The late Stephen Ross, one of the titans of academic financial economics, observed that finance had a problem with regard to the stock market. The problem is not the inability to predict market movements. Finance theory implies that markets movements should be unpredictable because markets respond to new news and new news cannot be predictable or it would not be new. The problem is that after the fact, after looking at all the news that arrived, financial economists still have a terrible time understanding why the market moved as it did.
I thought of Professor Ross as I attempted to explain the jump in Tesla’s stock price in the two days following the company’s earnings announcement. Based on a positive, but not that positive, announcement, Tesla rose 17.7% on Thursday and 9.5% on Friday, for a total increase of 28.8%. Due to the run-up, the company added over $16.9 billion in market value and roared past General Motors in market capitalization. The question I asked myself is suppose I was given all the information that the market had at the close on Friday as of Wednesday afternoon, how much would I have predicted the stock price would rise? My answer was 3% to 5%, not the 28.8%. I was facing Prof. Ross’s conundrum.
What makes the massive Tesla run-up particularly confusing is that prior to the earnings announcement the company’s market capitalization was already $46 billion even though the company had never successfully earned a year-over-year profit. Clearly, the market was impounding the expectation that the company would turn profitable in the future and those profits would grow rapidly. That is the only way to rationalize a $46 billion dollar valuation for a money losing company.
What was the positive new news about the company? It was not revenue growth; usually what investors look to first as evidence of growth. Year-over-year revenue actually fell. The apparent big news was earnings. Tesla’s Q3 earnings per share came in at $1.86 beating a consensus estimate of a loss of $0.42 per share. The biggest contributor to the earnings surprise was a quarterly gross margin improvement of 4%. Automotive revenue fell so the improvement to margins came via cost cutting not increased prices. Tesla offered little detail regarding the nature of the cost reductions or on the role of “non-recurring items” that also contributed to the quarterly profit. In addition, it is worth noting that Tesla’s shares outstanding have been consistently rising from 125 million five years ago to 180 million shares today due to a combination of new issues and the exercise of employee stock options. In comparison, in the past five years Apple shares outstanding went from 6.5 billion to 4.6 billion due to share buybacks. This means that Tesla’s market capitalization has been rising even faster than the stock price.
We have seen this before with Tesla. The company reported its first ever profit in Q3 2016 starting a run up that would more than double the stock price in the next six months. What followed were renewed losses as Tesla prepared to release the Model 3. Tesla achieved two consecutive profitable quarters when Model 3 production reached volume in Q3 and Q4 of 2018. But despite Elon Musk’s claiming Tesla was now going to be income positive going forward the company posted a $700 million loss, the largest in its history, at the start of 2019. All this makes us wonder how the current earnings information can justify a nearly 30% increase in the value of the company.
With regard to Prof. Ross’ observation, Tesla is not alone. The prices of the companies on our list of Bubble 2.0 stocks have been gyrating dramatically on the basis of scant, long-term, value relevant information. In the few months we have been tracking the ten companies, several have been both up and down by more than 25%. It is hard to reconcile such gyrations with changes in fundamental value, even after the fact. The bottom line is that investors in Tesla companies whose value depends on expectations of future growth must be prepared to live with large, unexplained, stock price movements. As a final note, when the 10Q was released, Tesla did back off about 4%, but most of the run-up remains.