If you’ve paid attention to the equity markets over the last month, you’ve heard that shares in Tesla Inc. (TSLA-NASDAQ) have skyrocketed. As the next chart shows, the stock is now at $905.15, up 116% so far in 2020 and 276% since the end of Q3 2019.
Check that. In the time it took to write that first paragraph, TSLA shares just rose to $920, taking the year-to-date return to 120% and the return since the end of Q3 to 282%.
Many investors have been wondering what has driven TSLA’s shares higher. RBC Capital Markets took a stab at coming up with possible explanations: “strong narrative, FOMO, short covering, ESG investing, growth managers needing to keep up with performance given Tesla’s size, momentum machines, eventual S&P500 inclusion, etc.” While we are unsure whether this list includes any of the actual explanations, we firmly believe one thing: TSLA’s recent share price movement is completely disconnected from the company’s fundamentals.
What makes us so sure? Here’s RBC Capital Markets describing the inputs to their financial model:
There’s technical jargon in there, but the important assumption to focus on is “FCF 30% CAGR for a 10 year period”. That translates to, “free cash flow growing by 30% per year during each of the next 10 years”. That is an astronomical level of growth to sustain for a decade. It’s so astronomical that only three large-cap companies have ever done it: Apple (AAPL-NASDAQ), Amazon.com (AMZN-NASDAQ), and Google (GOOGL-NASDAQ). And even with that kind of growth, it still only implies a fundamental value for TSLA of $630 per share. That’s 32% lower than where it is today!
To us, TSLA is just one example of how some pockets of the markets today have entered “Ludicrous Mode” (a phrase we stole from the company). To some investors, it seems that fundamentals just don’t matter as much as a compelling story.
Let’s take Virgin Galactic (SPCE-NYSE) as another example. The company last reported earnings on November 12, which represents the starting point on the chart below. Since then, shares have increased 240%. What has changed over that three-month span? Fundamentally speaking, absolutely nothing. On the other hand, the company does plan to offer commercial flights to space. And space flights – like electric cars – are cool and futuristic. So, I dunno, maybe investors have suddenly chosen to focus on things that are cool and futuristic instead of focusing on traditional metrics like profits?
Speaking of profits, the next chart shows that not since the dot-com bubble has there been a larger proportion of U.S. IPOs by unprofitable companies. This reinforces our guess that if investors aren’t evaluating companies based on profit multiples, they must be evaluating them on something else.
That “something else” could be progressive societal values. The next chart shows that flows into ESG (environmental, social, and governance) funds have been escalating rapidly. These funds strive to invest only in companies that are socially conscious (we’ll leave the debate about what actually defines a company as being “socially conscious” for another day). An ESG mandate is easy to stick with during a bull market. Time will tell whether investors will continue to place such a heavy emphasis on their social conscious if they’re losing money doing so in a bear market.
Vision over valuation
To recap the charts we’ve highlighted up to this point, it seems like high growth, futuristic business models, and ESG are currently in vogue, while fundamentals like profits are not. Consequently, this has had a negative impact on the returns of investors who have been focusing on valuation fundamentals. The next chart shows how this performance divide has grown in 2020: while the Russell 2000 growth index has continued its march upwards, the Russell 2000 value index has trended in the opposite direction.
We find it somewhat strange that we have to state this, but here we are: we believe that the value of a company’s shares is equal to the present value of the company’s future cash flows. Call us naïve, but at one point we would have assumed that all investors believed this too. The fact that this doesn’t currently seem to be the case reminds us again of the dot-com bubble, when companies that looked cheap based on traditional valuation metrics were shunned in favour of companies with grand visions. We all know how that ludicrous era ended, we’ll have to wait and see whether the current era meets the same fate.