Tesla’s shares were up over 700% in 2020, driven in large part by its anticipated inclusion in the S&P 500 index. Its market capitalization now exceeds $800 billion, making it the fourth largest constituent in the S&P 500. To put things in perspective, Tesla produces about 5% as many cars as Toyota (the world’s second most valuable car company) yet commands a stock market valuation that is four times greater. Tesla’s valuation works out to about $1.6 million per car, compared to about $20,000 for Toyota. Investors are projecting that Tesla’s superior technology will eventually result in world leading production volumes and profit margins.
Some might argue that comparing Tesla to Toyota is unfair since Tesla is the leading EV manufacturer while Toyota mainly produces internal combustion engines (ICE). Maybe so, but Tesla’s market cap is also larger than the next 10 non-Chinese auto manufacturers combined. Importantly, these companies collectively produce about as many EV vehicles as Tesla, in addition to profitably producing tens of millions of ICE vehicles per year.
For Tesla to become the world’s leading auto manufacturer, Elon Musk will have to increase production at least 20x from current levels, and likely much more than that to justify its valuation. Doing so will require large ongoing investments in production facilities and equipment. Unlike many capital-light tech businesses, Tesla is anchored to some unattractive old-world economics: it needs cash and lots of it, and free cash flow isn’t yet being generated internally. At present time, Tesla enjoys a low cost of capital due to low interest rates and its high share price. But these advantages won’t necessarily persist indefinitely.
Some investors point out that Tesla’s car manufacturing is just one step of several in Musk’s master plan to decarbonize the world, and that critics are missing the big picture by focusing on cars. Tesla’s real opportunity, it is claimed, is in its growing energy production/storage technologies. And why not be optimistic about Musk’s capabilities given his incredible track record with PayPal, SpaceX and other ventures?
Whatever Tesla’s future may be, it is also fair to say that investors are pricing in extreme optimism while possibly ignoring many risks, such as increasing competition and changing market conditions. If some of the key variables supporting Tesla’s valuation are downgraded from extremely favourable to even very good, it could mean big trouble for investors.
Tesla is just one of many examples of the unrestrained enthusiasm for high growth in today’s equity markets. Growth indices advanced over 30% in 2020, compared to value indices which remained essentially flat. This caps off the worst 10-year underperformance of value in over a decade. This has resulted in valuation extremes, with a forward P/E of over 30x for growth stocks versus 15x for value stocks. This dynamic feels a lot like 1999 when old economy stocks, despite sound fundamentals, underperformed more exciting growth stories by a sizeable margin.
The pandemic has changed consumer behaviour; this combined with low interest rates justifies some of the valuation differential between growth and value. However, there is also plenty of evidence of rampant speculation in markets. As mentioned in our Q4 letter, we’ve reached IPO mania with a record number of initial public offerings in 2020, with many of these money-losing companies doubling (or more) on their first days of trading. The pandemic has given many people more discretionary time and money than they’ve ever had, with fewer opportunities for entertainment.
There have been a record number of retail investing accounts opened in the past year, and individual participation in markets has ballooned. On peak trading days, individual traders are estimated to account for nearly 25% of U.S. trading activity. Increased retail participation in markets has led to some truly bizarre behaviour. On January 7th, Elon Musk tweeted “Use Signal”, encouraging his followers to use the encrypted messaging service. In response, day traders piled into the completely unrelated company Signal Advance Inc., sending shares from $0.60 to an intraday high of $70.85.
As pandemic restrictions are lifted, the greatest threat to speculative areas of the market might not be a catastrophic event, but rather people finding better things to do with their time and money than speculating in markets.
