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Shiv Kapoor, MaxKapital (364 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Do you, like Fama, believe that markets are efficient? Or do you lean towards Schiller's view that markets are inefficient? Or do you believe both? Can it be that the market is both efficient and inefficient? Markets are forward looking. Markets are in a constant state of flux. Markets are chaotic. Are markets in a constant state of disequilibrium in the journey towards equilibrium? Do inefficient markets tend to efficiency? And if yes, how can we follow the path to efficiency, or the journey to equilibrium?

A believer in efficient markets believes that the price reflects everything, and by everything, I mean everything known; i.e. expectations. For large well-established and well-followed stocks, obtaining expectations data from sources such as Reuters is relatively easy. And once we value those expectations, we can compare the value with price. If the value is below the price, a buy decision is indicated, because in time, in an efficient market, price will tend to value. However, a follower of efficient markets will believe that price leads expectations. Thus if the price is higher than the value, it is not because expectations are mispriced, but because expectations will change.

Expectations change with the passage of time and with changes in the economic cycle. And analyst focus is normally on the trailing twelve months, the current year and the forward year. To address this, if you elect to adopt a time arbitrage strategy, you can elect to value expectations which are likely to occur in a time period beyond this typical horizon. You can follow the links to read a couple of posts on time arbitrage strategy for Transocean and ArcelorMittal. A time arbitrage strategy is designed to outperform over the long term and is suitable for those who are not fearful of underperforming over the shorter term.

An alternative is to follow a more traditional Price/Value arbitrage strategy: you can seek out opportunity where expectations are mispriced. Using such a strategy, the aim is to outperform over the long term through smaller levels of outperformance continually through the short term. Because expectations change, there is a constant need to revalue constantly changing expectations and prices, and alter your capital allocation as these prices and expectations change. In large well-established and well-followed stocks, dramatic shifts in expectation are less likely. And so when price does depart from value, it is likely that the exuberance or despair of the investor community is driving prices away from the value and thus creating an opportunity. This approach would be most appropriate for value stocks and you can read my post on a Price/Value arbitrage strategy for General Motors here.

This brings me to the Price/Growth arbitrage strategy. This is a riskier strategy because stock selection is incredibly important. We all know the story of how Google or Apple grew, and of how investors saw amazing price gains over several years as a result of earnings growth far higher than market earnings growth. But what we do not hear is important too: we don't hear of the thousands of companies that wanted to grow rapidly and died trying. In this strategy, capital allocation is also incredibly important: risking a small portion of capital and hoping that one day it grows to be a substantial part of the capital is the way to go.

In my book U.S. Dow & Mega-cap Investment Strategy: Value Hidden In Plain Sight: Volume 1, I try to find a happy medium. Because both stock selection and capital allocation play a huge role in generating long-term returns, I do this by including a couple of stocks selected based on a time arbitrage strategy in the Global Leaders selection, and I do include a couple of growth stocks, and I include value stocks as the vast majority, and then I allocate capital based on the valuation of expectations.

This post is not about a time arbitrage strategy, nor is it about a Price/Value arbitrage. Nor is it about my book! It is about Price/Growth arbitrage. It is about Tesla (TSLA): a company best described as tantalizing, terrific and terrifying.

Tantalizing, Terrific and Terrifying Tesla

Tesla is tantalizing: Just look at this car and tell me you would not love to own it! Click on the photograph to visit the Gallery on Tesla's website.

Tesla is terrific: The Roadster that goes from zero to 60 mph in 3.9 seconds is outdone by the Roadster Sport that does it in 3.7 seconds. This performance comes from a car that doesn't run on gasoline. Click on the screen shot and it will take you to Features & Specs page on Tesla's website.

Tesla is terrifying:

When I look at the Roadster, I see tomorrow's car today. I see a car I would love to know better. And I see a car I'd love to own as my own. The Roadster is history, but the Model S is pretty neat and it's a heck of a lot cheaper. And the Model S P85 gets you to 60 mph in a none too shabby 4.2 seconds. And if you prefer, you can wait for the Model X, where 2014 reservations are likely to be delivered in 2015: it is expected to be a bit pricier relative to the Model S. I am nattering on about the price because it is important: for growth there must be volume, and no one can deny the link between price and volume.

Cheaper models are on their way. Models priced in the $30k to $35k are expected within the next three to five years. And I expect these to be fantastic. Once the first phase of innovation is done, the phase of learning while doing can lead to substantial savings, part of which can be passed to consumers, with little compromise on performance or quality.

I know there is huge growth potential. I know that Tesla has differentiated itself in the luxury automobile industry. I know they have built a powerful brand. In many ways Tesla is a technology company specializing in automobiles: with their intellectual property, they have built an entry barrier and created a major competitive advantage. And they have done all this using clean tech: no gas. But with the opportunity comes risk.

