If you had put a gun to my head a few months ago and asked me, “Long or short Tesla?” I’d have said “Short.” Today, I’d ask you to read my in-depth analysis on Tesla as a stock. (You can get the complete write-up here or email at tesla-article@contrarianedge.com).
After reading my Tesla opus, some have painted me as an enthusiastic bull on Tesla TSLA, +6.45% stock, some as a bear, and some as an undecided observer. Although I am an enthusiastic Tesla Model 3 owner, I can see both sides of the argument for and against investing in Tesla. This makes me neither bull nor bear, but someone who can map distinctly different paths for both Tesla the company and Tesla the stock.
Neither my investment firm nor I own Tesla shares. Why? Because Tesla stock violates the Fourth Commandment of Value Investing: It doesn’t have any margin of safety. (Here are the Six Commandments of Value Investing.) Also, Tesla, despite many positives, does not meet the threshold of a high-quality company (at least not at this stage).
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Let me explain. Unlike internal-combustion-engine (ICE) car producers, Tesla is vertically integrated; accordingly it is not just a designer, assembler and marketer of cars, it also manufactures most of the parts (including the battery and self-driving CPU) that go into its cars, and it owns the retail stores that sell Tesla vehicles. (Unlike ICE carmakers, it doesn’t wholesale cars to dealerships.) This path, though potentially more rewarding and maybe even necessary, is both difficult and risky.
This business model creates high fixed-costs and so requires a higher escape velocity (number of cars produced) to reach profitability. To make things more difficult, Tesla is still young for a car company, and excellence in car production comes from iteration. Tesla’s production techniques are still improving.
Tesla is losing money and has a lot of debt. The WeWork debacle has reminded investors that when financial markets are infatuated, they can throw billions of dollars at a company. But the second they sense fear and desperation, they go from valuing a company at $47 billion, as was the case with WeWork, to … well, we still don’t know if WeWork, which is losing billions of dollars a year, can raise equity without diluting its existing shareholders into the dust.
You don’t need to have a great imagination to see a future in which Tesla needs to raise a few billion dollars of capital. By that point its cash will be gone, and debt investors alarmed by nearly $15 billion of debt and unending losses will refuse to lend. Equity investors, exhausted by promises made but not kept, will punish the company with a valuation that will make the capital raised incredibly dilutive, thus basically impairing anyone who bought shares of Tesla at current prices.
There is also a scenario where the company is down on its luck with financial markets, the stock price has fallen to, let’s say, $50; Tesla’s market capitalization is down to around $10 billion (to pick a nice round number); and an ICE car company or a Silicon Valley neighbor buys it. From today’s price that would result in a 75% permanent loss of capital.
Then there is the scenario where Tesla achieves escape velocity, turns profitable, and starts minting money. At this point Tesla’s success will again depend not only on its own prowess but on the strength of its competitors. As I discuss in my previous Tesla articles, it is not a foregone conclusion that every ICE automaker will successfully transition to become a profitable EV maker.
The recent GM GM, +1.29% worker strike is an example of the pain ICE automakers face in changing workers’ skillset from designing and manufacturing engines to designing software. Check out this interesting documentary describing the struggle German ICE manufacturers are facing in the transition to EVs. As much as they want to welcome EVs – after all, Germany is trying desperately to switch to wind and solar — Germany is having a hard time embracing the disruption that change will bring to its population (including massive layoffs) and the expenditures that will come with it.
If some ICE auto makers fail to transition to the EV domain, this may open a door for Tesla to grab market share. There are 80 million cars bought globally every year — 17 million of them in the U.S. Can Tesla produce 5 million cars a year? At $40,000 per car and with a 20% operating margin, that is $8,000 profit per car. You can do the math. Tesla could start making $10-, $20-, $40 billion dollars in profits. The stock price might go up to, I don’t know, let’s say $1,000.
Now let’s come back to the muddy, slippery real world, where, I have to confess, I have absolutely no idea what probabilities to assign to Tesla stock. As long as Tesla is losing money, it is at the mercy of financial markets; and so we find ourselves in the murky world of complex systems, which requires a small detour.
