The stock market has gained a lot of popularity over the past few years, and especially the past few months. The average Joe, in my opinion, does not have the patience to wait five or more years for good stock returns. Many of these investors are only satisfied with the next multi-bagger, with especially the 10-bagger being the most popular. It is clear that we have come to a point where the impatient have arrived at the stock market again, hoping to become rich as fast as possible.
“The stock market is a device for transferring money from the impatient to the patient”Warren Buffett
These investors are being lured into stocks with lucrative prospects leading to some interesting price fluctuations. In this post I will use Tesla as an example to explain what I currently call the Hype Premium and the Fraud Discount. Then I will shortly describe what we saw happening recently with Nikola and Nano-X to see what it can teach us about assessing these types of stocks.
The Hype Premium
We live in a world where almost all information is accessible at our fingertips. New technologies emerge that can change the world in the same way as the car and the smartphone have already done. Investors want to get a share in the profits these technologies can generate in the future. A company that was unknown yesterday can suddenly become the hype of today.
Whenever a company presents a new technology to the newly founded investment crowds on social media, one story can quickly lead to another. A company may be picked up by a financial influencer, who announces his ‘bull thesis’ on such an investment. People start talking about the technology, mostly focusing on the potential to disrupt industries and the world. They start to cook up some high level valuation metrics for the company and slap a huge price target on it.
Before you know it, the only way for the stock is to go up, while the fundamentals do not necessarily support the sharply increasing valuation. It is all about the story. The bigger the hype, the further the price increases. The gap between the fundamental value and the price in this case is what I would like to call the Hype Premium.
I do not have the necessary access to data and statistical software to do it, but if an academic would happen to read this: please do some research to see whether the existence of a hype premium can actually be academically proven (for example based on social media mentions of the ticker symbol)
My personal problem with such a Hype Premium is that it ignores many of the risks a company faces in its growth path. It often even ignores the entire underlying business model and investments that are necessary to achieve it. What it certainly seems to ignore is the time value of money.
This is why discussions on these stocks can become very heated. People are often personally involved with their own hard-earned money. They see golden mountains, a mortgage free future, or other promises that they see as an absolute certainty. The more often they repeat the story, the less they see failure as a possibility.
When an investment banker or experienced financial analyst points out a flaw in the reasoning of these investors this may ignite a discussion similar to other academics trying to convince:
- flat earthers that the earth is actually a sphere
- religious people that humans evolved and were not created by a deity
- climate sceptics that global warming is caused by human activity
Before I dive into the examples to make this more concrete, I want you to know that I do not want to pick a side. I think it is beautiful to see people thinking about great future scenarios and that they enable companies to achieve this by devoting their attention and capital to their products. I also think you should always be wise with your investment strategy. I find it very sad when people go all-in on a hype that eventually fails, resulting in huge money losses and personal difficulties. In short, let’s all invest wisely and hope for the best future for humankind.
The Fraud Discount
The other side of the story is that some of the companies of which the valuation is driven up by these crowds can eventually turn out to be less promising than initially thought. This has huge societal costs, because these companies are often directly labeled as frauds and management is often prosecuted (sometimes to a further extent than just for running a questionable business), while the capital of investors is directly destroyed.
The examples I want to focus on are companies that swung between the lows of fraud allegations or bankruptcy threats and the highs of a hype. What I am looking for is a common denominator, or something that can help us to identify frauds and non-frauds in the future. I think this can be beneficial, because a company that was, or can become, a hype stock and is currently thought to be a fraud can be an incredibly lucrative investment opportunity.
Now that the scene has been set, let’s dive in the examples. I want to use the case of Tesla as the starting point through which some recent hype and fraud stocks may be better understood.
Tesla: The Prime Example
Tesla ($TSLA) is by far the most prominent example of a stock that has swung between a fraud discount and a hype premium valuation.
Tesla manufactures electric vehicles (EV) in the United States and China, with a factory currently being built in Europe (Berlin). The current models are the Model S, Model 3, Model X, and Model Y. Tesla plans to add a Semi-Truck, a New Roadster, and the Cybertruck to this line-up.