Firstly, in the U.S., with access to state subsidies, guaranteed residual, and an attractive financing, the car is well able to compete with luxury vehicles in the gas guzzling class. Yet in U.S., Tesla has to do more than build aspirational cars. It also has to build a network of re-charging stations: that will be an expensive proposition, and one which is not a worry for its gas guzzling competitors.

Secondly, to grow to a size which will justify the recent share price, Tesla is going to have to grow globally. In developed international markets, there will be no subsidies, and financing may not be so generous. In addition, as in the U.S., the cost of building re-charging stations will remain a drag on potential profits.

And when I look growth in developing markets, there are even more numerous risks. I can't imagine myself cruising the streets of Delhi praying to avoid a stray cow or pig on the roads and hoping I make it to the next recharging station in time. And hoping there is no power outage when I do make it to the station. And while Tesla has made a strong case for safety of its vehicles, I would be worried about what road conditions here might do to ignite the flames. Then there is sticker price shock and the market size. In U.S., the car might come to represent affordable luxury, but in India, after taxes and insurance, I would expect to pay over $200k: and finance that at interest rates near 15%! That limits market size.

The good news is that while growth creates challenges, with the company planning to develop a range of vehicles at lower price points, there is a very powerful mitigating factor. One which might even make current analyst growth expectations seem low one day in the future.

What might prove terrifying about Tesla is its recent share price, not its cars. Tesla hit an all-time high at $194.50 recently. Since that time, it has fallen 13% to $170. Does that represent an entry opportunity? Or does the fact that it has risen five-fold from $33.40 at its fifty-two week low to $170 suggest that it's foolish to buy at current levels?

I am virtually certain that at some point in the coming several years, Tesla will trade at a substantial discount to where it trades today. But virtually certain is not enough for an investor who is indifferent to losing some money in the short term, with an expectation of making a lot of money in the long term. Tesla is a good company, we'll never know if it's trading at a good price until we value Tesla, difficult as that may be.

The prospect of owning Tesla at $170 terrifies me, but not enough to deter me from having a shot at valuing the company. At the end of the exercise, I might end up with Tesla on a watch list with intent to buy if it ever reaches my target. Of course, before buying I would revisit my target based on expectations then prevailing. Alternatively, I may end up allocating a tiny piece of capital to Tesla: an amount which if lost would hurt my ego, but not my portfolio.

Approach to Determination of the Value Target

People buy and sell stocks, stocks make up the market, and the market itself exists in perpetuity. The owners of the market, be they you or another, will receive dividends, buybacks and real growth of dividend & buyback distributions in perpetuity. That is it, nothing else - your only return is from current and future corporate distributions. Thus what shareholders can expect to receive by way of returns is the dividend yield, the buyback yield plus real future growth, that, and that alone is what must be valued.

Typically the key areas I look at are beta, dividend, return on equity, earnings growth expectations and consensus average earnings estimates for the year-ending 12/31/14. Based on these criteria, I calculate a potential payout potential, which then discounts those to arrive at a value target. The payout potential is simply 1 minus the re-investment rate. The re-investment rate is the growth rate divided by return on equity. If a person has a return on equity of 10%, to grow by 6%, they would need to re-invest 60% of earnings: if a company earns $100, and re-invests $60 (instead of distributing it to shareholders), for a return of 10%, they would increase earnings by $6. The remaining 40% could be distributed to shareholders. A growth stock is in the process of value creation, having yet to reach the stage where it can return value to its shareholders. Thus the notional 40% available for distribution to shareholders would be deferred and reinvested in growth: you are sacrificing current value returned in exchange for the current potential return and real growth in future value returned.

This approach has limited applicability for a young growth stock such as Tesla. Thus I plan to project, based on a mix of the current market and my own expectations, what Tesla's earnings might be for the year ended 12/31/25: about twelve-years or a length of a typical two economic cycles is about how long it could take Tesla to make the transition to value stock from growth stock. These earnings will then be valued using the methodology noted in the preceding paragraph to arrive at a 2025 target price.

As far as growth is concerned, I am skeptical about analyst projections because the long term means different things to different folks outside of the current and forward year expectations. In addition, growth estimates are provided by very few analysts: for Tesla, on Reuters, only one analyst has provided a growth estimate of 18.9% (down from 54.9% one year ago), and that cannot be said to reflect market expectations. Thus I prefer to use a macro expectation in lieu of a company specific expectation. For the automotive industry, I feel a long-term growth expectation of 8% being 4.2% real global growth potential plus 3.8% global inflation is reasonable to expect. For Tesla I am looking at the potential revenue for the top 20 global automotive companies as the pie from which Tesla must eat.

The top 20 global automotive companies are expected to generate revenue of near $1.75 trillion during 2013. For the automotive industry, I feel a long-term nominal growth expectation of 8%, being 4.2% real global growth potential plus 3.8% global inflation is reasonable to expect. Thus, by 2025, we could see the revenue from the top 20 global automotive totaling near $4.4 trillion.

