The most crowded names in the market

If the last few months has reinforced anything, it is that the market can remain irrational for a very long time. Despite already being expensive, the disparity between the cheapest and most expensive has widened even further in recent months.

It strikes me that the longer interest rates remain low, the more concentrated on the winners everyone’s bets become.

Consequently, the companies doing well keep doing better and the gap between the best and worst widens. What history tells us however is that the gap itself is cyclical and will converge again. How? A correction usually delivers very low variance of returns. The difference between the best and worst narrows. It will be the same this time around.

By way of example, take a look at CSL. A conservative assessment of its current business – assuming a mature business and little in the way of price increases puts it on a valuation of, say $35 billion. Given the market is willing to pay another $70 billion on top – that’s two more CSLs – for the whole company today, suggests hope has caused prices to disengage from reality even for very high-quality businesses.

Since 2010, and including estimates for 2019 and 2020, CSL has generated total free cash flow of about US$9.7 billion. Yet it trades at US$67 billion. Meanwhile Rio Tinto will have earned approximately $63.4 billion over the same period and it trades at US$80 billion.

Further down the market capitalization spectrum, the story is similar. Currently ‘the market’ (aka investors) is willing to pay $31 billion for a portfolio that owns 100 per cent of A2 Milk, Afterpay Touch, Xero, Wisetech Global, Altium and Appen. All of these companies are attracting investors who believe in the idea that the global roll out of their platforms will be uninterrupted and unassailable – it never is.

To put that $31 billion market capitalization in perspective, the combined revenue of this portfolio of companies is just less than $2 billion and the combined net profit is just $240 million. In other words these companies are trading on a market capitalization of 129 times earnings. Oh, and by the way, of that $240 million profit A2M is responsible for $185 million of it. That means the portfolio without A2M is trading on almost 490 times earnings!

Seriously?

Overseas the story is not much different. Have a look at Tesla. Tesla is valued by the market at US$50 billion ($69 billion). Its founder has attracted a generation of investors who now believe that by transforming a car’s drive train from petrol to electric will somehow also transform the economics of making, delivering and servicing cars.

This can be seen in the market capitalisation of the company compared to the number of cars it delivered. In the most recent four quarters Tesla delivered about 127,000 cars, which puts the company on a market capitalisation of US$394,000 per car delivered.

How different is that to other manufacturers who, by the way, are also spending big on delivering electrification? Well, luxury brands like Mercedes owner Daimler and its rival BMW sit on a market capitalisation of less than US$30,000 per car sold. Further down the list General Motors sits on a market capitalisation of just US$5,000 per car delivered.

In all markets conditions there will be some value available. But when more money is being concentrated in the hands of fewer and fewer names we must keep a close eye on how heady the prices of those names are becoming. As I mentioned earlier, when a correction happens they will likely take everything with them.