Compared to other car companies, Tesla does not rely on combustion engine cars. Tesla is also the only car company that manages to seamlessly integrate consumer-centric software in the car, and pursues self-driving technology in its own unique fashion. Whereas other car companies use LiDAR technologies, Tesla wants to directly start with a fully computer vision-based system.
Tesla aims to vertically integrate the car manufacturing process. For the self-driving technology it even designed its own chip. This aspiration leads to operational advantages that other car manufacturers don’t have. Recently, Tesla presented a new battery design that would be able to further increase the range and longevity of its vehicles.
Next to the car business, Tesla is also engaged in the (renewable) energy business. It sells energy storage packs and solar (roof) panels. These products aim to bring energy to consumers more efficiently and to reduce grid reliance.
The hype with Tesla is, in my opinion, based on the core assumption that they have unique technologies that cannot, or can only hardly be, beaten by the competition. This can be divided into three key segments: Autonomous Driving, Battery Technology, and Manufacturing.
Tesla uses a unique approach to reach self-driving technology. Competitors use a different approach because current processing power is not yet capable to solely work with computer vision-based data. However, with Elon Musk blatantly calling LiDAR ‘a fool’s errand’, followers of Tesla are convinced that in the near future Tesla is the only company that can offer self-driving technology. The assumption of Tesla being the monopolist of self-driving technology is the core driver of the sky high valuation assumptions.
The recently presented battery technology improves the electric car to such an extent that Tesla cars will be much better and cheaper than the electric cars of other car manufacturers. This has led to people, including Elon Musk, assuming Tesla could sell 20 million cars by 2030 (as compared to Volkswagen currently selling around 10 million cars per year). This battery technology also leads to the belief that Tesla can grow to become the world leader in the energy market, as this technology may be either licensed to other car manufacturers or other companies working with batteries for other purposes.
Innovation at Tesla goes beyond their products, the software, and battery technology. It is also about the production process. By rethinking old-fashioned car production people expect Tesla to achieve much higher margins on their automotive sales. The recent production improvements related to the battery technology further shows that this can not only improve margins, but can also improve Tesla’s competitive advantage.
Tesla is one of the most valuable public companies in the world right now, so there has to be some truth in these hypes. I believe that is what makes it so easy for a company like Tesla to make these positive scenarios outweigh the caveats.
A lot of credible sources support these positive future scenarios. Elon Musk repeatedly supports the notion that Tesla will become the biggest and most dominant self-driving EV and energy company. As a co-founder of PayPal, people see Musk as a very credential source when it comes to building great companies. Cathy Wood, CEO/CIO of Ark Invest, is continuously putting out excessive price targets, which makes people further believe in the future of the company.
There are just as many hype theories as there are caveats. The caveats are mostly driven by a few individuals (called the ‘TSLAQ’ movement), mostly professional investors, that are constantly pushing narratives to show that Tesla is not, or will not become, the company it promises to be. Watch the $TSLAQ Twitter thread for some great entertainment.
Many short-sellers emphasize that Tesla’s underlying business is actually not profitable. They point to accounting tricks such as revenue recognition related to the full self-driving technology, other inconsistencies in the financial reporting (such as warranties, inventories, accounts receivables and other items), and regulatory credits sold to the competition. Tesla short-sellers also like to point out that many executives are leaving the company as a proof point that the company is not as successful as it seems.
The Demand Problem
As Tesla sometimes sells less cars than it produces, gradually loses market share in some geographies, and because sales of the Model S and Model X are declining, short-sellers love to point out that there is no actual sustainable demand for Tesla products. There is some merit to this theory, as Norway and the Netherlands, the markets where Tesla is biggest in Europe, had extensive government incentives for electric cars. Since these incentives decreased, the electric vehicle market in these geographies seems to have shifted away from Tesla and towards cheaper alternatives.
The short-sellers love to point out all the things that are wrong with the Tesla vehicles. It started early on with movies of exploding Tesla’s in car garages and it is currently focused on production problems, design problems and self-driving technology failures. The truth of the matter is, that these are mostly singular examples, and that except for the design issues no consistent errors have been proven. Also, the production problems with the Model 3 have been fully resolved, and Tesla seems to be ready now to quickly expand production globally.
