Not Using the “U” Word
While we will resist the urge to use the “U” word* to describe 2020, we can’t help but look back and think about how events that might have normally taken years to unfold happened in just one. Whether it was the economic contraction from the Covid-19 pandemic, lockdowns, a waterfall decline in the stock market, staggering job losses, policymakers’ early response with size and speed, a huge rally in the stock market, a fledgling economic recovery, revolutionary vaccine development, not one but three waves of (and continuing) viral spread … We think it would be a mild understatement to ask for a calmer 2021.
*The “U” word in this case is “unprecedented”
The Tale of Mr. Market: An Excerpt from Berkshire Hathaway’s 1987 Letter to Shareholders
Given the price action of the market in 2020, a parable created by the famed Benjamin Graham and made famous by one of his most notable pupils (and friends), Warren Buffet, describes how to best handle market fluctuations:
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.”
From where we sit, broad stock market indices have experienced both the depressed and euphoric sides of Mr. Market in 2020. And beneath the market indices, the individual stocks that make an index individually can each experience the extremes of Mr. Market as Graham – via Buffet – explains. Below, we want to focus on one that we sense is on the euphoric end of the scale: Tesla.
Trucking Through the Tulip Fields in a Tesla
History is littered with examples of certain assets making a parabolic move, going vertical and bringing forward decades of positive price movement into a noticeably short period of time. We wonder whether we are witnessing another such episode with Tesla, a well-known and widely followed common stock. With the addition of Tesla to the S&P 500, we can’t help but recall other episodes where bubbles took place, where historically – after looking back at them – seemed to not make sense (more on that soon).
Tesla does not make money on an operating basis selling cars. Its ability to attain some recent net profitability relies solely on selling carbon credits, a below the line item, akin to selling assets to make up for an operating loss. And financing? The company has sold $12 billion worth of stock this year. When we studied corporate finance, equity financing was (and still is) the most expensive versus debt, which is tax deductible.
Does the future of vehicle propulsion include electric? Absolutely. So why are we pointing out Tesla stock? Or, more interestingly, why are people so interested in the stock? We can’t say for sure; however, it’s much more likely when you have something that has captured people’s imagination, where average people can participate (think Robinhood trading app), where average people are talking about it (and, in some cases, how much money they’ve made on the stock) and, perhaps most importantly, a sense that it will last forever.
We can’t help but recall the “Tulip Mania” in Holland, circa 1630.
“Many individuals suddenly became rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clotheswomen, dabbled in tulips …”
Let’s examine Tesla through the lens of its primary business, passenger car manufacturing, and compare and contrast it with other passenger car manufacturers. This list includes: Ford, Toyota, GM, Volkswagen and Honda. The comparison will use easy to gather information, such as current market cap (company’s valuation) and trailing twelve months (TTM) revenues. While a company’s earnings are the bottom line, we selected revenues for the comparison as there are few places to hide when using the top line sales figure. Tesla’s market cap as of this writing was $834.2 billion, with their revenue at $28.2 billion (TTM). As a comparison, the combined market cap of Ford, Toyota, GM, Volkswagen and Honda totals up to $464 billion, with $835 billion of revenue (TTM). Graphical representations are below**:
As a quick summation reveals, stock investors have pushed Tesla’s value well beyond the combined value of Ford, Toyota, GM, Volkswagen and Honda, despite having a fraction of the revenue. Telsa would need to grow its revenue 3,000% to match the combined revenue of the five other car companies, which equates to growing at 25% per year until 2037.
Captured people’s imagination: check. People can participate: check. A sense that it will last forever: check. Tesla appears to us to be like a modern-day tulip bulb.
** Market Cap for Ford, Toyota, GM, Volkswagen and Honda (all billions): $35.8, $213.7, $61.6, $104.2 and $48.7, respectively. Revenue (TTM) for Ford, Toyota, GM, Volkswagen and Honda (all billions): $130.9, $241.2, $115.8, $227.2 and $120.4, respectively.
Data source: YCharts, Inc.
After a Very Long Winter, Value Pokes its Head Out
Our preference is for investments that exhibit more favorable valuation characteristics and companies that are shareholder-friendly in terms of paying dividends and reducing share count. These companies as a group are known as “Value” stocks and, for the past decade, have lagged their “Growth” counterparts – one of which is Tesla – by a significant margin. It has been a very long winter for Value investors but we have been encouraged by something that happened on November 9, 2020: the day Pfizer announced the results of the Phase 3 Covid-19 vaccine trial. On that day, Value outperformed Growth by the most significant margin on record. (See NDR chart below.) Other episodes of significant Value outperformance of Growth were in 1999, 2000 and 2001. Interestingly, that was the last time when you had examples of companies similar to Tesla in the marketplace. Valuations don’t matter until they do and, perhaps, Mr. Market is beginning to agree with us on that.