Is Tesla a Bubble or Not?

As Morningstar’s Daniel Needham noted during the introduction for the panel discussion, Arnott is known as a diversified, contrarian, value-oriented manager, and Wood is a concentrated, disruptive technology-focused growth-oriented investor. “They’re trying to identify companies that they think are going to do better than the market over the long term,” Needham said. “But they go about that in a very different way.”

Here’s an edited transcript of their lively debate around Tesla:

Needham:  Picking one industry that you’ve got a relatively strong view on, and that’s electric vehicles and specifically Tesla, I’d be interested in understanding: what are you seeing at what some may consider to be a high price relative to fundamentals that the rest of the market isn’t seeing?

Wood: Our research is centered around Wright’s law. Wright’s law is a relative of Moore’s law. Moore’s law is a function of time. Wright’s law is a function of units, started by Theodore Wright, who made this observation during the early days of airplane manufacturing, the new technology of that day. It basically says for every cumulative doubling in the number of units produced, so one to two, two to four, four to eight, costs associated with these new technologies decline at a consistent percentage rate.

In the case of the battery pack systems within electric vehicles, that cost decline is 28% for every cumulative doubling. Last year, we globally produced and sold roughly 2.2 million electric vehicles. Based on that cost decline in battery pack systems, the largest cost component of electric vehicles, we believe that the average electric vehicle price will drop below that of the average gas-powered price in the next year or so and will continue to decline so that in the year 2025.

So we believe that the number of electric vehicles sold will scale from 2.2 million last year to 40 million, which is almost half of total car sales globally that we expect in the year 2025. That’s a 20-fold increase. This is exponential growth, to be sure, 89% at a compound annual rate, simply based on this notion that these cars are going to become more affordable than gas-powered vehicles. 

Needham:  You made a very strong case for electric vehicles. Why will Tesla be the one that benefits from that? Why won’t the more traditional autos or the many other electric vehicle manufacturers capture that trend?

Wood: The traditional auto manufacturers had to make or have to make a major leap.  The vast majority of their sales today are gas-powered vehicles. They need to transition to electric. Tesla’s already started electric and has four major barriers to entry – has created four major barriers to entry. One, battery costs. It built its cars on cylindrical batteries. Most other auto manufacturers base their cars on lithium-ion pouch batteries. The costs of lithium-ion pouch are much higher today, I think roughly 15%, 20%, than the cylindrical batteries that Tesla uses. 

The second barrier to entry is the artificial-intelligence chip that Tesla designed. Now, Tesla is taking a leaf from Apple’s book. As you will remember, Apple created the concept of a smartphone. It believed that we would have a computer in our pocket. Nokia, Motorola, and Ericsson did not believe that. They did not design their own chips.  And you know where they are today. 

The other barrier to entry is the number of real-world miles driven that Tesla has collected. It has more than a million robots out there collecting data and sending it back every day.  My car is one of them. Therefore, it is able to discern corner cases and design its full self-driving system to incorporate these corner cases in a way that other auto manufacturers cannot.

And then the fourth barrier to entry – and it surprised me this one lasted as long, but I guess the dealer system was the reason – Tesla is still the only car doing over-the-air software updates to improve performance and prevent breakdowns.

Those four barriers to entry we believe have put Tesla ahead, and we think the distance actually is increasing.

Needham:  Rob? You’ve got some opinions on electric vehicles and also Tesla.

Arnott: I certainly do. We wrote a paper earlier this year called “The Big Market Delusion,” which looked at industries that are up and coming that are disruptive. Kudos to Cathie on looking for disruptors. They’re very, very important. But disruptors get disrupted, and I’ll come back to that in a minute.

The thing that we found very interesting is you find these cases in the Internet bubble, in the supercomputer bubble in the early ’80s--the list goes on and on – where every company in the industry is priced at lofty multiples, as if they’re all going to succeed.  Yet they’re competing against one another, so there will be winners and losers. And the market’s pricing things as if they’re all going to be winners.

