Do S&P 500 Investors Really Want To Buy Tesla Now?

Michael CannivetContributor Markets

LIGHTROCKET VIA GETTY IMAGES

When Tesla TSLA +2% joins the S&P 500 next month, it will be the biggest debut ever in the world’s most important stock index. Traders are expecting huge volume on December 18, the final day before Tesla is added. Many are also frontrunning the move.

Tesla shares are up 600% year-to-date and over 50% this month.

The electric car company pulled ahead of Berkshire Hathaway’s BRK.B -0.7% valuation on Friday, making Tesla the sixth largest publicly traded U.S. company with a market capitalization of 5 billion.

Tesla founder, Elon Musk, just leapfrogged Bill Gates to become the second richest person in the world. Musk’s net worth has risen over 0 billion in 2020 alone.

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Wealth accumulation at this rate is hard to fathom, because it’s never happened before.

It’s also hard to identify any particular fundamental trigger for Tesla’s epic gains in November. The company didn’t announce blowout earnings. Nor has the company announced any major new products.

The extraordinary rally this month can be traced to one important development. The S&P committee announced their intention to add Tesla to the S&P 500 on November 16.

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Source: Bloomberg 

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S&P 500 investors: Are you sure you want to buy Tesla now?

The Value of S&P 500 Membership

The value of a spot in the S&P 500 varies based on each company’s weight in the index. In Tesla’s case, Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, estimates inclusion will generate about billion worth of new demand for shares. This analysis presumes that passive fund heavyweights like Vanguard and Fidelity will be forced to add Tesla to their widely owned S&P 500 tracking ETFs.

There must be more to the story, though, because the numbers still don’t add up. Silverblatt’s estimated inflows are billion, yet Tesla’s market value has increased by over 7 billion since S&P’s announcement.

Clearly, there is a lot of speculation taking place and it isn’t the first time.

Revisiting the Tech Bubble

In 1999, Yahoo surged 64% in the five trading days between the announcement it would be added to the S&P 500 on Nov. 30 and its inclusion after the close of trading on Dec. 7. Certain nimble traders must have profited nicely from that move.

One group that didn’t prosper, though, was S&P 500 indexers. They got plugged buying in at too rich of a price, which ruined their long-term return. Yahoo! was eventually bought by Verizon VZ +0.3% in 2017 at a valuation approximately 75% lower than where shares traded the day it was announced the company would join the S&P 500 (2.75).

Source: Bloomberg. 

SILVERLIGHT ASSET MANAGEMENT, LLC

There has been a lot of talk comparing this market climate to the Tech Bubble era.

Here is how the CEO of Sun Microsystems described the valuation of his company’s stock in 2002.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.

Now, having done that, would any of you like to buy my stock at ? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?’

- Scott McNealy, Sun Microsystems CEO, Business Week

Tesla trades at a Price-to-Sales ratio almost double where McNealy’s stock was at its pinnacle.

Sun Microsystems’s stock peaked at before descending to single digits.

Not many CEOs are as candid as McNealy in acknowledging the hazards of investor euphoria. It’s a timely lesson, because financial conditions are even looser now than they were back then.

Tesla Valuation Concerns

Maybe Tesla is a car company, maybe it’s a battery company, maybe it’s a magnificent PR company. Whatever it is, it sure looks overvalued. 

Of all the valuation metrics out there, Enterprise Value (EV)-to-Sales is one of the most clean-cut and straightforward. On May 1, Elon Musk himself tweeted he thought Tesla was overvalued. Back then, Tesla was trading at 6x sales. Today, the multiple exceeds 18 times sales. Has Tesla become three times better of a company in just six months?

Elon Musk tweeted that Tesla's stock price was too high in May when the company traded at about 6 ... [+]

 SILVERLIGHT ASSET MANAGEMENT, LLC

Another way of looking at the valuation setup: Tesla is now worth more than the entire S&P 500 Energy sector.

Source: Bloomberg

 SILVERLIGHT ASSET MANAGEMENT, LLC

It’s no secret fossil fuel companies face challenges. And everyone knows the future will likely see more electric cars on the road. That transition will not happen overnight. But then again, passive investors buy only according to market prices, not fundamentals.

Measuring Profits

The reason Tesla is not already in the S&P 500 has to do with the fact the company was not profitable until recently. Profitability is part of the criteria for admission.

Now that Tesla has reported five consecutive quarters of positive net earnings, that variable is no longer a roadblock. “We believe the sustained profitability trajectory as evidenced in the September quarter was the final straw that got Musk & Co. into the S&P 500 this time around,” Wedbush Securities analyst Daniel Ives wrote in a recent note.

For some reason, S&P overlooks the fact that Tesla trades at a trailing P/E ratio of 928, and a forward P/E of 252, both of which are well above the long-term average P/E for the S&P 500 of around 17.

For some reason, it doesn’t matter whether Tesla earns one dollar of net profit or a billion dollars of net profit. Profitability is viewed through a simplistic prism akin to a pass fail exam.

S&P 500 investors: Does that seem rational?

Modern Market Structure

To pretend that there is anything logical about adding Tesla to millions more portfolios now defies common sense. 

Normally, it is not wise to chase a stock after a monster rally. There’s even a name for this sort of misbehavior: ‘heat-chasing’. Yet, the mother of all heat chasing trades is about to take place when Tesla formally joins the S&P 500 on December 21st.

In 2020, market structure dynamics are overriding fundamentals. Nowhere is that more evident than in Tesla shares. Depending how you look at it, Tesla may be the hardest or easiest stock in the world to fade right now.

So, one last time, I’ll ask the question: S&P 500 investors, are you sure you want to buy Tesla now?

Disclosures:

1) I went short Tesla for the first time on Friday.

2) Despite my valuation concerns related to the stock, I am actually a fan of Tesla as a company and its founder, for reasons I outlined in this piece a couple years ago.