Mispriced Expectations And Price-Value Arbitrage: Ford, GM, And Tata Motors

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 |  Includes: F, GM, TTM
by: Shiv Kapoor

Do you, like Fama, believe that markets are efficient? Or do you lean towards Shiller's view that markets are inefficient? Or do you believe both? Can it be that the market is both efficient and inefficient? Markets are forward looking. Markets are in a constant state of flux. Markets are chaotic. Are markets are in a constant state of disequilibrium in the journey towards equilibrium? Do inefficient markets tend to efficiency? And if yes, how can we follow the path to efficiency, or the journey to equilibrium? And does what holds true for a market also hold true for a single stock?

A believer in efficient markets believes that the price reflects everything, and by everything, I mean everything known; i.e. expectations. For large well established and well followed stocks, obtaining expectations data from sources such as Reuters is relatively easy. And once we value those expectations, we can compare the value with price. If the value is below the price, a buy decision is indicated, because in time, in an efficient market, price will tend to value. However, a follower of efficient markets will believe that price leads expectations. Thus if the price is higher than the value, it is not because expectations are mispriced, but because expectations will change.

In large well established and well followed stocks, dramatic shifts in expectation are less likely. And so when price does depart from value, it is likely that the exuberance or despair of the investor community is driving prices away from the value and thus creating an opportunity.

Expectations change with the passage of time and with changes in the economic cycle. And analyst focus is normally on the trailing twelve months, the current year and the forward year. To address this, if you elect to adopt a time arbitrage strategy, you can elect to value expectations which are likely to occur in a time period beyond this typical horizon. You can follow the links to read a couple of posts on time arbitrage strategy for Transocean (NYSE:RIG) and ArcellorMittal (NYSE:MT) A time arbitrage strategy is designed to outperform over the long-term and is suitable for those who are not fearful of underperforming over the shorter term.

But if you seek to follow a more traditional price/value arbitrage strategy, you can seek out opportunity where expectations are mispriced. Using such a strategy, the aim is to outperform over the long-term, through smaller levels of outperformance continually through the short-term. Because expectations change, there is a constant need to revalue constantly changing expectations and prices. And alter your capital allocation as these prices and expectations change. In my book U.S. Dow & Mega-cap Investment Strategy: Value Hidden In Plain Sight: Volume 1, I try to find a happy medium. Because both stock selection and capital allocation play a huge role in generating long-term returns, I do this by including a couple of stocks selected based on a time arbitrage strategy in the Global Leaders selection, but allocate capital based on the valuation of expectations.

This post is not about a time arbitrage strategy. Nor is it about my book! I recently read a post about Tata Motors (NYSE:TTM) pondering why Tata Motors was cheap relative to General Motors (NYSE:GM) and Ford (NYSE:F). I liked the post, and as a person with a long position in Tata Motors on the Indian Stock Exchange, I decided to value expectations for the three companies to see which one had the best price/value arbitrage opportunity. That is what this post is really about.

Approach to Determination of the Value Target

People buy and sell stocks, stocks make up the market, and the market itself exists in perpetuity. The owners of the market, be they you or another, will receive dividends, buybacks & real growth of dividend & buyback distributions in perpetuity. That is it, nothing else - your only return is from current and future corporate distributions. Thus what shareholders can expect to receive by way of returns is the dividend yield, the buyback yield plus real future growth, that, and that alone is what must be valued.

Thus the key areas I am looking at are beta, dividend, return on equity, earnings growth expectations and consensus average earnings estimates for the year-ending 12/31/14. Based on these criteria, I calculate a potential pay-out potential, which is then discounted to arrive at a value target. The pay-out potential is simply 1 minus the re-investment rate. The re-investment rate is the growth rate dividend by return on equity. If a person has a return on equity of 18.23%, to grow by 8%, they would need to re-invest 43.88% of earnings: if a company earns $100, and re-invests $43.88 (instead of distributing it to shareholders), for a return of 18.23%, they would increase earnings by $8. The remaining 56.12% could be distributed to shareholders.

As far as earnings growth expectations are concerned, I am skeptical about analyst projections when the company being evaluated is a large-capitalization company, operating in a mature and competitive market. The long-term means different things to different folks outside of the current and forward year expectations: more often than not the long-term expectations expressed are less predictions and more hope. In addition, growth estimates are provided by very few analysts, while earnings estimates are provided by many. And so earnings growth estimates cannot be said to reflect market expectations. Thus I prefer to use a macro expectation in lieu of a company specific expectation.

