Good morning. Yesterday’s US economic data combo — persistently high job openings and a soft manufacturing PMI survey — presents an increasingly familiar but uneasy contrast. The economy is slowing but the labour market remains tight. The Federal Reserve’s job is hard. Email me with your thoughts: email@example.com.
Tesla shares are down more than 70 per cent since they peaked, a bit over a year ago. This is a big decline, and it is natural to wonder what has changed. But there is little to explain. Tesla was wildly overpriced, and now its valuation is reverting to a more normal level.
Tesla’s enterprise value (its market capitalisation plus its net debt) in November 2021 was $1.2tn. That was more than the next four most valuable carmakers (Toyota, Volkswagen, Mercedes and Ford) put together. That’s bonkers. Electric vehicles made up just 3.2 per cent of light vehicle sales in the US in 2021. Tesla’s peak valuation implied that it would come to dominate an industry that is still in its infancy. That is not a high-percentage bet. A lot can happen, competitively, between now and the day most new cars are electric.
The chancy nature of the Tesla story was reinforced by recent news that its fourth-quarter deliveries fell below Wall Street’s hopes and, perhaps more importantly, that production is outrunning sales. Rising inventory is not a good look for a brand that is meant to be taking share. But, to be clear, this news is a tiny part of the explanation for the share’s decline. As my colleague Bryce Elder put in an excellent Alphaville post yesterday, the main story is simply “gravity”.
If the overpricing was so obvious, why did it persist as long as it did? Again: no mystery. Wild overpricing happens in markets. Speculative frenzies result from fundamental aspects of human nature, and it is very dangerous to bet against them. A wildly overpriced stock that has been rising is more likely to keep rising than to fall. But when (using Ben Graham’s metaphor) the market slowly stops acting like a voting machine and starts acting more like a weighing machine, it restores one’s faith in both the market and human nature.
Is Tesla’s current valuation fair? The company’s enterprise value is now about the same as Toyota’s, with about a third of the revenue. Its forward price/earnings ratio is 26 to Toyota’s 9 (all these figures come from Capital IQ).
Twenty-six times earnings is a high but not totally bonkers earnings multiple. And maybe Tesla is worth it. It is increasing revenue much faster than the large carmakers — 55 per cent in the third quarter. More impressive still are its 16 per cent operating margin and 18 per cent return on capital, both way above its big peers. Tesla appears to have cost and capital efficiency advantages that will help it reinvest and outgrow its big, slow competitors in the future.
The most thorough and thoughtful valuation of Tesla I’ve seen was done by Aswath Damodaran of NYU, almost precisely as the stock was peaking. Damodaran (who I basically want to be when I grow up) arrived at an equity value of just under $640bn — notably higher than the current $390bn. His assumptions struck me as heroic, though: 10mn cars sold by 2032, up from 1.3mn this year, for a compound annual growth rate of 22 per cent. That suggests that Tesla will have something like 10 per cent of the world’s light vehicle market a decade hence.
In short, while Tesla’s valuation prices in a lot of good news, but it has left the territory of plain insanity.
A question remains. Has chief executive Elon Musk gone a little bit batty, and should that translate to a discount on Tesla’s shares? The purchase of Twitter looks like a bad mistake, and his management of that company looks haphazard. Some thoughts on this in the days to come.
Readers respond on private capital
Readers had quite a lot, good and bad, to say about yesterday’s letter on private markets. One reader from the private credit industry found my argument glib and unprofessional. I argued that private market alpha comes mostly from leverage and is mostly sopped up by fees. He thinks it comes from “deep operational and governance involvement” including “sourcing, structuring, negotiating, and vastly deeper diligence and superior protective covenants”.
This is the industry’s basic argument: that it is long-term focused, knows how to improve company operations, and knows how to write better debt contracts. I am sure there are particular private equity practitioners and groups who create value in these ways, just as some mutual funds are run by good stock pickers. The relevant point, however, is whether the structure of the industry allows it to provide something markets can’t, over and above the additional returns one would expect from higher leverage. In the last decade or so, I don’t see much evidence of that, in private equity in particular. In private debt, we will have to see how the results roll in now that capital has come flooding in the past few years.
The proof is going to be in the pudding. But remember, recent decades gave private markets the gift of steadily falling interest rates. Decades to come will not.
Erik van Ockenburg, a corporate chief financial officer, made a slightly more subtle version of this argument:
Private equity is “governance arbitrage”. In a nutshell, what it comes down to for me, is that PE is a better governance model, which THEN allows to fund at 6 times EBITDA whereas banks wont go that far for public companies: the leverage then obviously helps create outperformance, and as you rightfully point out is an important source of alpha, but it is part of an overall PE operating model that allows for it, where governance is much more professional and intense than I have seen in listed companies
To push this argument to its extreme: it is the high leverage that produces all the extra alpha. But what PE firms are good at is not improving corporate operations (always a suspect claim) but helping companies carry a huge amount of debt without blowing themselves up. This is a very interesting idea.
Nicholas Coulson wrote to suggest that the recent mediocre performance of private equity in particular might be cyclical:
Distressed asset prices and sharply lower valuations could set PE up for decent performance once the market has been purged of all the QE excess . . . as someone who first became a consumer of the PE product in 2007/8, we may see a recovery after the shakeout.
This is a fair point, but I would emphasise again that over the next 10 years the industry will not have the advantage of steadily falling rates. The next recovery might not be as profitable as the last one.
Another reader wrote:
Having invested in listed securities [and] private markets, one big benefit I see is that private-market investing prevents “non-rational” human decisions reacting to short term market movements . . . being exposed to high volatility often pushes us into short-term actions and reactions on market events which are quite random and makes us lose sight of the long-term.
I’m much more sympathetic to this argument. If not seeing prices every day makes you less likely to do dumb things, that is worth paying for. But 2 per cent of assets and 20 per cent of profits?