I mentioned disruptors get disrupted. Palm was spun off from 3Com back in the year 2000 and had an initial value that was more than 3Com was valued at before the spin-off, and within a day or two was worth more than General Motors. Palm was disrupted. BlackBerry came along with a better product. BlackBerry was disrupted. Apple came along with a better product. 

So, what we find is again and again: Disruptors are massively important to the economy and to economic growth. But you have to look at (a) how disruptive are they, (b) how much of a premium are you paying for that disruption, and (c) are they vulnerable to being disrupted themselves?

Needham:  So, from that perspective, we can say that you think the valuations are stretched within the EV space?

Arnott: Yeah. Cathie and I have both been around the industry for a long time, and we saw in the Internet bubble that there were countless disruptors, and they were radically reshaping the way we communicate, the way we transact, the way we interact with our clients. 

But the market got ahead of what was likely to happen. Briefly, Cisco was the largest market-cap stock on the planet. Since that time, for 21 years, they’ve had 12% annual earnings growth, 13% annual sales growth, and their share price is lower than it was at the peak in 2000 with double-digit growth for 21 years. So the market was expecting stupendous growth. It got impressive growth. But it was priced to reflect expectations of stupendous growth. 

That’s where I’d be inclined to push back. Cathie, not to take anything away from you, there have been 108 mutual funds and ETFs over the last 30 years that have gone up over 100%. Five of those are yours. Wow! But 70% of them were down the following year, 80% of them were down the following three years, by an average of 53%. So big gains. I guess my question would be: What’s the sell discipline that can protect those gains? What’s the sell discipline that can rotate you into undiscovered disruptors, where the market is unaware of what they’re doing?

Wood: Well, first of all, just to support Tesla’s position out there, there may be a lot of electric vehicle manufacturers, but they are tiny. Tesla’s share is surprisingly high. We thought it would go down. I think at the end of 2018, it was roughly 17% of global sales. Instead, it went up. 

In terms of the differences between our styles and our strategies, we are looking forward, not backward, and many of the questions you’ve just asked are backwards-looking. And we are looking at exponential growth opportunities that have evolved as these innovation platforms have started to mature and move into prime time. When I say mature, I mean from an innovation point of view.

So we are able to track whether or not we are right. I think the expectation out there is maybe 20% compound annual rate, and it’s come up quite dramatically from a consensus point of view. If we’re right on the unit growth dynamics, Wright’s law being a function of units means that the costs are going to come down. This exponential growth trajectory is going to be cemented.

Now, an example of the convergence among three of our platforms is autonomous taxi networks. This is the next big leg of valuation for Tesla, we believe. Autonomous taxi networks are the convergence of robots – autonomous vehicles are robots. Energy storage – they will be electric. That’s the cheaper way to go and the better way to go.  And artificial intelligence, they will be powered by artificial intelligence. So we’ve got cost declines in these three – robots, 58%. That’s more collaborative robots. Energy storage, the 28% on the battery. Artificial intelligence, 68%. You get the convergence of that, you have an explosion. We think no one’s even close to Tesla. The closest might be in China. But we think what’s going on in China right now is going to turn off a lot of innovation.

Needham:  Cathie, you’ve talked a lot about the cost side of it, specifically Wright’s law. That requires you to predict demand. Demand’s always been hard to predict. So when you’re thinking about the adoption of these disruptive technologies, how do you think about the range of possible outcomes? And specifically, how do you think about the potential that you’re wrong when you’re valuing these businesses?       

Wood: Our investment time horizon is five years. That’s the first thing. But we listen to every earnings call. We’re talking to managements, just like other teams. And we get market share data and unit data all the time. So we are constantly getting a reminder – this is either happening more slowly or more quickly than we expected.