If a company operating in a highly competitive and largely commoditized market enjoys exceptionally high growth, it will not be long before the competition lowers the growth rate for the company, while the industry as a whole maintains its long-term growth rates. For the automotive industry, I feel a long term growth expectation of 8% being 4.2% real global growth potential plus 3.8% global inflation is reasonable to expect. Just to be clear, growth expectations would be important for a company like Tesla (NASDAQ:TSLA): they have that something special that differentiates them from the market, thus allowing them to grow at a faster rate. But in this post, we are not looking at valuing Tesla.

As far as return on equity is concerned, capital structure can have an enormous impact on return on equity. A highly leveraged company can have a very high, but volatile return on equity. In addition, a company can have a low return on equity just after a major acquisition simply because its book value if far higher than tangible book value, which would have been book value absent an acquisition. An exceptionally high return on equity for a company operating in a highly competitive and largely commoditized market would be competed away before long, absent something special allowing a company to retain the advantage - I do not believe Tata Motors, Ford or General Motors has that special something. Besides, what is of interest to me is the return on equity which can be generated from each additional $ re-invested in operating assets to drive growth: this expectation is best reflected by expectations at industry, not company level. Thus I prefer using the average non-cash return on equity [(Net Income - Interest income from cash) / (Book value of equity - Cash and Marketable securities) of 18.23% for the automotive industry.

Ford

Reuters records a beta of 2.19, a dividend of $0.48 (yield at share price of $16.68 is 2.87%), a return on equity of 29.07%, consensus average earnings estimates for the year ended 12/31/2014 of $1.48, and a long term growth rate of 11.67% for Ford.

Using the recent 3% rate on the ten-year US Government bonds as the risk free rate and the very long-term market return of 9%, investors in a stock with a beta of 2.19 should require a long-term return of 16.14% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})]. The present value of $1.48, growing at an annualized rate of 8%, with a return on equity of 18.23%, a pay-out potential of 56.12%, and a required rate of return of 16.14%, is $11.02. This is calculated as Earnings multiplied by Pay-out Potential multiplied by (1+ Growth Rate) Divided by (Required Rate of Return minus Growth Rate).

The current share price is $16.68. With the value at $11.02 it would appear that there is no price/value arbitrage buy opportunity.

This is not to say Ford is not a buy, though in my view it is not. It simply says Ford is not a mispriced expectations price/value arbitrage opportunity. If you did the research and estimated a long-term earnings growth rate of 13.5%, and were proven right, then the share would be priced to deliver long-term returns of 16.14% annualized over the long-term at $16.51. You would generate alpha because you challenged the efficient capital markets hypothesis, and won.

Alternatively, if you felt Ford had repaired and restructured under Mulally sufficiently for its beta to contract to the industry average of 1.7 over the coming years, then at $17.25 it would be poised to deliver a long-term return of 13.2%. Yes it's a lower return compared with 16.14%, but your return requirements will be lower because of the lower beta indicating less risk. Again buying on such an expectation is not a mispriced expectations price/value arbitrage opportunity, it is departing from expectations and challenging and winning versus the efficient market hypothesis to create alpha.

General Motors

Reuters records a dividend of $1.20 (yield at share price of $36.84 is 3.11%), a return on equity of 12.48%, and a consensus average earnings estimates for the year ended 12/31/2014 of $4.46, and a long term growth rate of 16.04% for General Motors. No beta is recorded because the company has not been operational for over five years. Therefore, I am using 1.68 as beta - this is the three-year regression beta.

Using the recent 3% rate on the ten-year US Government bonds as the risk free rate and the very long-term market return of 9%, investors in a stock with a beta of 1.68 should require a long-term return of 13.08% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})]. The present value of $4.46, growing at an annualized rate of 8%, with a return on equity of 18.23%, a pay-out potential of 56.12%, and a required rate of return of 13.08%, is $53.21. This is calculated as Earnings multiplied by Pay-out Potential multiplied by (1+ Growth Rate) Divided by (Required Rate of Return minus Growth Rate).