The TSLAQ community also loves to point out all the wrong-doings of Tesla CEO Elon Musk. After multiple allegations from the SEC and other questionable public appearances (such as smoking a joint on a podcast) people have continuously questioned whether Musk is a suitable CEO for a public company the size of Tesla.
So far, the Tesla short-sellers have been proven wrong. Most likely that is because most of the issues pointed out have not resulted in a major impact on the overall business of the company. For example, the difference between a $100 million profit or a $100 million loss because of a tax credit will not completely disprove the entire future business model of the company. Other new allegations are very obvious or minor in a way that they start to seem like desperate attempts to still make their initial thesis seem relevant (such as the ‘failed’ presentation of the Cybertruck). Therefore, it is in my opinion unlikely that we will see Tesla trade at a discount in the near future.
My View on The Debate
I have often mentioned that I think the current valuation of Tesla is ridiculous (and clearly represents a certain form of a Hype Premium). People are then very quick to tell (or attack) me that I don’t know what I am talking about. As a former owner of Tesla shares, I would like to emphasize once more that I have done extensive research on the company.
Back in 2019 I made a full Discounted Cash Flow valuation model. When Tesla shares went above $600 I slowly built down my position in the company, selling my last share at exactly $1,000 simply because I could not justify the valuation anymore. I do see Tesla reaching a future value of $2,500 per share, but not within the next five years (note that these numbers are not split-adjusted).
I do get why many people see much higher price targets for Tesla, but I think they are overlooking some key business essentials. Here I would like to shortly explain five flaws people make in their current investment thesis for Tesla.
Industry Profitability and Valuation Essentials
The car industry is very competitive. Competitors will do everything in their power to take a share of the profits of Tesla if they happen to become the largest car, energy or transport company in the world. This will deteriorate the profits and competitive advantage of Tesla on the long-term, unless it can get a long-term strategic advantage that cannot be taken over by these competitors.
However, Elon Musk himself said on Battery Day that the only advantage he expects is in manufacturing. Operational excellence is not strategy (as is very well explained by strategy guru Michael Porter), so in my opinion Tesla really needs to come up with something else to justify its current $387 Billion market capitalization.
“Also for long-term competitiveness. Eventually, every car company will have long-range electric cars, eventually every company will have autonomy, but not every company will be great at manufacturing. Tesla will be absolutely head-and-shoulders above anyone else in manufacturing. That is our goal.”Elon Musk on Battery Day
Something people also seem to completely overlook is the relationship between the car sales, margins and autonomous driving technology. Some key questions that are overlooked in my opinion are the following:
- If Tesla is going to leverage a robotaxi network, will they actually sell 20 million cars per year (as there will be less demand for cars when they are self-driving)? What does this mean for the (excess) manufacturing capacity that is currently being built?
- If Tesla is going to produce a car for $25,000, what will the margins of such a car be?
- How much capital expenditure is needed to scale up to an annual production of 20 million cars from around 600,000 cars today?
- When will Tesla actually reach a level of profitability that will justify the current valuation and what are the risks associated with not succeeding? Does this justify the valuation when this profitability is appropriately discounted?
- Why is it so attractive that Tesla will enter the mining business, since capital expenditures in this industry is very high and margins can (at times) be very low?
We should not forget that other disruptive technologies may emerge. Electric vehicles are sustainable, but have already been around for a very long time (with the concept being around since the 19th century). Tesla is just making this technology affordable and publicly accessible. However, true full industry disruptions can still make Tesla (and other car manufacturers) obsolete. Think about hydrogen powered autonomous drones, or batteries made from salt and water for grid storage. There is currently no competitive edge for Tesla to beat these emerging technologies, of which the risk only becomes larger when Tesla can actually succeed in becoming the autonomous EV monopolist.
Further to the point of technology, I would like to point out that Tesla is doing a lot of things different from many competitors in the industry and along the entire supply chain. Think about the aforementioned autonomous driving example: is Tesla so smart, or are all the other manufacturers and scientists incredibly stupid?
