For a moment this week, Tesla surpassed General Motors as the most valuable auto manufacturer in the US based on market capitalization. Tesla’s stock is up a whopping 45% this year alone, vs. GM which is down slightly.
For investors, this is a classic “disrupter vs. incumbent” story. This sort of clash actually occurs rather frequently. It’s just that this particular version is high profile—and it matters to us, because many of our clients’ portfolios own GM and don’t own Tesla.
In this note, we’ll briefly discuss how our Fundametrics® Research views the stocks of GM and Tesla, and more broadly, why it works the way it does.
The Loved vs. Unloved
Over the past two years, as we have been buying GM, the news has been great for Tesla and disappointing for GM. Stocks are mainly about future expectations, and right now investors believe Tesla to be better positioned for growth than traditional auto makers like GM. And, arguably, this is true.
Consider that much of GM’s recent volume growth came from temporary trends like high demand for replacement vehicles, big discounting, and cheap gas. As demand has slowed and the threat of rising interest rates materializes, these trends are running their course.
Companies like GM are now left with high inventories, potential price wars, and possible glut of used cars. Time to cut production?
In contrast, Tesla appears to be free from these adverse forces. It is focused on mass-produced electric cars that include software for self-driving functionality. Sure, there are challenges to face, but Tesla has first-mover status and innovative leadership propelling it. The company doesn’t carry the baggage of the traditional producers.
Concept vs. Reality
It’s too trite to simply say that Tesla faces a large mountain to climb and can’t pull it off. Amazon provides a good example of a company who continues to innovate and generally exceed high expectations. They have been clocking traditional retailers now for years.
Although revealing, analysis of the investment opportunity must go deeper than simply saying, “Tesla only has $7 billion in revenue and only produces 85,000 cars (vs. GM’s $166 billion and 6.7 million), all for the same market cap." Can you hold to your long term conviction, even as incremental news works against you?
The price an investor pays for the future is of vital importance, and the odds of mistakes in any plan are high. Our own view is that, someone will succeed in delivering the future, innovative car. The question is who and when, and at what cost? The verdict is years away, with many unknowns. (Recall that Amazon was one of the few Internet-centric retail survivors from the tech bubble, and it took time to emerge.)
Meantime, we prefer an investment that has much lower expectations, with more tangible upside potential. The probability of a company like GM surprising to the upside over the next three years, in our view, is higher than that of Tesla.
Research in Action
Our Fundametrics® Research seeks the following profile for investment: 1) attractive valuation; 2) signs of incrementally better fundamentals; and 3) a good chance of cushion if things go wrong.
By that measure, GM is significantly more attractive than Tesla. This was the case 18 months ago, and it is even more so today.
We have developed over 135 factors to analyze the financial position of a company, but to simplify, consider the following:
- Valuation: GM ranks a 2 (out of 10) vs. Tesla’s 10 (out of 10). Since inception, the groups of stocks ranked a 1 or 2 (our Buy indicators) have outperformed the groups ranked a 5 (our sell indicator) or a 10 (an “extreme sell”).
- Fundamentals: GM ranks a 3 vs. Tesla’s 10. By fundamentals, we are examining quarterly trends in tangible income statement items, as well as analyst earnings forecasts.
- Cushion: GM passes our Financial Warnings assessment for acceptable risk (profitability trends, accrual activity, debt servicing, etc.), while Tesla actually fails it.
In simple terms, GM trades at 5.5X earnings for 2018, compared to 162.6X for Tesla, which has negative earnings currently. GM’s valuation is not out of line with its historical range. Earnings estimates by analysts are among the absolute highest for Tesla (of all 450+ stocks over $10 billion in market cap), while they are among the lowest for GM. We find that analysts are often too ambitious in their most rosy forecasts.
Now, in fairness, fundamentals for GM could get worse before they get better, even as Tesla posts good results. Our system is flexible enough to recognize when the price we are paying for deteriorating fundamentals is not supportable, which could end up being the case for GM. But a key point is that expectations are already very low for GM, and is to some extent already weighing on the price of its shares.
By comparison, GM is more attractive than Ford in our research as well. Ford scores better on valuation, equally on cushion, but much worse on fundamental improvements.
Wrapping It All Together
We close with three key, broad points:
First, we are trying to get the long term profile right for a stock, not the short term. We do not measure investment returns from quarter to quarter, or even from year to year.
Second, we are less interested in getting any one stock right. Instead, we want all stocks in the portfolio to match our preferred profile, so that we aren’t dependent on any one stock. This helps us manage stocks that inevitably end up disappointing.
Third, we strive to avoid chasing high-flyers. We recognize that a handful may end up delivering, but what more often happens is that investors recognize the potential way too late and well into the hype. Buying early is good, but it usually entails buying when there’s fear and doubt about the future.
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Fundametrics® Research Process
The Fundametrics® research process is our proprietary computer-based research system, which screens our universe of stocks and decile ranks them according to specific valuation criteria.