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Brad Cornell

How Fast Sentiment Can Change – Tesla

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Throughout much of the last several years the Los Angeles Times has been enthusiastic about Tesla.  The paper enthused about the gigafactory, the Model 3, the powerwall and the solar shingles.  It was a surprise, therefore, to read the following headline on Saturday in the Times business section: “Tesla enters survial mode as layoffs loom, stock sinks.”  The fact is that not much has changed at Tesla from a fundamental standpoint.  It still faces the same issue of competing in the hotly competitive and capital intensive automotive market.  It still has problems trying to make money while honoring its promise of a $35,000 Model 3.  But now sentiment seems to be switching.  And sentiment can move much faster than fundamentals.  The stock was down over 12% on Friday.  It will be interesting to see what happens when trading reopens on Tuesday.

Apple, Inflation and Valuation

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In light of Mr. Cook’s revision of expected fourth quarter revenue for Apple, it is worth revisiting the question of whether the stock is overpriced.  To examine that question, I made the following assumptions.  To begin, the four quarters from Q4 2018 to Q3 2019 will show a year-over-year decline of 5% in revenue and EBIT from the same period a year before.  After that, Apple will have no real growth into perpetuity.  That is, revenue and EBIT will grow at the rate of inflation.  As an assumption for long-run inflation, I use 2% which matches the Fed’s long-run target and is consistent with current inflation rates.  For a cost of capital, I use 8.2% initially falling to 8% in the long run.  This discount rate is slightly greater than the discount rate used by my colleague, Aswath Damodaran, in his valuation of Apple.

It is worth stressing that assuming growth at the rate of inflation means that Apple will not grow in real terms, even as the real economy expands.  This is a very conservative assumption.  It means that in the years ahead Apple will become a progressively smaller part of the overall economy.  Prof. Damodaran uses what is arguably a more reasonable assumption that Apple will grow at 3%, about equal to the long-run growth rate in the overall economy.

The bottom line is that with the initial 5% drop and growth at inflation after that Apple has a fundamental value of $163.52.  If I retain the 5% drop and use Prof. Damodaran long-run growth rate of 3%, the value rises to $170.47.  If I used Prof. Damodaran’s cost of capital, the number would be even higher.  At $143, the stock looks like a buy, not a sell, even considering Mr. Cook’s revision.

Finally, Apple can help its own cause by stressing innovation.  The company did not upgrade its iMac line at all in 2018.  The standalone Mac Pro has not been upgraded since 2013.  It is time to get moving.  These are, of course, small steps compared to the iPhone, but they are a signal to customers and investors that Apple is pushing ahead on all fronts.

Efficient Markets?

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The efficient market hypothesis holds that the market prices of securities accurately reflect the fundamental value of those securities.  This implies that if no new fundamental arrives, prices should remain relatively constant.  It turns out this is not true, even in the case of the overall market, let alone for individual stocks.  Research by Summers and Poterba published in the Journal of Portfolio Managment in 1988 and a follow up article by Cornell (yes the Cornell of Cornell Capital) published in the same journal in 2012 looked at the 50 largest moves in the S&P 500 index of periods of 25 years.  Both papers found that the majority of the large moves were not associated with the release of any news related to valuation fundamentals.  That brings us to the current experience.  First, the S&P 500 dropped nearly 20% in close to record time only to be followed by one of the largest one day price increases (in points, not percent) in history.  And then the next day, the index dropped sharply erasing more than half of the previous day’s gain by midday before reversing again and finishing up on the day.  In all of this there has been basically no new fundamental news.  The only possible candidate is a 25 basis point increase in the Fed’s target interest rate, but that hardly qualifies as new news.  To begin, the action the Fed took was largely anticipated.  What’s more it is far from clear why changes in the Fed’s targets for very short-term interest, even if coming as a total surprise to the market, should have much impact on stock prices.  At best the relationship is complicated.  Among other things it depends on why the Fed is changing its target.  (For a detailed discussion of this issue see Damodaran.)