Many bull theses put out there are in my opinion simply irrational. People still ask Elon Musk about Tesla boats, airplanes, or other vehicles. However, while Elon Musk does mention the transition to liquid oxygen for SpaceX, he somehow does not mention the threat of hydrogen for electric vehicles, even when it comes to boats and aircrafts.
Investors also dream about synergies between Tesla and other Elon Musk enterprises. However, the acquisition of SolarCity (and the ongoing lawsuits) shows that this is not that easy. All relationships between these companies will be watched closely due to antitrust and transfer pricing laws, in all jurisdictions these subsidiaries operate.
As a last note, I would like to point out that inclusion in an index such as the S&P 500 should not matter for any investment. The only thing that in my opinion has been proven by the S&P not yet including Tesla after four consecutive quarters of profitability is that they are also still not comfortable with the underlying (GAAP) profitability of the company.
All issues described above can best be summarized by the risk of failure. People tend to value Tesla as if it will succeed in all its goals, without setbacks or surprises. This tunnel vision is incredibly dangerous and can lead to unjustifiable valuations. This further increases the downside and lowers the expected returns of the stock, because there is hardly anything that can still surprise investors to the upside. Battery Day showed that, because despite presenting breakthrough technologies Tesla shares actually fell as much as 9% the following day.
The Tesla Tipping Point: 24th of October 2019
The chart below shows Tesla’s price action in 2019, which is the year I think we should focus on to identify the right investment opportunity for Tesla. The three highlighted points show the hype highs and fraud lows of the year.
1. Rough Start
Tesla started 2019 on a relative high. The prospects were good and people expected Tesla to bring the Model 3 in mass production, which was crucial for the path to profitability. However, in January 2019 Tesla announced it would fire personnel so it could bring down the price of the Model 3. This lead to a steep drop in the stock price on January 18th and kicked off a period of misery for the company.
2. Bankruptcy Scares
Investors were worried about the debt load of Tesla. In the first half year of 2019 there were more setbacks that increased these worries. First, Elon Musk admitted in May that there was more money needed to support the company. As a result, Morgan Stanley even put out a $10 price target (which would be $2 split-adjusted). The empty promises and worst case scenarios made the TSLAQ short-seller case stronger, increased the pressure on Elon Musk for possible frauds and made a lot of people believe Tesla would actually go bankrupt.
3. The Guerilla Recovery
From June 2019 onwards the stock started to recover. Many people following the stock closely, including many financial YouTube channels (for example Financial Education and HyperChange) noticed positive changes happening in the company. At some point, valuation guru Aswath Damodaran even made a valuation and decided to buy shares in Tesla. Later he (fittingly) stated that at that point, ‘a story stock lost its story’.
Production of the Model 3 was picking up, the Shanghai Gigafactory was built in a record time, and people started to predict a profitable third quarter in 2019. When Tesla announced profits in the third quarter of 2019 the stock surged 20% and never looked back (aside from the dip resulting from the pandemic), even though many professional short-sellers still questioned the underlying profitability.
In 2020 the hype with Tesla stock truly picked up. The company did a capital raise and all bankruptcy fears disappeared. Currently the stock is valued at $415 per share, a more than 690% increase compared to the jump to around $60 after the earnings surprise on October 24th 2019.
Nikola and Nano-X: Hypes of The Recent Past?
Following Tesla’s incredible returns and price action, many stocks have gone through the hype and fraud cycle. Two of them I want to highlight are Nikola and Nano-X.
Nikola ($NKLA) is a producer of a hydrogen-electric truck. The stock traded around $13 on April 27th 2020. As soon as June 8th 2020 the stock traded for $64. The company came (at least for me) out of nowhere, but following Tesla’s success, people expected Nikola to follow a similar or even greater path.
However, following fraud allegations from Hindenburg Research (there turned out to be no working prototype, similar to the Theranos story), Trevor Milton resigned as CEO and the company seems to continue without revenues (despite a $2 Billion investment from General Motors).