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In 2025, the top 20 global automotive companies may well look very different to the 2013 list in terms of composition, but the nominal growth adjusted revenue provides a reasonable estimate of the potential size of the market.

If we assume that Tesla takes 1/25th (4%) of the revenue share from the top 20 global automotive companies' pie, during 2025 it would generate $175.7 billion in revenue. A 4% share of top 20 automotive companies' revenue would put Tesla in the same league as Audi today, but well behind BMW or Daimler which are expected to hold a revenue share of around 6.2% and 9.3%, respectively.

A 4% top 20 revenue share is challenging but achievable. In the short time that Tesla has been around, they have developed a powerful brand and an amazing product. Over the coming years, Tesla will compete head on head with Audi, BMW, Daimler, Porsche, Lexus, Acura, Infiniti and the like. But with cars planned in the $30k-$35k price point, they will also take market share from General Motors, Ford, Toyota, Honda, Nissan and the like. Having a product profile covering the luxury and high end markets makes the achievement of 4% revenue share in twelve years easier. If Tesla has to grow from approximately $2 billion to $175.8 billion over twelve years, it will have to achieve a highly challenging annualized growth rate of 45.08%.

This is the projected revenue (nominal terms) growth trajectory, which displays how revenue might grow between now and 2025 in $ millions.

What would revenue of $175.8 billion in 2025 mean for earnings in 2025? The average net margin earned by the top 20 global automotive companies is expected to be 4.48% during 2013. At median levels the net margin is expected to be 4.36%, while at the 75th percentile, it is expected at 6.25%. The average net margin for Daimler, Audi and BMW is expected to be at 6.92%, and this level lies near the 81st percentile of net margins among the top 20 global automotive companies.

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I am using a margin of 6.92% to estimate Tesla's earnings in 2025 at $12.2 billion, and this margin would put Tesla at the sixth highest net margin earner from among the top 20 global automotive companies in 2013.

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How does that translate into earnings per share? Today there are 137.13 million shares on a fully diluted basis. Adding leverage to the capital structure of Tesla is inevitable if the annualized growth target of 45.08% is to be met. Tesla could add leverage and drive annualized growth rates to 18% to 20%. To add more leverage could hurt the company and thus I assume there will be substantial dilution through the issuance of equity and hybrid financial instruments. In my view Tesla will need to dilute at an annualized rate of 6%, and to this I will add about 1.5% as additional dilution on account of employee and executive compensation. Thus the annualized dilution rate would be 7.5%. Accordingly, in 2025, the diluted shares in issuance would likely grow from 137.13 million to 326.62 million and the $12.2 billion in earnings will translate to earnings per share of $37.22.

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The next question is what value (not price) can we expect from Tesla, a company with earnings per share of $37.22 in 2025? I am assuming that in 2025, Tesla is done with its growth spurt. I assume that competition has intensified from the auto majors and new up-starts (or start-ups!), and Tesla is ready to make the transition to a value company from its prior status as a growth company. I am assuming that by 2025, yields on the ten-year government securities which reflect risk free rates will have normalized to a long-term average of 5.5%. I have further assumed that the rise in interest rates will slow the nominal growth rates for the automotive industry from 8% estimate at present, to 6.7% in 2025. Assuming that Tesla has a capital structure and business mix similar to the broad automotive industry in 2025, it can be expected to carry a beta consistent with the industry average beta of 1.7 which we see today. On the other hand, if we assume that Tesla quality, together with lower than industry financial leverage, and a mix between luxury and high-end vehicles which provides for lower volatility in earnings through the economic cycle, we could see lower than industry average betas of 1.2. An investor with a 9% market rate of return would require a rate of return of 11.45% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})] for a stock with a beta of 1.7. An investor with a 9% market rate of return would require a rate of return of 9.7% for a stock with a beta of 1.2.

At this stage, a company with a return on incremental equity of 18.23%, which is the industry average at present, will need to re-invest 36.75% of its earnings to drive growth of 6.7%. The remaining 63.25% will be available to shareholders. What might a notional payout of $23.54 (63.25%*$37), with a long-term growth expectation of 6.7% be worth to investors with a target rate of return of 11.45%, assuming a stock beta of 1.7? It is worth (present value in 2025) $529. What might a notional payout of $23.54, with a long-term growth expectation of 6.7%, be worth to investors with a target rate of return of 9.7% assuming a stock beta of 1.2? It is worth (present value in 2025) $837. The present value in 2025 is calculated as Notional Payout * (1+Growth Rate) Divided by (Required Rate of Return minus Growth Rate).