So why has the market been moving up and down so much?  The honest answer is we don’t know.  Markets can move dramatically on the basis of scant fundamental news leaving financial economists scratching their heads.  But in this regard, we financial economists have one step up on the financial media in that we know what we don’t know.  Whenever there is a sharp move in the market, the media feels the need to explain it somehow.  When there has not been the release of any fundamental news, those explanations are little more than speculation, often based on unverifiable guesss about market “psychology.”  It is best to pay them no mind.

Advisors say “Get Defensive”

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From Charles Schwab to Goldman Sachs, analysts and investment advisors are warning investors to “get defensive.”  That may be good advice, but from a fundamental valuation standpoint it is a bit odd.  From a fundamental valuation perspective, the time to get defensive is when the ratio of market price to reasonable estimates of fundamental value is at peak levels.  As we noted in this blog on numerous occasions, that was the case at the end of the summer.  We argued that that was an ideal time to “get defensive.”  Today, even with the sharp pull back in stock prices, the ratio of price to value still remains on the high side in our opinion.   By definition, however, much less so than at the end of the summer.  The key point is that whether or not to “get defensive” should not be based on recent movements in stock prices because there is virtually no autocorrelation in stock returns.  That means that the fact that prices have fallen sharply in the past month has predictive power or whether they will fall next month.  Nonetheless, it after major pull backs that you see widespread warnings to get defensive.  The best advice is to ignore recent movements in the market and make decisions regarding whether to “get defensive” on the basis of a thoughtful comparison of price and value.

Why Fundamental Valuation Matters

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First, a little humility.  When we posted our list of ten bubble stocks we were not predicting an imminent collapse.  (Though, in fact, a collapse has occurred.  The ten bubble stocks are now down an average of almost 25%, 30% excluding Tesla.)  What we were saying is that prices appeared to be well above fundamental value.  Assuming that the two are going to converge at some point implies one of two things can happen.  One, future stock returns will be low relative to fair risk-adjusted returns on equity for an extended period.  Two, there will be a sudden collapse that quickly brings price down toward fundamental value.  The fact that the second has occured was not something we could predict, but neither was it a complete surprise.  In the long-run it is fundamental value that matters, it fact it is virtually all that matters.

Disappointment and Concern at the Los Angeles Auto Show

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As readers of this blog know, we have consistently opined that at prices exceeding $350 Tesla is significantly overvalued.  Therefore, Cornell Capital has pursued an investment strategy of writing call options with a strike price of 350 when Tesla stock reaches that level.  The strategy has worked well over the years and we continue to pursue it, but last weekend the Los Angeles auto show gave us pause.  We have marveled in previous posts at the lack of exciting, “sexy,” electric car offerings by major traditional manufacturers.  The L.A. show was jarring in that respect.  Teslas small exhibit was packed, as was that of Rivian, an exciting new electric startup.  However, the rest of the show was an electric desert.  Porsche did not even have a Taycan on display.  As we went from BMW, to Toyota, to Daimler, to GM, to Ford and so on the word for electric was 2020, if then.  The sole exception was Jaguar with their iPace.

As we have been driving Teslas for almost six years at Cornell Capital, it is aggravating to not have more real choice in electric cars by now.  But as writers of Tesla options, our concern is graver.  Why is the competition letting Tesla get such a large head start?  It makes sense that they may want to wade into the electric world slowly, given all the complicated political issues including the future of government subsidies.  However, the actual response has been more glacial than just slow.

There is also the issue of “learning by doing.”  Economic theory teaches that way you get better at making electric cars is by making them, not by talking about them, drawing mock-ups, or even producing demos.  There are innumerable little details that Teslas competitors will not get right until they are actually producing, selling and servicing electric cars. Those who wait too long may be unable to keep pace in the next decade.

In short, we fear that Tesla may have more market power than we have modeled.  If consumers begin to think of Tesla as synonymous with electric cars, then the company may be worth more than we have thought.  A price of $350 still appears to us to be rich, but less so than we thought before the show.

Climate Change and the Stock Market

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No, I am not going to say how climate change impacts the stock market or even more far out how the stock market may impact climate change.  The point here is that the two phenomena share a statistical property that makes both controversial and difficult to interpret.

