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Brad Cornell

Tesla Competition in Germany

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Apparently the German Minister of Economic Affairs reads our blog.  In a recent meeting with the leading German automakers, he said (here is the link:

“I really wonder when you, Mr. Zetsche (Mercedes), or you, Mr. Diess (Volkswagen), or Mr. Krüger of BMW will be able to get an electric car build, which is only half as sexy as one by Tesla. As far as the attractiveness of your e-cars is concerned, you could actually come up with some fresh ideas.”

At Cornell-Capital, we have been saying this for years.  The Model S came out in 2012 and we anticipated the arrival, not too far thereafter, of sexy well designed competitors.  We are still waiting.

Warren Buffett once told me, never fly on an airline that has coffee stains on the seats.  While coffee stains themselves are not a big deal, there existence says somehting about the quality of the airline’s management that could be critical.  The failure of German automakers to have introduced sexy competition to Tesla by now also may say something about management – that they lack the chutzhap to compete with the likes of Elon Musk.  At least that is what the market price of Tesla’s stock suggests.

Asset Sales and Corporate Restructuring

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You often hear that as part of a restructuring to improve its financial position, a company plans to sell assets.  GE is a focal point of such discussion currently and the company has sold off some divisions.  But before you accept the view that such actions are beneficial, you must ask yourself where the benefit comes from.  To answer that question, it is necessary to distinguish the operating value of the assets, which equals the present value of the expected future cash flows under current management, and the cash value, which equals the price at which the assets could be sold.

One possibility is that it makes sense to sell the assets because you have found a sucker who is not reasonably assessing the future cash flows.  This is just a version of the greater fool theory.  If a company can find a greater fool, then it is lucky.  However, such rare happenstances cannot serve as the basis for a systematic restructuring program, so let’s assume that all the potential buyers are rational and well informed so that there are no suckers.

In that circumstance, it makes sense to sell the asset only if the cash value exceeds the operating value.  But why would someone else pay more than the seller’s operating value?  It must be the case that the buyer believes he can operate the assets more efficiently.  This would be the case, for instance, if there were synergies or if the current owners lacked the skill to manage the assets effectively.

All this begs the question of why it makes sense for GE to sell assets.  True some of the assets like the power division may be struggling and losing money, but that just means they are not worth very much.  There is no reason to believe that they will be worth more to a potential buyer unless GE is mismanaging the assets, or the buyer can employ synergies that GE lacks.  Given the size and scope of GE’s businesses, the synergies explanation does not seem likely.  If GE is mismanaging the assets, the best solution presumably would be to solve the management problem, not to sell the assets.

Putting GE aside, the situations in which asset sales would be beneficial are likely to be quite rare.  Asset sales should not be thought of as some sort of restructuring panacea, but as a tool to be used only in unique circumstances where the sale value exceeds the operating value.

Options and Market Declines

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            At Cornell-Capital we write a lot of options.  In some cases, it is part of a hedging strategy in which we own the underlying stock.  But it many cases, Tesla is an example, it is naked writing.  You would think that these short options positions would do well when the market drops like it did in October and they do, but less than you would expect.  The reason is that market declines, particularly recently, are associated with increases volatility.  For example, changes in the VIX index are negatively correlated with the return on the market.  The result is that when stock prices fall, volatility rises, so that there are two offsetting effects on the price of options.  The rising volatility pushes option prices up, muting the impact of declining prices.

Company Information Releases and Stock Prices

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            I don’t often disagree with Warren Buffet, but his position on companies providing guidance was one example.  In a previous post, I argued that the more information companies give investors, the more accurately they will price stocks, on average.  Perhaps there will be instances where investors might over- or under-react to certain information releases, particularly if it is vaguer information like guidance.  But that possibility should not make executives the paternalistic managers of investor sentiment.

            The problem is a good deal worse if companies decide to withhold value relevant historical information as Apple has now decided to do regarding the number of units it sells.  Withholding that information clearly makes it more difficult for investors to value Apple accurately.  Remember that the fundamental social role of the stock market is to move funds from savers to investors.  That task requires accurate pricing so that funds are allocated to the companies with the best opportunities.  If companies withhold information and pricing becomes noisier, the capital allocation process is impeded, and everyone loses.

