When I read investment message boards, I can tell that investors are about to make bad investment decisions when they abandon traditional measurements of value and instead suspend disbelief by focusing on esoteric business metric. This is nothing especially out of the ordinary–there are always areas of the economy vulnerable to either excessive greed or excessive fear that temporarily persuade intelligent, hard-working men to depart with their money on a whim.
Those thoughts come to my mind when I read articles touting investments in Tesla Motors. There are many things to like about Tesla the company. The Roadster and Model S recapture some of that sexiness in American car design by harking back to the era when Americans actually based part of their identity on the cars they drove.
It is impressive that Tesla has been able to commercially produce an EPA-compliant electric vehicle that can travel 236 miles on a single charge. The Model S, introduced in June 2012, can cover a bit more ground–almost 300 miles. I think a critical mass will be reached once Tesla’s electric charge can last 700-800 miles on a single charge, providing the ability to make cross-country travel possible without the need to find a charging station.
But the appeal of a cool-looking car that charges itself has enticed so many investors that appreciate Tesla’s story that the price of the stock no longer has any connection to the fundamentals.
Some people aren’t aware that Tesla isn’t even a profitable enterprise. Since 2008, it has lost between $82 million and $396 million every year. The company has regularly issued its stock to avoid overleveraging its $2.6 billion in required debt payments, and this has been a smart move (when the stock is overvalued, the borrowing power through debt issuance because the cash received is worth more than the pricey ownership interest that gets diluted).
The downside, however, is that the earnings per share will be slow to advance when the company eventually returns to profitability because there will be an expended share count. Tesla had 90 million shares outstanding in 2008, and now has 120 million shares outstanding. That’s a 33% handicap that needs to be made up to restore the status quo. Just because Tesla is borrowing intelligently does not mean that it comes without shareholder consequences down the road.
I would expect Tesla to continue borrowing at a rate between $500 million and $1 billion per year (either through balance sheet debt or share issuance) because the Model S is sold for $71,000 but actually costs Tesla $75,000 to make each one.
There are many different levels of investing skill. The beginner level of stock-picking is about recognizing that not all household names necessarily make great investments. For instance, Alcoa may be a billion-dollar aluminum company, but it is one of the worst assets you could possibly hold for a 40+ year holding period among large-cap companies. Everyone has heard of Ford cars, but you wouldn’t want to tuck Ford into a blue-chip portfolio and forget about it: Over the past 25 years, your reward would have only been 4.75% annual compounding.
The intermediate stage of investing is about thoroughly understanding the “why” aspect of what makes certain companies great long-term holdings, and then exercising the discipline to figure out the right valuation for the company.
When I study Tesla, I see a company that flunks both tests. It doesn’t even pass the test of companies that make great investments, as car companies turn toward losses during recessions and the boom times of the good years does not create enough of a countervailing force to justify enduring the cyclical nature of the industry.
Look at Jeremy Siegel’s data on the auto industry. Over almost every twenty-year rolling period, the best auto companies deliver 7% annual returns and the industry average is around 5.5%. Plus, a sizable minority actually experience bankruptcy or negative annual compounding. This is not waiting for the fat pitch to swing–it’s entering an industry where you start the at-bat with an 0-2 count.
And secondly, there is the question of valuation. Right now, Tesla is valued at $32.5 billion. That is a crazy valuation for a company that has never been profitable. The highest analyst estimates call for $600 million in profits in 2020. By then, the share count will be higher, so the earnings per share won’t move up as much as you think. But even if that somehow were not the case, the current valuation amounts to 50x the high projection of earnings five years from now. That is not investing–that is hoping someone comes down the road acting even more irrational is willing to pay a higher price for the stock.
Tesla traded at $15 per share in 2010. Now, it is at $250. People point to the 35% annual revenue growth to justify the valuation. The problem is that the revenues have been able to grow because Tesla is taking losses on every car it makes. It has actually been the beneficiary of a recovering economy for almost the entirety of its publicly traded life, and the company still hasn’t been able to turn a profit. What will happen during a deep recession when the pool of available customers shrink?
Cool companies don’t always make good investments. The backdrop of the auto industry alone should give every investor pause before making a long-term investment (car companies can be intelligent three to five year investments if you are anticipating economic recoveries, but they are almost never suitable candidates for buy and forget it holdings). The excitement surrounding Tesla has driven the valuation to a level that is over 50x the high-end estimates of expected profits in 2020. People who claim the stock market is a casino are correct when they enter the world of speculation. When you pay $32.5 billion for a slice of ownership for a company that is losing $300 million per year and never been profitable, you are taking a spin of the Roulette Wheel.