On the valuation side, how do we value these exponential growth opportunities? What we do is in our five-year time horizon, we are projecting out, again, based on Wright’s law, based on evidence, is the demand coming through as expected? Usually, by the way, demand does come through. Better, cheaper, faster, more creative, more productive typically works. The demand is there if the costs are right. And we project out the cash flows based on our Wright’s law and our cost trajectories to arrive at an EBITDA in year five. 

For many of the categories that we invest in, except perhaps genomics, we will simply put a FAANG-type multiple, a mature innovation company multiple, on these stocks. So what we have, then, is multiple degradation – significant multiple degradation relative to today’s multiples. Our minimum hurdle rate of return is 15% at a compound annual rate. And right now, if you were to look at our flagship strategy, based on those cash flow assumptions and tremendous degradation of multiples, our compound annual rate of return expectation is 30% per year.

Needham:  That’s a decent return, 30%.

Arnott: That’s a very good return if you finish at FAANG-type multiples several years from now.

Wood: Yes, 18, 19 times EBITDA is a mature innovation company multiple. We do not believe our companies will be mature in year five. 

Needham:  So there’s upside there. Maybe, Rob, just on to the fundamentals, I’m going to use a quote from a very well-known value investor, Warren Buffett. He said, “Beware of past performance proofs in finance. If history books were the key to riches, the Forbes 400 list would be full of librarians.”

Your approach is very much geared in looking at historical fundamentals and relying on some of those relationships to hold. So, how do you think about some of these disruptive elements when you’re building a strategy based off historical fundamentals or making assumptions about fundamentals?           

Arnott: A lot of our work is based on mean reversion. Cathie alluded to mean reversion valuation multiples for the disruptors. Mean reversion is the most powerful factor at work in the capital markets. It shows up on earnings growth. When you have very rapid earnings growth, it tends to mean-revert down. When you have tanking earnings, it tends to mean-revert up. Not in all cases. There are value traps.

So when you’re looking at a whole spectrum of disruptive companies, there will be some that turn out to be spectacular. Go back to the first tech bubble. How many of the 10 largest market-cap tech stocks in the market in the year 2000 outperformed the market over the next 10 years? Zero. Not one. How many outperformed over the next 20 years? One, Microsoft. What about Amazon and Apple? They weren’t anywhere near the top 10. They were bubbling up from underneath, and in the case of Apple, was perceived to be poised of the brink of ruin. 

So what you find is that when you have bubbles, and bubbles can appear anywhere – I’ll come back to a definition for them in just a moment – when you have bubbles, they tend to burst. Our definition for a bubble is a very simple one. If you’re using a discounted cash flow model or some other valuation model, you’d have to use implausible assumptions to justify today’s price. We plugged in 50% growth for 10 years for Tesla, assumed profitability matching the best of any automaker – and that may be the wrong choice, but the best of any automaker of any single year of the last 10 years – and we came up with a net present value of 430 bucks. I view 50% growth as implausible. Cathie does not. So I view Tesla as a bubble. Cathie does not.

But two things are interesting about bubbles. One, they can go much further and last much longer than any skeptic would expect. So be very careful about short-selling bubbles. You can make a ton of money if you have a good exit strategy.

The second observation about bubbles is that implausible growth assumptions doesn’t mean impossible. Amazon in the year 2000 would have qualified for my definition of a bubble, because you’d have to use extreme growth to justify the then-current price. Amazon was a terrible investment in the 2000s, got it all back with room to spare in the 2010s. And in the 2010s, it grew 26%, 27% per annum, which was enough to make it 11 times as large as it was 10 years previous, 11-fold growth.

Now, to justify Tesla’s current price, you’d have to assume roughly 50-fold growth over the next 10 years. Is that impossible? No, anything is possible. Do you believe it’s plausible? I don’t. So I view it as a bubble. And as with Amazon in the year 2000, I could be proven wrong. But as with Amazon in the year 2000, you might have to wait a while for the market to catch up to the actual growth opportunities if they are as extravagant as Cathie says.

Needham:  So, you both agree that Tesla’s a great value at the moment, so that’s good.

Arnott: Oh, it’s such a bargain.