To get started, take a look at the chart below.  It plots the return on the market minus the return on 30-day Treasury bills over the 101-year period from 1927 to 2018.  The data are taken from Prof. Ken French’s website.  Basic analysis of risk and return predicts that the average return on the market would be significantly greater than the average return on Treasury bills – and it is.  But try to see that from the chart.  The problem is that the underlying relation, that the average return on the market exceeds that on 30-day Treasury bills by more than 8% per year, is dwarfed by the variability of the market returns.  It takes careful analysis and more than forty years of data to identify a statistically significant difference between the two returns.  Trying to draw conclusions from short-run variation in stock prices is a hopeless endeavor.

The same is true of climate change.  Serious long-run statistical analysis leads to the conclusion that human industrial activity has led to, and continues to lead to, a slow inexorable increase in average global temperatures.  This is analogous to the long-run difference between the return on the market and the return on Treasury bills.  But there is immense short-run and location dependent variation in weather.  The California drought, for example, may be due in some part to climate change, but most of it is probably due to random weather variation.  California had prolonged droughts well before the industrial revolution.  What makes interpreting the market or the climate so difficult and controversial is that we humans have short lives and shorter attention spans.  We want to understand things in terms of what is happening now, or at least in terms of what happened recently.  Unfortunately, in the case of the stock market and climate change that is not possible.  The only way to understand either is careful statistical analysis of long-run data.

Fuel Costs Comparison: Tesla vs ICEs

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Hidden within a previous post on “How Green is Your Tesla” was a discussion of fuel costs.  But with gas pricing falling, I thought fuel costs deserved another look.  Attached is a handy spreadsheet that calculates how many miles per gallon your gas powered car has to get for fuel costs to be less than for a Tesla Model S 85.  The calculation is done assuming that electricity costs either 25 cents or 35 cents per kilowatt hour.  Those are the second and third tier rates charged by Southern California Edison in the Los Angeles area.  You can plug in your own rate, but remember you want a marginal rate after taking account of your normal home usage.  The marginal rate is more likely priced at a higher tier.  The spreadsheet also takes account of the fact that the actual Tesla range is on the order of 67% of the stated range as documented in the previous post.

As the spreadsheet shows, given a cost for gas of $4.15 per gallon (the currrent mid-grade rate in Los Angeles) , the breakeven mileage is 34.0 mpg at the 25 cent electric rate and 24.3 mpg at the 35 cent rate.  The bottom line is there may be a lot of reason for choosing an electric car but saving on fuel costs is not likely to be one of them, at least at current prices.

Explaining Stock Market Moves After the Fact

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Whenever the market moves sharply, the media feel compelled to offer an explanation.  Sometimes this is reasonable.  For instance, a sudden increase in reported inflation is likely to be bad news for the market.  But much of the time, there is no logical explanation for why prices have moved.  Steve Ross, the seminal financial theorist, said it best before his untimely death in 2017.  Professor Ross put it this way,

It is one thing not to be able to predict what asset returns will be since they will depend on news, and news, by definition, is information that has yet to be revealed.  It is another, though, to observe the movement of prices and not know why they moved after the fact.  I am particularly troubled that contemporaneous news seems to explain so little of the contemporaneous prices.

By contemporaneous news, Professor Ross had in mind the revelation of actual value relevant information such as announcement of last month’s inflation rate, not ex-post speculation or what biologist Stephen Jay Gould called “just so stories.”  Examples of such just so stories include things like rising fear of inflation and panic selling.

When most of a company’s value is attributable to growth options the problem is compounded.  Market values rest not on what a company is doing today, but what it could do in the future.  As we have noted repeatedly in this blog, dreams of the future can evaporate for no apparent reason.  The last six weeks have been a good reminder of that.  Why they evaporated at this particular juncture is anybody’s guess.

Bubble Stocks Latest Update

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The group of ten is now done over 26% since our post.  Even Amazon is off 25%.  Roku is nearing the 50% level.  Tesla remains the sole outlier that is up.  If it is removed from the average, the other group of nine is down over 30%.  The value of growth options can evaporate quickly.