I’m right there with you because Mohnish saw something back then, because when I’m looking at the free cash flow of this business back when he would have bought this, it doesn’t make any sense to me. I would have never jumped into the pick, because when you’re looking at the free cash flow, it was a disaster. It was all over the place. So, what was he seeing back then that made him jump into this? I got the same question as you.

Stig Brodersen  40:39  

Yeah, you’re definitely right. I just have to bring out again that the structure you see now, that’s only been in place since 2014. So you can’t necessarily use all the numbers that you see before. To answer the question about what was it that Mohnish saw? I think he saw a lot of tailwind in the car industry. Mohnish was very aware of the management and what they did. They *inaudible* five-year plan on May 6, 2014. 

Now, the interesting thing is that the management has really followed the plan and really met all the goals. They have updated the plan as they went along because it makes a lot of sense for instance, they realize that Jeep was a lot more attractive than they originally thought. 

For instance, the Jeep brand sold 1.4 million vehicles last year. It was not necessarily a bad idea. I also see this as the management being dynamic and adaptive to the environment. They have done really, really well in that regard and they have some very specific plans about the debt. That’s when you look at it back in time, it looks horrible with the debt burden they have, but they’re actually being able to pay that debt off according to plan. 

So originally, they raised a lot of debt so they could expand and so far, it’s turned out really, really well. It’s definitely not bad at all. For instance, for 2018 operating margin, the goal is 7%, I think there’s a good chance that they can reach that. It’s now at 5.1%. 

Clearly, this looks good coming from a climate of almost no margins at all. I think the best way to explain the effect of a cyclical stock would be to say, I’m just making up these numbers, but say that you have an EPS of $1, and that’s something that the market really doesn’t like. You will value that at a PE of 3, and now your increased earnings to 4. So, going from EPS of $1 to $4. 

Now, when the market sees that, and they’ve seen the initiatives put in place to do that, they might value that EPS of 4 with a PE of 8. This might sound like an extreme example, but that’s how you would go from a stock price of $3 to $32, even though that EPS only increased four times. That is the power of a cycle stock, if you can time it right, which is obviously the hard thing. It’s really hard to do any kind of timing 

I also agree with both of you. It might seem a bit too late that I mention it now, but I don’t necessarily see Fiat Chrysler as something that I would hold for the next, call it, 10 years. I think [it] is a sort of play, almost like a special situation perhaps, which is kind of like a curse word. I guess, when you’ve really been following this Warren Buffett approach that we talk a lot about of– own and buy into companies you want to hold forever. I definitely don’t plan to do that with this type of company. 

So is now a good time to invest? Or did someone like Mohnish receive the game that really wasn’t this stock? I don’t think so. I think that he is rewarded for his foresight of this stock but as you progress, and you can have more and more faith in the management, you can [have] more and more faith in the business. 

Clearly, there’s a premium you will be able to achieve that will be smaller, but it’s called a certainty or at least the validity of the plan actually materializing is also so much higher. So, for slow learners like me, we shouldn’t be rewarded as much, but I still think there’s more to gain.

Preston Pysh  44:07  

So you brought up the point about it being a cyclical and I think that that was one of the reasons why I punished it so badly on my expectation for future cash flow is because when you go back and you look at the last credit contraction in 2008 and 2009, and you look at the free cash flow of the company, I mean, it just got punched in the face. 

If we realistically think that that’s going to happen over the next 10 years, which I do, I think that you’re going to have that same type of fallout with their free cash flow. So, if you’re not accounting for that and your model, I think that you’re just not looking at it appropriately. That’s probably one of the reasons why I’m so hard on where I think that they’re going to be with their free cash flow moving forward is because I’m expecting another credit type event to occur and I think it’s going to be ugly for them.

Stig Brodersen  44:50  

Yeah, it’s definitely a good point. I mean, there’s a variety of different factors that really influence the global demand. Global GDP growth for instance, that’s one. Consumer confidence that’s another and then credit is such a huge driver because primarily people buy cars with credit. 

Another point I’ll just briefly like to talk about is how we talk about how AI or driverless cars, how that’s really going to disrupt so many industries, and I think it will happen. Though, I also think that in the near future, there is a lot of value in a company like Fiat Chrysler because they have these valuable brands they can spin off. They’re catering to a segment that might not welcome driverless cars too fast and have more than two more SVG focus with higher margins.

