Stocks and Shares

Prancing investors pile into Ferrari

There’s no doubt that Ferrari makes fine and fast cars, of both the racing and road going varieties. Owning a Ferrari is almost a rite of passage for those that want to show that they’ve made it in life. But it’s not just Ferrari owners that are rich. Ferrari stock was listed on the New York stock exchange this week with a distinctly rich valuation. Is this iconic Italian company really worth it, or have investors been blinkered by the brand?

Ferrari’s company logo is a prancing horse. It’s cars are most usually bright red. They’re fast, luxurious and no doubt exciting to drive. Ferrari’s ever successful Formula 1 racing team adds to the glamour surrounding the brand. It’s also a source of cutting edge research into new technology that finds its way into the road cars.

Even Ferrari’s brand new ticker code used to identify it on the New York Stock Exchange expresses energy. Ferrari stock trades under the code “RACE”.

Classic Ferraris sell for millions of dollars – sometimes tens of millions. New ones sell for hundreds of thousands of dollars. Little boys around the world hang posters of Ferraris on their bedroom walls, play with toy Ferraris, and yearn to own a real one when they grow up (or at least when they grow bigger).

So there is no doubt that Ferrari has an aura of excitement around its products and its brand. In fact the brand punches well above its weight given the size of the business. It’s recognised throughout the world.

It’s far too easy for investors to get carried away by famous brands that they recognise, and then overpay to invest in those companies’ shares.

But that doesn’t mean that Ferrari stock is necessarily a good investment. Just like any company, what it’s worth comes down to profits and growth prospects. It’s far too easy for investors to get carried away by famous brands that they recognise, and then overpay to invest in those companies’ shares.

This seems to be the case with Ferrari. Fiat Chrysler Automobiles (NYSE:FCAU) sold 10% of the company to investors this week in an initial public offering, bringing its own holding down to 80% (the other 10% is owned by a descendent of the company founder).

Shares were listed at a price of US$52, which was at the top of the indicated price range. That shows there was plenty of demand from investors.

At the time of writing the price has risen 11% to US$57.88, which gives the company a market capitalisation of $10.7 billion (total company value at current share price).

This is where the problems start. Last year the company made a net profit of 261 million euros, or US$294 million at the current exchange rate. This means the company trades with a price-to-earnings ratio (P/E) of 36 times last year’s profit after tax.

That’s a rich valuation by any yardstick. But it wouldn’t matter if Ferrari was a hugely profitable and fast growing company. Unfortunately neither of those is the case.

Let’s look first at profitability. For this we’ll look at return on equity, which is how much profit is made on a company’s net assets (assets less liabilities).

Ferrari’s return on equity is a modest 10.2%. That puts it between Renault’s 10.6% and Nissan Motor’s 10.1% – both purveyors of far less glamourous products. It’s also way behind BMW’s 14% and Daimler’s 16.5% (Daimler makes Mercedes).

In other words Ferrari isn’t especially profitable for its sector. In fact in a list of 13 car companies that I put together it ranks 10th for return on equity, and is 21% below the average for the group. Yet, despite this, the stock’s P/E is a massive 175% higher than the average 13.2 for the group.

So much for profitability. Perhaps there is massive growth potential that explains this rich valuation? Unfortunately the news is bad there as well.

Profits have been lumpy in recent years. Measured in euros they were up 7% in 2013 and a further 8% in 2014. But measured in US dollars they were up 12% in 2013 and then actually fell 5% in 2014, due to fluctuating exchange rates.

It’s a similar story for the first two quarters of this year. Q1 was up 18% in euros but down 5% in US dollars. Q2 was up 4% in euros but down a massive 15% in dollars.

To justify a P/E in the mid-30s you’d want to see consistent double digit earnings growth and great prospects for it to continue in future. I can’t see that at Ferrari.

One of the major issues for investors is that Ferrari limits production volumes to retain exclusivity. In 2014 it produced just 7,255 cars, which is a drop in the ocean compared with the 120,000 cars produced by Porsche.

There’s talk of increasing to 10,000 cars, but that’s still tiny. And even with that increase it doesn’t justify the huge P/E premium.

But if production numbers are limited then so are profits. You can’t sell more of what you don’t make.

Certainly there’s no shortage of wealthy people to buy these cars in this new gilded age of wealth disparities. Fancy sports cars are mere trinkets for the owners of mega-yachts and private jets. But if production numbers are limited then so are profits. You can’t sell more of what you don’t make.

To me this looks like a classic case of investors getting swept up by the hype surrounding a famous brand, without thinking about the fundamentals of the business behind it.

All investors should remember that brands are there to sell products. You should resist the temptation to let them influence your investment decisions.

Like horses, which are prone to skittishness and unpredictability, there will always be prancing investors around. You should resist the temptation to copy their behaviour.

Fiat Chrysler has done well to sell part of its stake in Ferrari at such a rich price. But the new investors should beware. Sooner or later this over priced stock is likely to turn into a car crash.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.