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Tesla recently traded at $170. If you expect it to be worth $529 by 2025, by buying it at recent levels, you more than triple your investment in twelve years: that provides you with an annualized return of 9.92% over twelve years. If you expect it to be worth $837 by 2025, by buying it at recent levels, your investment rises almost five-fold in twelve years: that provides you with an annualized return of 14.21% over twelve years. Is that enough?

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I would err on the side of caution because of the horrendous risks and optimistic growth assumptions, and go with $529 as a value target in 2025, and thus assess the return potential at 9.92%. From the broad markets, I can expect a 9% (6.5% real, and 2.5% inflation) annualized twelve-year return including dividends: this is consistent with historic very long-term market returns. This 9% return expectation is not stable. Between 12/31/13 and 12/31/1980 we have seen a one standard deviation in twelve-year annualized returns amounting to about 4.3%. Thus over the coming twelve years, I can expect annualized capital appreciation of between 3.1% and 11.7% plus a dividend yield of about 1.9%, with an average expectation of 9% including dividends. In the circumstances, I feel a return expectation of 9.92% is inadequate for the risk undertaken - a premium of 92 basis points over broad market is not adequate for the risk being undertaken.

What is an adequate twelve-year return expectation for Tesla? What do we know about Tesla today? We know it has grown to be a powerful brand with a great product. It has a proven ability to innovate at the highest level. Ownership quality and leadership is impeccable. And it has a huge growth opportunity ahead. But it comes with huge risks too. If we use the recent 3% yield of the 10 year government securities yielding 3% as the risk free rate, an investor with a 9% market rate of return would require a rate of return of 13.2% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})] for a stock with a beta of 1.7, with 1.7 being the present industry average beta. If we use the recent 3% yield of the 10 year government securities yielding 3% as the risk free rate, an investor with a 9% market rate of return would require a rate of return of 17.3% [Risk Free Rate Plus (Beta Multiplied by {Market Return Less Risk Free Rate})] for a stock with a beta of 2.38. This beta of 2.38 is higher than the 1.7 industry average and is a reflection of where beta might rise to, on account of expectations of rising financial leverage, a changing product or business mix, and equity dilutive events over the coming twelve years.

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To generate a twelve-year annualized return of 13.2%, assuming a $529 value target in 2029, Tesla would need to trade at $119 to be attractive. But the question I ask myself is that if I wanted a 13.2% return expectation, I could achieve it with far lower risk, by simply buying a selection of leaders in the automotive industry. Thus a better aim might be to set up a twelve-year annualized return expectation of 17.3%. This return expectation would be met only if the stock trades down to $78.

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Another factor to consider is beta quality. When we work with regression analysis to calculate beta, we know that the resulting beta has a high standard error and reflects the financial leverage and business mix over a period of time instead of the point in time that you invest. If we calculate a bottom up beta to address these concerns, we are exposed to beta errors caused by changes in financial leverage and the business mix at company and industry level over the investment horizon. In addition we add a new risk of incorrect analyst judgment, because the exercise of judgment is required when calculating a bottom up beta. Finally, a bottom up beta cannot quantify the impact of qualitative facts on beta, which get picked up by the beta calculated using regression analysis. On balance, in my view regression analysis is the better tool, with the five-year regression being most appropriate for long horizon investors. But in the case of Tesla, the company has not been publicly traded long enough for a five-year regression analysis. Thus in my analysis, I have used industry averages, bottom up betas, and a three-year regression analysis.

We must also contemplate how leadership quality impacts beta. We know that Amazon is a low beta stock, despite completely failing to meet earnings growth objectives the past several years. Investors get impatient from time-to-time, but the stock's beta has not risen, mainly on account of CEO Jeff Bezos and the company's perceived leadership and ownership quality. And it retains its valuation, because it retains its growth expectations and consequently its growth stock character. I may sound like I don't like Amazon, as it happens, I do like it. I would not buy it here, but neither would I sell it. Why I like it is another long story, best summarized by saying, like Tesla, it is building tomorrow today: it takes time to build the future, they'll get there.

With Musk, low beta is a theme we might see repeated at Tesla. And if we do, see a Musk beta of say 1, with earnings growth expectations delivered, we could see the stock valued at near $1.1k in 2025. That would imply annualized return based on a $170 entry price of 16.76%. There is a risk of loss buying at $170, but there is also a risk of losing out on future returns by not buying at $170!

In my view at $170, Tesla goes on a watch list. And if it gets to $120, I will do my due diligence and possibly nibble. If it gets to $80, I will re-visit my due diligence, and then possibly buy much more.

Let me conclude by saying that this post is not a recommendation of any sort. Nor is it research. Nor can it be considered due diligence. It is merely an idea, or an investment thought-piece: if you like, it is a penny for my thoughts! I'd be delighted if you enjoyed it and it got you thinking, but if you buy, or if you sell, be sure to do your homework, research and due diligence first.

Source: Tryst With Tesla