Mar 22 2021 - Why Is Tesla Stock Dropping?

Summary

  • After hitting an all-time high of a little over 0, Tesla stock has shifted into reverse, sliding to ~5 as of my writing this article.
  • Last year, market participants drove up the price of Tesla in order to get billion of price-insensitive index funds to buy their shares back from them.
  • Warren Buffett and Charlie Munger warned in 1999 about how index funds could increasingly be gamed in this fashion as they grew.
  • How long-term investors should think about Tesla's valuation and price history.
Tesla office building Photo by Sundry Photography/iStock Editorial via Getty Images

Tesla, Inc. (TSLA) is the quintessential cult stock. Eccentric-genius-billionaire founder? Check. Convoluted accounting? Check. Die-hard fan base? Check. Elon Musk, who recently changed his official title to "Technoking," and Zach Kirkhorn, his CFO/Master of Coin, managed to guide TSLA to (slight) profitability in 2020 and look to do the same for 2021. This is being helped in no small part by their audacious decision to invest .5 billion of shareholder money in Bitcoin (BTC-USD). However TSLA stock has recently started to fall after briefly hitting an all-time high of over 0, which has some shareholders nervous. I think they have good cause. In order to decipher what's going on at Tesla, you have to understand a little about the business, macroeconomics, and Wall Street in general. From there, you're free to make your own decisions about the stock.

Tesla Stock Price

Here's TSLA's price history for the last year.

Chart Data by YCharts

Tesla was up 10x since the lockdowns started but now has started to reverse. The most obvious question is why? There are some catalysts I could point to, such as short-selling constraints, TSLA stock being a popular destination for stimulus checks, the stock split in August, and retail speculation in general. From looking at academic research, however, one catalyst really sticks out to me, which is the inclusion in the S&P 500 index. Index funds are designed for simplicity. They buy and hold the stocks in their index, and that's all there is to it. However, one issue with index funds is that they have to add and delete stocks periodically, which creates an opportunity for Wall Street to front-run them by buying the stocks that will be added to the index and selling the stocks that will be deleted ahead of the index funds. The most widely quoted estimate of how much this costs investors is about 0.28 percent per year-or roughly 3 percent of the overall return of the S&P 500. I think this is too high and the financial industry and government ought to do something to stop it. I won't hold my breath. What's interesting is that this amount isn't constant, but rather fluctuates widely based on the amount of speculation that occurs in the market. For example, in the late 1990s, the amount that front-running cost the S&P 500 was about 3x higher than its long-run average. Under reasonable assumptions, the higher the percentage of total assets there are in index funds and the higher the amount of speculation is in the market, the worse the front running will be. In Tesla's case, these combined to form the perfect storm, with S&P 500 index investors the likely victim.

Why is Tesla Stock Dropping?

In my opinion, market participants drove up the price of TSLA stock in 2020 because they knew they could get S&P 500 index funds to pay any price they asked. The higher they drove the price, the more the index funds were forced to buy. In this, they found the ultimate "greater fool," meaning a buyer that would not only buy at any price but would buy proportionally more the higher the price went. Tesla finally joined the S&P on December 21 at nearly twice the price it traded for a few months earlier. As index funds began to buy in their required amounts, the stock continued to rise, topping out in late January with concurrent speculation that Tesla would invest in Bitcoin. In all, index funds were forced to buy over $80 billion in Tesla stock, the largest single addition to the S&P 500 index in history.

Market commentators immediately drew parallels to the December 1999 inclusion of Yahoo in the S&P 500 index. The Yahoo inclusion was one of the biggest single-stock wealth transfers in history when the index was made to buy Yahoo stock at dramatically higher prices than were natural due to the same situation occurring.

38513626-16163747449556606.png

Source: Business Insider

Back in 1999, hedge funds drove the price of Yahoo up in anticipation of the S&P 500 inclusion. A year later, Yahoo's valuation had plummeted and Wall Street laughed all the way to the bank. 2000 would mark the costliest year ever for the S&P 500 for index front running. Warren Buffett and Charlie Munger addressed this very problem at their 1999 annual shareholder meeting.

If indexation grows, say to 15 percent of the money, they're going to have to come up with some kind of solution... Or it will simply get too disruptive to the market.

-Warren Buffett, at the 1999 Berkshire Hathaway shareholder meeting.