Think of a complex system as a pot of soup that is prepared by one of those fancy French chefs with a big mustache and a toque, who proudly uses dozens of ingredients (most of which you cannot pronounce) in everything he cooks. Even if you identified, properly pronounced, and tasted each ingredient separately, you’d still have no idea what that soup would taste like.
Financial markets are just like this pot of soup except that they are supersized by an infinite number of random variables coming from different directions, ranging from politics and presidential tweets to Mother Nature. Even if you have made a lot of prescient predictions, something invariably comes along that makes all of your predictions worthless.
Most cash-generative companies can withstand significant trepidation in the financial markets because their dependence on them is highly tangential (they may need to refinance their debt only once every few years). Tesla’s ability to pay its bills (once it chews through its cash) is dependent on multiple factors we cannot foresee. Therefore, in real life, assigning probabilities to Tesla’s success or failure is much more difficult than with the discrete probabilities you get with a coin toss.
Accordingly, at its current price Tesla is worse than a casino gamble, because aside from the highly suspect estimate of Tesla’s upside and downside, we have a hard time assessing our chances with this stock.
If Tesla shares plunge to $50, then in my highly hypothetical scenarios, the best-case offers 20x upside (from $50 to $1,000), while there is zero downside at $50. At that price you really don’t have to have brilliant insight into what lies ahead for Tesla.
Tribal investing wars
I know others have strong opinions — positive or negative, bullish or bearish — about Tesla the company, Tesla the stock, and its CEO Elon Musk. Humans, after all, are tribal. Our tribalism goes back to the age of cavemen. Deep in the cave, armed with rocks and sticks, fending off predators, we found comfort that the people around us (our tribe) shared the same animosity toward the lion at the front door.
Tribalism makes complete sense when it comes to family — you want to know that someone will always have your back, no matter what. Even in the workplace, if used strategically, tribalism can unite and motivate employees to create a better product than the competition (the other tribes).
But in investing, tribalism is dangerous to your wealth. When you allow tribalism to impact your thinking, you lose the ability to think independently.
If you own Tesla stock and are in the bull cave, you feel like you are surrounded by Tesla bears who are attacking you. You stick close to your tribe of bulls. You are looking for your views to be constantly confirmed by the braying of your tribe. And they will be. You’ll only hear bullish talking points. Your fellow tribesmen will withhold contradictory evidence and put a positive spin on any negative news.
The same applies for Tesla bears. It is amazing to see how the same Tesla news can be interpreted diametrically oppositely by these tribes. Tesla releases its latest production numbers. The bulls: “Production numbers are screaming to new highs!” The bears: “Sales of the Model 3 may be up, but sales of the profitable, high-margin S and X models are down.” It’s not like unlike watching MSNBC and Fox News analyzing the same news from the White House.
Tribes by definition have an “Us vs. Them” mentality. But here’s the punchline: There is no “them” in investing. It doesn’t matter if you think a stock will go up or down, or you’re convinced that people who hold a different view are your enemy.
What bulls and bears think and do will only temporarily impact the stock price. In the end, only fundamentals matter – the company’s earnings power and, ultimately, the valuation investors are willing to pay for it. The Roman philosopher Seneca said, “Time discovers the truth.” He was not talking about stocks, but he could have been.
The fundamentals of a stock are the “truth.” In our research we make a proactive effort not to avoid being part of either the bull- or bear tribe. If you are truly trying to be a truth seeker, you need to have an open mind – something you won’t be able to have if you are a permanent resident of an insular camp. When we are analyzing a company we are considering buying (we don’t short), we seek out bearish arguments from bears who have done their own primary research. Bears’ words won’t harm us.
We don’t take their views as a personal insult but as a gift that can help us discover the truth. If the bears show us a hole in our otherwise bullish thesis, I’ll change my mind — I won’t buy the stock, and I may even sell it if I own it. I will thank them — they spared me the pain that would have come when time discovered the fundamentals.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which holds no positions in any of the companies mentioned in this article. He is the author of “Active Value Investing” (Wiley) and “The Little Book of Sideways Markets” (Wiley)
More about Tesla: This article is a conclusion to Katsenelson’s 37-page Tesla and EV industry analysis. (You can get complete analysis as an email series, PDF, EPUB or Kindle ebook here or email at tesla-article@contrarianedge.com, or you can listen to it as an audio book; Part 1 here & Part 2 here).
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Also read: How does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.