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In today’s post, we want to talk about the challenges of adding a company as large as Tesla to the S&P 500 index, Tesla vs. Berkshire Hathaway, and the Electric Vehicle bubble.
The challenge of adding Tesla to the S&P 500
Following the announcement on November 16th that Tesla will enter the S&P 500 index, the company’s share price surged more than 40%, and the average trading volume of the stock spiked (see Figure 1).
Announcing that Tesla will join the index turns out to be the easy part. The hard part is doing so. Adding Tesla, a company with more than US $500 billion market cap is no easy feat. Tesla is by far the largest company the index has ever added. Upon its inclusion, it will be the 6th largest company in the index, larger than Berkshire Hathaway (more on this later) and only slightly smaller than Facebook.
Because of Tesla’s size, its inclusion will generate US $100 billion in trades from Index funds selling other companies to accommodate the new addition and to buy new Tesla shares. This means that any volatility in the share price can affect the addition process, causing large price movements.
To mitigate this, large investors will add Tesla shares to their portfolio over two trading days (Dec 18th and Dec 21st 2020).
What will happen to Tesla’s share price after the addition?
The risk after the addition is that Tesla’s share price might drop. As we mentioned in a previous article, stocks added to the S&P 500 typically show higher returns a couple of weeks before the inclusion date, only to decline after. Figure 2 shows the typical returns of stocks before and after S&P 500 inclusion.
As we know, Tesla is anything but typical. The company’s share price has jumped almost 600% this year alone. Part of this jump was due to Tesla beating expectations amid the pandemic, and the other was due to the anticipation of its S&P inclusion. There’s a risk that the share price will drop precipitously after the official inclusion date.
Tesla is larger than Berkshire Hathaway?
Yes, you read that correctly. Tesla is more richly valued than Berkshire Hathaway, Warren Buffett’s holding company. Is this justified? Here’s a comparison between the two companies (see Figure 3).
Here are a few key observations:
- Tesla’s market value currently stands at US $550 billion, exceeding that of Berkshire Hathaway’s, and just shy that of Facebook’s.
- Berkshire Hathaway’s revenue is 8.8x higher than that of Tesla’s.
- Berkshire Hathaway’s last 12 month’s’ operating income is US $61 billion, compared to Tesla’s US $1.7 billion.
- Berkshire Hathaway’s operating margin is 4x higher than that of Tesla’s.
- And finally, Berkshire has more than US $145 billion in cash and cash equivalents, while Tesla’s is 10x lower.
Either Tesla is overvalued or Berkshire Hathaway is undervalued. Likely, both are true. Buffett seems to think that his company is undervalued. In Q2 of this year, he initiated the largest share buyback the company has ever done in its history (about $5.1 billion dollars worth of stocks).
Note: a share buyback occurs when a company believes its share price is undervalued, and uses its cash reserve to buy back its shares from public investors to increase the share price.
The Electric Vehicle Bubble
Tesla is not the only electric car company that has experienced a significant share price run up this year. In a previous post, we discussed how many of the pre-product launch EV companies are going public by merging with blank check companies (SPACs). This trend is alarming because these EV companies have not only raised billions of dollars, have not delivered products or do not have significant revenue, and yet they have seen their share prices skyrocketed (Figure 4).
The surge is observed not just for electric car companies but also for charging station companies such as Blink Charging (went up almost 17x in 6 months, without significant revenue or R&D expenditures!) and Workhorse.
The runner up to this surge is Nio, a Chinese EV maker. As recently as Dec 2019, the company only had slightly over US $900,000 in cash, and after burning more than US $4 billion in the past 3 years, Nio faced significant risk of going under in early-2020. Luckily, a local government bailout provided the lifeline the company needed. Since this summer, Nio’s share price has increased more than 13x.
Figure 4 reminds us of the different stages of a bubble (see Figure 5).
Yes – there are macroeconomic conditions that help the electric vehicle industry, which would lead to overall growth, but the rapid pace of increase in share prices that is clearly divorced from reality strongly suggests that we are in a bubble.