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Tesla's entry into the S&P 500 has garnered strong investor interest. As an active manager, Stu Kedwell, Co-Head, North American Equities, shares how his team considers high profile stocks. He looks at various growth scenarios for Tesla, and talks about what a bear or bull case could look like. [9 minutes, 24 seconds] (Recorded December 8, 2020)


Hello and welcome to the Download. I’m your host, Dave Richardson, and look at this, it’s Stu Kedwell actually on Tuesday. So Stu’s day is back. Stu, welcome.

Hi, Dave. Thanks for having me.

Look at this! Not only can you trust Stu to manage money really effectively, he’s managing his calendar now and so am I. So we’re back in synch Stu.

Back on Tuesdays. I like it.

Back on Stu’s days! OK, so what I want to talk to you about today, I’ve got a few questions from people I’ve been talking to. They saw Tesla; high profile stock, obviously an incredible performance and an even better story, Elon Musk, electric vehicles, batter-ies, all of the things around Tesla, etc. And it was recently added to the S&P 500. You and your team manage several mandates that invest in large US companies. But you’re an active manager. So given what you’re trying to accomplish for investors who invest in your fund mandates, what do you do when a big, expensive, high-profile stock all of a sudden gets dumped into an index? What do you do as an active manager?

It’s a great question. We do the same thing with any candidate that might be up for consideration in the funds. Now, it is part of the mandate, but just because it’s part of the mandate doesn’t mean it has to be owned. And then the second thing you do is look at a wide variety of scenarios that might sit in front of Tesla. Tesla has really been a very strong stock. We’ll see over time whether the weight of expectations arrives relative to its current share price, but you would run a bear case, which would involve a lot of com-petitive activity around electric cars and a more narrow usage of the electric batteries. And then you would have a bull case that would have a target market well beyond just automobiles and the use of electric batteries, the Tesla batteries and a whole wide varie-ty of end markets. So, you know, it is a fairly challenging investment because the range of outcomes is extremely wide. So you have to take some note of that. But then the sec-ond thing you can also do is look at the valuation that you have to accept. And business like this would be very hard to value on earnings, even at the best of times, because there aren’t any. So you’d be looking at the price to sales ratio that you have to pay for Tesla at the get go, which right now is around 19 or 20 times its forward sales. And you’d be trying to say, well, what’s required to make this a successful investment over a long period of time? And over a long period of time, you would need many years of very strong growth and you would need very wide margins off that revenue that would arrive a number of years down the road. And that’s what it would take to make Tesla a success-ful investment. So, just to put it in perspective, when Google went public, it began around the mid 20s times sales. And it’s one of the few companies that compounded its revenue by greater than 30% for 10 years; not every year within that 10 years, but cer-tainly over the time span. And with its margins, even though it went public at 25 times sales, within 5 or 6 years of going public it was down to 6 or 7 times sales. It did that by growing into it. Then for the next 10 years, it’s really traded between 5 and 8 times sales and still delivered quite strong returns to shareholders. So for a company like Tesla, you would need to see that type of growth and then you would need to see Google-like mar-gins; Google is unbelievably cash generative. And the other thing that might differenti-ate it versus some investments is that Google is not very capital intensive. Once the search engine is built, you really get the benefits of that over time. Tesla, being mostly a car company, every two or three years, you’re going to have to refresh the models. It’s going to be quite competitive and we’ll see how that entirely pans out in terms of what margins the business has and how much capital is required to execute on that growth plan. So, there’ll be a lot of things that come into play. At any given point in time, there is always a scenario that makes a stock quite successful and there’s always a scenario that makes it quite a poor investment. And we have to weigh the odds as to whether or not we think that’s in our favour. In a shorter-term standpoint — and we’ve talked about this before —, if you’re not going to buy and hold something for a very long period of time, then you need a different toolkit to go at that investment. And a momentum-oriented toolkit that some growth investors might use would focus you very much on the near-term indicators and the rate of change in those indicators. And what you might see in the stock market is that you could have very strong growth, but it might be declin-ing at the margin. By that I mean your business that grows at 30% one year, 25% the next, and then 20% in the third year, that would be quite good growth for any business, but that might be a disappointment to the stock market. So in the very short term, when you’re looking at some of these names, you have to focus on the key metrics and really focus on are they accelerating or decelerating? And that would be a toolkit that people might use in the short term. But there’s no question that Tesla has benefited from a lot of enthusiasm around electric vehicles and batteries in the future. That has driven it to the S&P 500 selection committee and after two attempts, finally getting an addition.

So you kick the tires, but you don’t necessarily buy it or avoid it. It’s how it fits into the overall portfolio and whether it makes sense with the methodology that you use to select any investment that you might put into the portfolio.

Yes, we really like to have the odds in our favour over a very long period of time. When we think about making investment decisions, we know that we’re going to shoot for a healthy batting average on our success rate over time. Any investor knows he’s not going to be right 100% of the time. But we think about the S&P 500 compounding our investors capital at 7 to 9% over a very long period of time. And embedded in that 7 to 9% are all sorts of different investments that we have to evaluate. But the most im-portant thing is that we compound the capital as best we can over a very long period of time. And that’s where the investment process has been quite helpful at that historically.

Yes, and just to be really clear, I’m using Tesla as an example of a high profile company that was recently added to a major index that many funds would use as a benchmark. We’re not recommending Tesla. We’re not saying don’t buy Tesla. That’s up to every individual investor. We’re just using it in this example to highlight the thinking behind a professional investor and how they would go about making that evaluation as to whether or not they’d included in their portfolio now or in the future. So, please, this is not a buy recommendation or a sell recommendation on Tesla. It’s just how do you think about it in the in the context of a broader portfolio.

One hundred percent and the great thing about the S&P 500 is that the selection committee alone has identified 500 pretty good businesses. There’s not a lot of crap in the S&P 500. So, Tesla gets added, but sitting beside it is Apple, Microsoft and PayPal, and a bunch of health care businesses and all sorts of businesses that have done a very good job at compounding their share prices over long periods of time. So there’s a lot of ways to bake a cake when it comes to the S&P 500. And we think our process is pretty helpful in that regard.

Yes, it’s tough to beat, but you’ve had a pretty good run against it. So, again, that’s why I wanted to get your thinking on an interesting topic. So Stu’s days are back. We’ll see you next Tuesday, Stu. Thanks a lot.

Thanks for having me, Dave.


Recorded: December 8, 2020

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