Investment Risk and Stock Prices

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            Academics and practitioners alike recognize that increase in the perceived risk of equity investing, and the associated increase in the risk premium, can cause stock prices to fall.  Most of the measures of risk are abstract like the historical standard deviation of stock returns or the future implied volatility of returns as measured by the VIX.  There is one more basic measure that I believe has a more visceral impact, the frequency of large drops, defined as 1% or more, in widely reported stock indexes.  When sharp price drops occur not only do investors lose money, but the decline is big news in the financial press.  Pundits weigh in with explanations for the drop and worry about whether further declines are likely.  If several drops occur in close proximity, the impact is multiplied. 
            For the foregoing reasons, I like to track the frequency of 1% drops.  In the year from October 1, 2016 through September 30, 2017, for example, there were only 5 drops of 1% or more.  Furthermore, they were widely dispersed and typically followed by immediate recoveries.  Such a low rate of large drops was well below historical averages and, no doubt, conveyed an impression of quiescent times.  In October 2018, the situation was dramatically different.  There were 5 drops of 1% or more in that month alone – a rate 12 times that of the past year.  Not surprisingly, the financial press was filled with stories about the increased risk of stock investing along with a host of explanations for the drops.  From my perspective many of the explanations are speculative at best, but tracking the frequency of large drops is a recommended exercise nonetheless.

Bubble Stocks Update

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            With all the turmoil in the markets, I felt it was time to take a look back at the ten bubble stocks from my post after the close on October 3.  The table below shows the performance between the close on October 3 and the close today (October 29).  The table shows that the average return for all ten has hit bear market territory – down more than 20%.  If Tesla, the one exception to the rule is eliminated, the average for the other nine is down an astonishing 25.5%.  Turning to the individual stocks, there (AMD, Roku and Square) are down more than 30%.  Amazon has shed more than $250 billion in market value.  It is stunning how quickly sentiment can change on relatively scant economic news.


What Do Auto Price Earnings Ratios Tell Us?

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            On October 24, 2018 Tesla announced its best quarter ever.  Sales rose to $6.8 billion from $4 billion the previous quarter.  Gross margin improved to 22.33% from 15.46% in the second quarter of 2018 and 15.05% in the third quarter of 2017.  Most importantly, earnings per share turned positive and reached a record level of $1.75 per share.
            With Tesla’s new-found profitability, for the first time it is possible to compute meaningful P/E ratios and to make comparisons with other auto manufacturers.  To do so I assume that Tesla earns the same $1.75 per share for the next four quarters.  Some might say it should be more because Tesla is a growth company.  Others may say it should be less because Tesla pulled out all the stops to be profitable in the third quarter, including selling only high margin Model 3s.  Those of you who disagree can alter the table below to reflect your own assumptions.
            The table reports the forward P/E ratios for Tesla and the other major auto manufacturers.  The first thing to note is that all the major manufacturers tend to trade around a forward multiple of 6.  Toyota is a bit higher at 8.33 and Fiat/Chrysler is a bit lower at 3.89, but not of them approach double digits.  In contrast, Tesla’s multiple is 47.19.  While one would expect Tesla’s multiple to be higher because of its greater growth opportunities, the gap is so large that it appears as if Tesla is in a different business.  It seems hard to believe that as Tesla matures its multiples will not drop toward the industry average.  If that happens, the growth in earnings will have to be dramatic to maintain the current stock price.

What are Bear Markets?

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            With stock prices down sharply last week the words “bear market” and “correction” have once again been bandied about.  In response, I first offer the standard definition of both terms and then a warning.  A “correction” is defined as a drop of 10% or more in major indexes like the S&P 500 from previous highs.  It is called a “bear market” if the drop is more than 20%.
            As properly defined, both corrections and bear markets are ex post concepts – they say nothing about the future.  Too frequently both terms get misinterpreted.  People say we are “in a bear market” as if that means that prices are more likely to fall than rise in the near future.  In fact, there is no such predictive content.  To the extent that past recent drops in prices predict anything, it is that future prices are slightly more likely to rise.  However, the effect is so small as to be of no practical importance.  The warning is that if you hear people talking about bear markets, listen carefully.  They may not know what they are talking about.

Production Hell, Delivery Hell, What the Hell is next for Tesla?

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Service hell.  Though it might be more hell for owners than for Tesla.  Tesla reported a 3rd quarter profit ather the market closed today and the stock has sky-rocketed again.  The company showed that it can produce the Model 3 in meaningful volume at margins of 20% (as long as the cars are sold for a minimu of $46,000).  The problem is that as all these added cars roll out, they will all have to be serviced.  In fact, the new Model 3s may need more service than the S or X given the race to produce them.  As the owner of an S (in fact I have owned three of them), I am dreading service hell.  Recently a light came on in my car saying that my suspension needed service.  My initial call to Tesla went unanswered.  Fortunately, the light went out.  Next time I may not be so lucky.  With limited servicen centers, no third party service outlets, and a lot of new Model 3s on the road, customers may be about to enter service hell.  What it means for the stock price is another question.