By Vitaliy Katsenelson
Many of us played this game when we were kids: You say a number; your friend tries to demonstrate his knowledge by saying a bigger number. At some point you proudly get to infinity — the largest number of all. Your friend doesn’t blink; he says, “Infinity times a hundred,” then he thinks for a second and spouts out, “Infinity times infinity!”
How do you beat that? When assets get overvalued and get into crazy territory, explaining their overvaluation feels like playing this “infinity times infinity” game. But at least, if we line up different crazy valuations next to each other, it is going to be easier to distinguish levels of craziness.
Let’s start with the least crazy of all the crazies — bond-substitute type stocks. In this example I’ll focus on Coca-Cola /zigman2/quotes/209159848/composite KO -0.46% , but I could single out almost any consumer goods company — such as Kimberly-Clark /zigman2/quotes/201766540/composite KMB +0.47% , McCormick /zigman2/quotes/206739653/composite MKC +0.05% , WD-40 /zigman2/quotes/204555241/composite WDFC -0.11% , and many others that pay a stable dividend.
Coca-Cola is truly an incredible business: the company makes a concentrate and ships it to bottlers, who put in the hard capital, bottle that syrup, and distribute it to every corner of the world. Coke, in concert with its bottlers, has the best distribution system in the world.
Since bottlers do all the heavy lifting, this business earns a very high return on capital. Coke is one of the most beloved brands in the world (unless you are a Pepsi person). This company has experienced incredible growth over the past century. However, unless Coke gets penguins at the South Pole to consume its fine bubbly, it has run out of new markets to sell into. This is exactly what has happened to Coke since 2010 — revenues and earnings have stagnated. If you look at the financials, only two things have grown: the stock dividend (due to an increased dividend payout) and the company’s debt — which has tripled.
Coke is a high-quality company — it can raise prices along with inflation on its namesake product, which represents about half of its revenue. It may struggle to do so on other, more commoditized parts of its product portfolio, but nobody questions whether Coca-Cola will be around in 10- or 20 years. Most importantly, investors are convinced Coke will continue to manufacture its 2.6% dividend until the end of time. They are so focused on the the dividend that they are ignoring how much they are paying for this income stream: Mr. Market will let you have Coke today at 30 times earnings.
But what happens to Coke’s stock price when interest rates go up? Coke’s 2.6% “infinite” dividend will not be so shiny if U.S. interest rates climb a few percentage points. If the 10-year Treasury /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.45% is yielding 5%, Coke’s dividend will lose its luster and the stock will decline to a valuation multiple with a “1” in front of it.
Today, many Coke shareholders are experiencing what behavioral economists call “empathy gap.” They tell themselves, “I am fine even if the stock declines 30%–50%. I will stick with getting my 2.6% dividend, which will rise with inflation.” However, when the stock price declines and safe alternatives offer double that yield, they’ll change their thinking — thus the gap.
Side note: Dividends don’t need to be a shiny object that lead you to eventual financial ruin if/when interest rates rise. Just change the sequence of your analysis. Here is what we do at IMA in dividend portfolios : We identify the universe of stocks in the U.S. and other countries that pay stable dividends, but only the ones that are both high-quality and undervalued end up in the portfolio.
Coke is just a lightweight on the crazy spectrum. The degree of crazy will increase with each example, culminating with smelly, hot air, I promise.
The next one is Tesla /zigman2/quotes/203558040/composite TSLA -6.63% . I’ve spilled a lot of ink on this company. I even wrote a series of essays that I turned into a small book ( you can get it here ). I love my Model 3. Almost three years after I bought it, I still enjoy driving it, and I am not even a “car guy.” My wife is about to get a Tesla. I like a lot of things about the company.
But the stock is a very different matter. An important lesson that many tech investors learned after the bursting of the dot-com bubble in 1999 and the dot-com bubble in 2021 is that there is a difference between a good company with great products and a good stock. The connection between the two is valuation. The price you pay determines your future return. Price did not matter when valuations were rising, but it will when they aren’t.
Tesla arguably has the best electric vehicle on the market. Customers love its products. This is no small thing. Unlike the Detroit Three, the German Three, and the Asian Five, which spend tens of billions of dollars on advertising, Tesla has zero advertising budget. Hundreds of thousands of its fanatically loyal customers are its marketing force. Most car companies don’t have that type of goodwill. These billions of dollars of savings Tesla can put into more R&D or lower prices or higher profitability.
But Tesla has a market capitalization of $1 trillion — roughly equivalent to what the whole rest of the global auto industry is worth. When Tesla’s market value was at half a trillion dollars, I described its valuation as “ discounting a temporal wormhole into the future .” Today it is priced at double infinity.
Let’s move on to the next level of crazy. GameStop /zigman2/quotes/203755179/composite GME +4.33% is in the hands of self-described “apes” that are standing for the little man against what they see as a corrupt system, and are willing to blow themselves up financially while propping up the prices of worthless companies. GameStop is a retailer of packaged games while the world is moving to digital downloads — a tsunami that is going to wash away this brick-and-mortar retailer. At its peak in 2016 the company made $400 million of profit. Its revenue has declined by half since and it is now losing money. These apes currently are giving this dying relic an $8 billion market cap. Its valuation is at almost an all-time high, when its financial situation is at an all-time low. Imagine you won an $8 billion lottery. Would you invest it in an imminently melting, money-losing ice cube whose revenues will eventually dwindle to zero?
GameStop makes Tesla look like a value investment. At least Tesla is a company of the future. Of course, there is another “ape” stock – AMC Entertainment Holdings /zigman2/quotes/200235402/composite AMC +18.86% , the movie theater chain. AMC has often lost money throughout its existence; before the pandemic it made $110 million. Its revenues are down by two-thirds since then, while its share count is up 4x and debt is up 5x. You can acquire this darling outright for just under $10 billion, and it comes with $10 billion of debt. At least GameStop has a net cash balance sheet.