Finding Value In a Frothy Market

There are values in any market.

At times like this, they’re just hard to find.

We’re in the “hard zone” today as the stock market bounces near all-time highs, and FOMO (fear of missing out) has hit everything from AI stocks to meme coins.

I’m seeing fewer opportunities today than I have in years, even in companies I like long-term. The business matters, but as a buyer, so does the price I pay.

But some values do exist.

There’s one simple way to know if a stock is a great value for long-term investors. Is management aggressively buying back shares or not? If they are, it’s time to pay attention, and I’ll give two great examples of using buybacks as a weapon against an undervalued stock.

The Dangers of High Valuations

Let’s start on the bubbly side.

Stocks that get the most attention in the media are often those going up and to the right. However, the coverage often overlooks valuation in favor of covering momentum. When the momentum fades, coverage slows, and no one covers the falling stock.

Look at the price-to-sales ratio of three popular stocks today: NVIDIA, Tesla, and Palantir. NVIDIA and Palantir both trade for over 30x sales, and while their businesses may be doing well, that price puts a lot of downside risk on the table for investors.

For perspective, in 1999, Microsoft’s valuation peaked at $615 billion, which was 31x sales. Despite growing revenue to $92 billion by 2014, the stock lost money from 1999 to 2014.

Tesla looks cheap among this group, but consider that General Motors trades for 0.36x sales and is growing faster and making more profit than Tesla at a 30x higher multiple.

But as frothy as some valuations look, there are still values in the market. And managers who see their stocks as undervalued are looking at these valuations as an opportunity to juice the upside when valuations normalize.

Case Study: How Apple Used Buybacks as a Weapon

The CEO of a company with an undervalued stock only has a few options to goose the stock price. They can change the narrative and hope the market bites, or they can take matters into their own hands.

Buying back stock with excess cash at low valuations can be a way to boost returns when the market sentiment changes. Consider Apple as a great example. From 2014 to 2016, the stock was trading for 10x-12x earnings (not sales, but earnings). Management got aggressive buying back shares, reducing the share count by 5% annually between fiscal 2015 and fiscal 2018.

The impact on Apple’s stock was fewer shares outstanding when the multiple shot higher late in the decade. This is simple math.

P/E = Price per share divided by Earnings per share

Or when you cancel out the “per share” part, you get:

P/E = Market Cap / Net Income

What buybacks do is essentially reduce the market capitalization of a company by the size of the buyback.

The market can adapt by normalizing the P/E multiple, raising the stock price, or the multiple falls even lower.

If a stock is undervalued and management uses cash to buy back stock, it’s a weapon against the low valuation. It is one of the only weapons management has at its disposal.

If the P/E multiple then expands, as it did with Apple, shares can skyrocket higher, as evidenced by Apple’s 715% return despite just a 76% increase in earnings.

Buybacks and multiple expansion multiply to magnify investors’ returns.

The Asymmetric Opportunity From Buybacks Today

The overlooked stocks on the market today have an opportunity to buy shares back at a low price and benefit from multiple expansion if/when it comes. We are in 2015 Apple territory with these stocks.

I’ll start with General Motors, which is already up 61.4% since the spotlight article last year. In November 2023, when the P/E multiple of the stock was 4x, management initiated a $10 billion buyback program. They added another $6 billion in buybacks this year. The share count is already down 19% and will go under 1 billion shares outstanding early in 2025, about a 1/3 reduction in two years.

In the worst case, GM keeps buying back shares. However, the opportunity for multiple expansion is the autonomous driving program, Cruise. It hits the ground running next year and has a better cost structure than Waymo on the Chevy Bolt platform.

If Cruise is successful, the multiple will expand from the 0.36x sales we see today.

Another favorite of mine is MGM Resorts, which has bought back 34% of its shares since 2021. It has a solid cash flow business in a regulated environment and a very low valuation (price to FCF shown here).

And the stock is down 17% this year. What is management doing? Buying back even more shares!

The multiple may not expand this year, but we have online gaming growing and expanding into Brazil, and the MGM Osaka project is expected to open in 2030. That one resort could generate $4 billion in revenue per year and over $500 million in cash flow for MGM.

By then, shares outstanding could be down another 50%.

There are cheap stocks in this frothy market, and good managers are using their cash flow to buy back stock at a value. In time, that could provide leverage for asymmetric returns.

Disclaimer: Asymmetric Investing provides analysis and research but DOES NOT provide individual financial advice. Travis Hoium may have a position in some of the stocks mentioned. All content is for informational purposes only. Asymmetric Investing is not a registered investment, legal, or tax advisor or a broker/dealer. Trading any asset involves risk and could result in significant capital losses. Please, do your own research before acquiring stocks.