Right now, the stock is trading at $24.25 still giving Nikola a market capitalization of more than $9 Billion. Just as a comparison that is more than French auto producer Renault ($RNO.PA), which is currently trading at a market capitalization of just over €6 Billion.
My conclusion here is that even if Nikola turns out not to be a fraud, the current market capitalization seems way too high for a company that does not generate any revenues. If it does turn out to be a fraud, the conclusion to the story is pretty clear.
Nano-X ($NNOX) produces a new and revolutionary X-ray machine. Allegedly the company is able to produce an X-ray imaging device (Nanox.ARC) for $10,000 where it costs current incumbents in the industry millions to make one. Additionally, Nano-X wants to further leverage this solution by also providing software and cloud services (Nanox.CLOUD).
Nano-X went public through an IPO in August 2020 for $18. When the hype was picked up the stock rose to over $65 in September. However, Citron Research came up with a report stating that Nano-X is Theranos 2.0 and has no working product and/or technology. This sent the stock back to below $24.
Personally, I think the Citron Research report is terribly written, incomplete and without sufficient structure. Reading a counter-post and an objective story on the stock made it clear that the conclusion in the Nano-X story still has to be sorted out. Especially since the CEO stated that he will show a working product to the public. After this news the stock recovered to over $37 in just one day.
The Nano-X Hype Premium may still be intact for the coming two months, with this increase possibly being similar to Tesla’s 24th of October 2019 moment, as the start of the turnaround where short-sellers are going to be proven wrong.
Other Fraud Stories
When looking at all these fraud examples that started as or subsequently returned to a hype status, I think we can draw up the following three key lessons for your own research:
- The Product: check whether the company’s product actually works and make sure this is diligently fact-checked. In the case of Tesla people could experience the cars themselves. In the case of Nikola and Theranos no one could tell with 100% certainty that they experienced a working product in real-life
- The Financials: for retail investors it is hard to catch financial fraud or manipulation when it is done by a multi-billion company with seasoned professionals. The best thing you can do is to check for the metrics you can check and see if the numbers make sense on a high level. Whenever researchers, journalists or analysts think they see fraudulent activities you have to be very careful. See for yourself if the allegations make sense and act accordingly
- The People: make sure the people behind the business have solid credentials and are not only involved as directors, but are actually operationally involved in the business. Directors can be hired on a part-time business with limited attention, while employees and operational personnel needs to be on the job on a daily basis. In the case of Tesla, Elon Musk is operationally involved and has a track record of successful businesses. Something similar could not be said for Elizabeth Holmes for example in the case of Theranos
Doing your own research on these companies is key and will make a vital difference. If you can prove that an alleged fraud is not a fraud, you can gain stellar returns in a short period of time. However, this requires a large time investment to assess the real risks of such a business and you really need to know your risk tolerance if you decide to eventually invest in this kind of venture.
The other way around, I would personally never short a hype stock. To all the ‘TSLAQ’ short-sellers – even though I also think the current valuation is ridiculous – I can only say their biggest mistake is to underestimate the unlimited upside of a hype stock.
A fraud cannot immediately show performance, real achievements and facts to disprove short-sellers. As an investor you have to do your due diligence. The first and foremost step is to make sure that the product is real. The second step would be to make sure the financial reporting is up to standards. The third is to look at the team and what the company is actually doing. Then, you need to know yourself to make a right decision.
Whereas Elon Musk did get angry at short-sellers, videos made by independent fans of the Shanghai Gigafactory and Model 3 production output did not lie. People experienced Tesla’s products for years and were more often an ambassador than that they disliked the products. The financial part is hard to disprove, but as long as there is critique on reporting standards I think it is wise to stay careful and vigilant.
The investing public hyped up Nikola, whereas the broader public hyped up Tesla. In the end, the customer is always right.
So what is this going to tell us about Nano-X? The announcement of the CEO that he is going to show the product to an audience excites me. Therefore, I picked up a small amount of shares to follow this stock more closely as I think it will move from the fraud discount back to the hype premium. However, I know very well this is merely based on the speculation that they can present a real product and a compelling business case in the future.