A common news item this week is that Elon Musk now has a higher net worth than Warren Buffett as a result of Tesla’s meteoric stock price rise from $177 last year to $1,500 now. Setting aside the fact that Buffett has donated tens of billions of dollars to charity that explains the disparity, I think now is an important time to discuss what I call “the foundations of wealth.”
When you own an asset of any kind, there are two components to the investment’s value. There is the productive capacity of an investment (i.e. profits and the portion that can be distributed as dividends) and then there is the future capacity of an investment (i.e. guesses about what types of productive capacity the investment will have in the future that manifests itself in the price of the asset).
Current productive capacity of an investment is always the most stable foundation of wealth because the value is constantly manifesting itself. If you own the Beatles musical catalog, and you are receiving $0.10 on average around the world every time the song is played at a rate of 7,000,000 compensable instances per year, that is $700,000 that you receive regardless of what any one else in the world thinks that your ownership is worth.
In contrast, there is the future capacity component of earnings. If you expect that the Beatles’ catalog will generate $100,000,000 over the next fifty years, you might value the catalog at $10 million today. If you expect $50,000,000 over the next fifty years, you might value it at $5 million. This portion of value is equally real but far more unstable because a slight shift in the calculation of future value has a ripple effect through time. Conversely, when expectations brighten, prices rise accordingly.
In most instances, the foundations of your wealth are on sturdier ground if you own an entity making $1 million in profits is valued at $10,000,000 compared to if you own an entity earning $50,000 in profits valued at $10.95 million. The reason is that the latter foundation requires someone else in the marketplace to value your entity at 219x earnings or your profits need to be growing much faster than your peers for your foundation to hold up over the time.
In the case of Tesla, I think the stock is so overvalued that there is no real foundation underlying the basis for the wealth. If you own $100,000 in Tesla stock, it is very different than owning $100,000 in Berkshire Hathaway stock. For the Berkshire shareholder, the $100,000 represents $6,700 in annual profits from over 112 subsidiaries and 30 common stocks in leading enterprises along with approximately $25,000 in cash in the bank. For someone with Tesla stock, the foundation for the $100,000 is much flimsier. It is currently losing money, but even if it were earning the industry average 5.8% profits on its $26 billion in revenue, it would be a $289 billion company trading at 190x earnings. And those earnings are hypothetical under a scenario that imputes a profit margin where none currently exists. With the sole exception of Amazon, the world is not kind to companies that trade at that type of P/E ratio with a market cap in the billions of dollars.
In the 1990s, the major lesson was that stock prices without an underlying foundation of real profits can get you in trouble very quickly. The average Californian with over $100,000 in stock-market investments lost 41% of their wealth between 1998 and 2002. Wealth built upon high valuations can disappear very quickly because a swing from high valuation to low valuation can mean more than half of your net worth in certain circumstances.
Right now, stocks like Tesla, Beyond Meat, and certain internet-based videoconferencing firms are having their “moments” where the valuations are north of 100x earnings. That just can’t be a siren call for you. It is hard to say when, but a moment will come when rationality returns.
As Warren Buffett once said: “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
It is remarkable that, now of all times, this lesson requires application. But momentum is a powerful force. Various studies have shown that people make 401(k) investments based upon funds with the highest recent returns. A rising stock price, for one reason or another, can feed its own momentum for a time as others buy it simply for the reason that it has been going up. But if you buy stocks that are not backed by earnings, you will often lose money. In contrast, if you buy stocks that are backed by earnings, you will rarely lose money. Go through life aligning yourself with the best presumptions and you’ll be the House that, on balance, wins.