John Huber  45:41  

Yeah, I agree with a lot of the points that you guys have kind of… I’ll just kind of echo some of the concerns I have about the business itself. I’ve sort of casually looked at the automakers and every time I look at them, I just look at how difficult the businesses [are] when you look at the economics of the business, and Stig pointed this out. It’s an extremely capital intensive business. They tie up a lot of working capital and they tie up a lot of capital and fixed assets in their factories and equipment. 

It’s not only capital intensive, but it’s very labor intensive. So it seems like every time the business begins to make money, the unions come in and want a piece of that pie. So it’s very difficult to make lasting profits in this business through the cycle. The other thing that I’ve noticed and I think you pointed this out of how good Marchionne is at Chrysler, but in general, it seems like the auto businesses are always so focused on defending their market share, and they’re so focused on the top line. 

I think a lot of it has to do with the culture. A lot of it has to do with just the nature of the business. I think when you plan to when you plan for SAR being at 17 million, then you have a certain amount of labor and a certain amount of production capacity at the moment and a certain… Your factories are running it at a certain till and you want to keep that going, and so you get this cycle where manufacturers are so focused on just running cars through the assembly line and sending them to the dealers and focused on the top line. Then, you get this discounting environment and prices coming down. So, it’s a very difficult business; ultra competitive. 

However, having said all that, it is interesting, and you pointed this out about what Pabrai said, but I actually heard an interview of maybe a month or two ago with him, and he talked about how he made a five-fold return on his Fiat investment. I had to go back and check because I was really shocked by that, that his returns are so high investing in such a mediocre or some might say a kind of a lousy business. 

Ferrari spinoff was a big part of that, but it is interesting to look at cyclicals, and I don’t really look at a lot of cyclical stocks, but I think there is is a case to be made for investing in these types of stocks when you know times are really bad when conditions are terrible. Peter Lynch used to say this that you know, when times are bad you want to buy…You want to buy cyclicals when times are bad and earnings are low, and thus the P/E ratio is actually high. 

One of the things that makes me a little nervous about the car companies right now is we’re at or maybe not quite there, but just past the peak of the cycle potentially, but we’re near the peak and car companies are still running on near record profits and P/E ratios are mid-single digits. So my concern is where we are in that cycle and what the earning power looks like 3 or 4 years from now.

Preston Pysh  48:47  

John, I think you hit the nail on the head. Going back to Hari’s original question, what was Mohnish seeing that made him pounce on this at the exact right time. He was looking at this Peter Lynch idea of if you’re going to invest in a cyclical, find the absolute best company in that field run by fantastic management that has the best financials that’s being punished because it’s going through this cyclical change, and everyone hates it and buy it at that at that moment. When you look at when he would have done this, that’s exactly what he was doing.

John Huber  49:22  

I think Marchionne wrote a report called, I think was called Confessions of a Capital Junkie, I may be getting the name of that wrong, but he basically wrote a paper. It was interesting because it showed me that he was cognizant of the natural problems or the nature of his business, which is a very capital intensive business, and companies produce low returns on capital. 

His basic argument was we need scale, so we can get together and share designs, and maybe cut some of the workforce; share some of the R&D expenses and so forth. So his argument was bulking up. What’s interesting is they’re kind of going the opposite route and so I’ve been wondering, as I read some of the parts, I saw an article or paper, I think last week, talking about the Jeep valuation. 

The argument was the same with Ferrari, when they spun it off. That’s worked out tremendously well for Ferrari shareholders and Chrysler shareholders, but it seems like they’re shrinking as opposed to bulking up and consolidating, which is what Marchionne’s original desire was.

Stig Brodersen  50:31  

Yeah, it’s a really good point, John, and as most shareholders, I really like to see the company grow and prosper. But as an investor, I also think what is the best financial result here? It might be to string because it really depends on the price, not to bring in another sports metaphor, but it’s sort of the same thing if you sell your star player. Is that a good deal? 

Well, it depends on the variety of factors and one of the most important ones, that’s the price. So can it be sold for more than its value? It might be so that even though it was not the intention, the best return you can get as an investor might be from seeing that crisis string and thereby getting your return in the forms of special dividends or in shares in the new spin off companies. 

Alright guys, that wraps up the first part of the Mastermind discussion. Stay tuned for next week’s episode of The Investor’s Podcast, where we will discuss the stock picks that Preston and Hari brought to the group.

Outro  51:30  

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