Wednesday, May 31, 2017

The Mystery of Tesla

       The Model 3 will be coming soon.  The Model 3 is a cheaper version of the Model S, a four-door electric sedan.  A car design not very popular in America or elsewhere in the world.  It is unclear that Tesla can sell it at a price that will make a meaningful profit.  Meanwhile, the company is involved in the highly competitive home solar business for which government subsidies are coming under fire and the highly competitive battery business.  In many investors' minds this somehow adds up to being the next Amazon.  The stock has risen nearly 70% since December 2015 on virtually no fundamental news.  I can see why Mr. Musk suggested that the stock was overpriced.  It will be a very interesting next few months as the Model 3 actually begins to appear.

Monday, May 29, 2017

Tesla, Ford and GM

     Recently, the fact that the market capitalization of Tesla passed that of Ford and GM attracted a good deal of attention.  In some quarters, it was taken as evidence that Tesla was overvalued.  How could a company the manufactures a small fraction of the number of vehicles be "worth more" than Ford and GM?

     While I agree that Tesla is overvalued - my DCF models suggest values of abour $170, not in excess of $300 - comparison of market capitalizations is not the appropriate benchmark.  Instead, what should be compared are the operating values of the companies or what is often called enterprise value.  The enterprise value equals the value of the equity plus debt minuses cash and short-term securities.

      The table belows shows the calculation for all three companies.  As advertised, the equity value of Tesla exceeds that of its competitors.  However, the enterprise value of Tesla is less than half that of Ford and GM.  Therefore, while it might be right to conclude that Tesla is overvalued, that conclusion should not be based on a faulty comparison.

Sunday, May 28, 2017

Investment Performance

     Superior investment performance relative to a given benchmark can be attributed to some combination of three basic drivers.  The first is investor skill – the ability to find and exploit mispricing as it arises.  The second is valuation changes combined with an investment strategy that diverges from market capitalization rates.  For example, a manager who tends to purchase large cap growth stocks will outperform its benchmark, assuming its benchmark is broader than large cap growth stocks, when the valuation of those securities rises.  The final is bearing risks that are not captured in the benchmark.  For instance, a value manager who is measured against a CAPM benchmark will outperform, on average, if there is a risk premium associated with holding value stocks that is not captured by the CAPM benchmark.

     What distinguishes the three drivers is that they have markedly different implications for whether the observed historical superior performance can be expected to continue.  If performance is attributable to skill then clearly it should persist as long as the skillful managers run the portfolio, but with a caveat as described by Berk and Green (2004).  Berk and Green note that skillful investment managers have an incentive to capture the return on their skill.  There are two ways to do that – by charging higher fees and by accepting added funds to manage.  The first method reduces the net performance, but not the gross performance.  The second, however, could eliminate much of the gross outperformance because as funds under management grow it becomes increasingly difficult for even a skilled manager to earn superior returns.

     To the extent that superior performance was a result of valuation changes, and to the extent that the manager continues with the same investment strategy, superior performance should not be expected to continue. Over the horizon on which most managers are evaluated, typically three years or more, there is no evidence of momentum in stock prices.  In fact, academic research suggests that there is a slight tendency toward mean reversion.  This implies that to the extent the past performance was a result of valuation changes, managers who outperformed in the past can be expected to slightly underperform going forward.

     Finally, if historical superior performance was the result of bearing a price risk that was not reflected in the benchmark, that performance should be expected to continue.  However, it is somewhat misleading to call it superior performance.  Investors who interpret the higher returns as evidence of skill will be disappointed in those states of the world when the risks they did not recognize they were bearing are realized.

Saturday, May 27, 2017

DCF Analysis and the Allocation of Capital

            Much of this blog has focused on fundamental valuation as an investment tool that can be used to identify mispriced stocks and, hopefully, make superior returns.  While important to individual investors, there is another aspect of fundamental valuation that is more important from a social perspective.  Remember that in a market economy the social function of the financial market is capital allocation.  There is no central planner to decide how much money should be allocated to social media, versus electricity transmission, versus automobile manufacturing as so on times thousands. 

            To see how DCF analysis plays a central role in the allocation of capital imagine a thought experiment in which a fresh $1 million is injected into the capital market.  Where does it get allocated in a competitive market?  The answer is to that activity which investors conclude has a present value of expected future cash flows most in excess of $1 million.  That is to the activity that has the greatest DCF value.  So DCF analysis is not just a tool for making money.  It is a critical part of the process by which society decides what things are worth doing.