The current share price is $38.60. With the value at $53.21 it would appear that there is a strong price/value arbitrage buy opportunity.

Tata Motors

Reuters records a beta of 2.5, a dividend of $0.15 (yield at share price of $30.29 is 0.5%), a return on equity of 22.68%, consensus average earnings estimates for the year ended 3/31/2015 of $3.38, and a long term growth rate of 25% for Tata Motors. The problem here is that Tata Motors estimates are provided by only four analysts, and that is too small a number to consider the estimates as representative of market expectations.

And so I turned to Reuters India site. On the Reuters India site, I will ignore the beta because the 1.68 beta reported relates the regression versus Indian markets. Since I am comparing the stock with General Motors and Ford, the 2.5 beta as reported on the Reuters US site is most appropriate. The dividend and return on equity are consistent with those reported on the Reuters US site. The consensus average earnings estimate from forty-nine analysts for the year ended 3/31/2015 is Rs 50.36 per share. Since five shares are equivalent to an ADR, the estimate per ADR is Rs 251.80 per share, or $4.09 per ADR based on present exchange rates ($1=Rs 61.60). The growth rate indicated on the India site is 20.87%, but these are not relevant because I am adopting a macro based expectation of 8% for the automotive industry.

Using the recent 3% rate on the ten-year US Government bonds as the risk free rate and the very long-term market return of 9%, investors in a stock with a beta of 2.5 should require a long-term return of 18% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})]. The present value of $3.38, growing at an annualized rate of 8%, with a return on equity of 18.23%, a pay-out potential of 56.12%, and a required rate of return of 13.08%, is $24.77. This is calculated as Earnings multiplied by Pay-out Potential multiplied by (1+ Growth Rate) Divided by (Required Rate of Return minus Growth Rate).

The current share price is $30.29. With the value at $24.77 it would appear that there is a no price/value arbitrage buy opportunity.

This is not to say Tata Motors is not a buy, in my view it is. It simply says Tata Motors is not a mispriced expectations price/value arbitrage opportunity. If you did the research and estimated a long-term $ earnings growth rate of 16.5%, and were proven right, then the share would be priced to deliver long term returns of 18% annualized over the long-term at $30.13. You would generate alpha because you challenged the efficient capital markets hypothesis, and won. India, where Tata Motors has a large presence, is a growth market, the past five years sales at Tata Motors have grown at 39.47%, while earnings have grown at 25.38%. Present forward five-year growth expectations are at 20.87%. Assuming the Rs depreciates at a 4.37% annualized rate, the $ growth rate would be 16.5%. The 4.37% annualized depreciation is conservative, it could be far lower. I mentioned in a previous post "Between 1991 and now, the Rs has depreciated at an annualized rate of 3.8% and the annualized depreciation rate since 2003 has been 2.3%.".

In conclusion:

General Motors has a clear price/value arbitrage buy opportunity. It is possible that the price has remained below the value, due to the government rescue and stake in the company for the past several years. The overhang and fear of an exit by a substantial shareholder (the government) hurting price will also have acted to suppress prices. Now that taint is removed: perhaps General Motors will commence a slow march towards its value. But it might not. The very substantial ownership of General Motors stock by the Union ( UAW ), might offend the capitalist classes, and stop the price from reaching for value. I say cut them such slack: perhaps a sensible outcome on irrational executive compensation, offset by treating labor fairly can work together and create a solution which will not harm owner interests.

Ford Motor is certainly not a buy, and most likely a sell opportunity, especially when you compare balance sheet quality with General Motors or Tata Motors. It is not a short opportunity.

Tata Motors is not a price/value arbitrage buy opportunity, but it is a buy opportunity based on superior growth prospects. A buyer in India could consider buying Tata Motors Differential Voting Rights (NYSE:DVR) instead of the common stock. The DVR's have full economic rights, but lower level of voting rights, together with a right to slightly higher dividends: and let's be honest, retail investors voting rights amount to nothing! The holders of Tata Motors DVR shares can cast one vote for every 10 DVR's held, and they receive a dividend 5% higher than what ordinary shareholders receive. And the share price of the DVR trades at a discount of 48% to the ordinary shares: thus the yield doubles and there is gain potential if the discount to the ordinary share narrows.

Disclosure: I am long TTM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Tata Motors ordinary shares listed in India