Weekly Update (09-19 – 09-26): Is Nvidia Expensive?

Hi all –

We hope your September is going well! We wanted to send out an update on what we are seeing in markets entering the final few months of the year.

• Far be it from me to determine what the appropriate price is for a stock whose fate largely relies on its future execution.

• However, what negative market pundits seem to be fixated upon is not Nvidia’s competitive advantages (which are many), nor the probability that they live up to their expectations.

• Most negative arguments against Nvidia rely heavily on NVDA’s price-to-earnings “Multiple” vs other stocks in the market.

• I have long been puzzled by the approach of comparing one stock’s multiple to another stock’s. Even more puzzling than this, is to compare any one stock’s multiple to the broader market.

• It is well known that stocks have unique competitive advantages, and can trade at “discounts” or “premiums” to the broader market. Such discounts and premiums are under no mandate to revert back to the market level. In fact, high quality companies such as Microsoft have been known to continuously increase their earnings and cash flow multiples as they go through many iterations of reinventing themselves into broader, more robust and creative businesses with much larger end-markets. Such companies have multiples that we are yet to see “mean revert.” We would further argue that most of the folks who make this simplistic argument of multiple mean-reversion work for “value funds” or companies whose results are highly cyclical, never reaching new highs and sometimes reaching new lows. Such companies are primed for mean-reversion. Many of the magnificent 7 companies are innovative enough that they do not follow the “value company” mean reversion dictated by economic cycles.

• In general, we would observe that the primary impediment to companies’ success is not their competitors, but their own management teams who may be inferior, or self-serving in various capacities. When viewed from this standpoint, it may be more useful to evaluate the market as the professional golf league. Each golfer’s primary adversary is their own mental state, and they are constantly striving to beat their own “best score.” It makes more sense likewise for companies to focus on their own products, strengths, and weaknesses, rather than obsess over what their competitors may or may not be doing (because frankly they may not have any idea.)

• A more useful mental exercise is to compare a stock’s current multiple of value to its prior multiple. From this perspective, Nvidia is trading close to as cheap as it has been in the last five years, based on the price to free cash flow multiple.

• This is in spite of the fact that Nvidia’s sales recently jumped 50% in a single quarter, and their net margins are at their third highest level of all-time (with gross margins at their all-time highs of 77%). Sticking with the golf example, this would be like Rory McIlroy at the top of his game, getting his best scores ever, but having the media lambast him and expect him to be some kind of spectacular failure (simply due to his recent and ongoing success.)

• While we have observed that most in the media and I would venture to say most professional money managers, even those of hundred billion dollar firms, often cite price to equity frequently as the pertinent measure of value, if we simply run a statistical horse race between price to earnings vs price to free cash flow, over the last 20 years, rebalanced monthly, we will see that price to free cash flow trounces price to earnings by over 500 basis points per year.

• All of these points are not meant to provide commentary on whether or not we believe Nvidia is expensive or cheap, it is to say that according to the game we play, which is to kick out or exclude the weakest companies in the index, we would observe that 80-90% of companies in the market seem to have fundamentals that would suggest they are weaker or more vulnerable than Nvidia, so they are the companies who, from a risk-management perspective, we focus most on.