With index funds now having nearly 50 percent of the financial market share for the US, Buffett's thoughts were prescient. Since the move in Tesla stock cannot be explained effectively by a change in business fundamentals, chicanery is the most likely explanation. As index funds continue to grow and an increasing amount of investors believe that financial statements are irrelevant, this represents both a problem for the American public and an opportunity for smart and patient investors.

Should You Buy The Dip in Tesla?

I personally wouldn't, but will dive a little into Tesla's fundamentals. To understand what is going on in Tesla, you really need to understand what Tesla is and isn't.

First, what Tesla isn't:

1. Heavily shorted. Tesla was once among the most heavily shorted stocks on the NASDAQ. In 2018 Elon Musk famously mailed a pair of short shorts to New York hedge funds who had shorted his stock. The story goes that he also mailed shorts to the Securities and Exchange Commission.

Musk later sold short shorts on Tesla's website for his favorite price of .420 (if you don't get the reference, ask my readers in the comments-I'm sure they'll tell you). Today, Tesla's short interest is less than 6 percent, according to the Seeking Alpha dashboard. Some of this is likely related to convertible arbitrage with Tesla's debt, meaning that the true short interest is lower. ~6 percent short interest is above average, but by no means is an abnormal amount of short interest, as the 99th percentile for short interest usually corresponds to a level of 20 percent of shares outstanding or higher. The institutional appetite for betting against Tesla is simply not there anymore. Short sellers in Tesla have long ago thrown in the towel.

2. At risk of bankruptcy in the near future. The main reason that Tesla was so heavily shorted in the past is that they were in danger of running out of cash. After the surge in Tesla's share price, Tesla has raised so much capital at such a low cost that liquidity simply isn't an issue anymore.

And here's what Tesla is:

1. A low-margin, capital expenditure heavy business. There are simple, beautiful businesses in the world that are hard to screw up. These kinds of businesses require little to no capital to operate, and often as a result have no need to be publicly traded. Tesla is the opposite-their margins are low, their fixed costs and labor requirements are high, and to keep up with the competition requires them to invest billions in capital expenditures like new factories. This makes Tesla a risky business, and this is the reason that most automakers have gone eventually gone bankrupt at one point or another. If you look at Tesla's cash flow statement, their capex is almost always higher than their depreciation and amortization, which generally indicates aggressive accounting, aggressive business strategy, or both in the case of Tesla. Another interesting point is that Tesla made more profit on Bitcoin than they made in net income in the trailing 12 months, which shows how hard it is to make a buck as an automaker.

2. A world leader in innovation. Tesla isn't the most profitable business in the world, but Elon Musk is an engineering genius who a big part of moving the automotive industry forward from internal combustion engines to electric motors. This means that Tesla is likely to have a high valuation compared to its earnings based on pure popularity. The problem with this is that Tesla doesn't exactly have a monopoly on electric vehicles. Automakers have successfully adapted to new technology over time, such as automatic transmissions and power steering. While Tesla is currently leading electric vehicle sales in the United States, they're going to need to spend a ton of money to maintain this advantage in market share.

3. Overvalued based on business fundamentals. When Tesla reports earnings, they always report their non-GAAP earnings in the press release. This way they can exclude Elon Musk's compensation from earnings, among other things. Tesla makes a little money, but not much. Any way you slice it, Tesla trades for more than 100x their projected 2022 earnings. In my affluent corner of Texas, Tesla's are a dime a dozen, so it's not like we're dealing with an early-stage company. Tesla is a huge company, and its valuation is even more massive than its earnings, or even earnings potential based on reasonable estimates for the next few years. Over the long run, stock returns really do converge with business fundamentals, which account for 95 percent of long-run equity returns. Tesla's earlier valuations were supported by the plausible, since late 2019, this is no longer true. This is the point that effectively supersedes all the other points. The below graph shows business performance vs changes in PE ratios.

38513626-1616371695834254.png

Source: The Journal of Portfolio Management

In the long run, there's a 95 percent correlation between the success of an underlying business and the cash flows therein and stock performance. I've made money trading Tesla in the past but the valuation makes no sense to me. When I owned Tesla in 2014 and 2015, you didn't have to jump through as many logical hoops to justify the valuation, and honestly, after a 10x runup without corresponding success at the underlying business, this is an easy stock for me to avoid. I wouldn't buy the dip here.

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