My TFSA Update January 2017 - Why I Decided To Bet Against Tesla

Last update on Feb. 13, 2017.

Image Credit: Alexander Kondratenko / Shutterstock.com

 

In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book. In this post, I’ll also explain why I decided to short (i.e. bet against) a small amount of Tesla stock.

 

January Results: Down 15.3%

At the end of January, I had $64,677 in my TFSA account. This is after I had made my annual contribution of $5,500, so when I factor that in, I lost 15.3% in January, essentially reversing the gains I saw in December. By comparison, the Canadian stock market went up by 0.8% while the U.S. stock market went down by 1.2% in Canadian dollar terms. I don’t need to tell you that January was a terrible month for me.

The majority of my portfolio currently consists of oil and gas stocks, so the performance of my portfolio should largely be tied to oil. In January, oil prices went down from $53.75/barrel to $52.75/barrel. Given the small extent of the oil price decline, I don’t think the crash in oil stocks were warranted.

In times like this, I’m reminded of an old Warren Buffett quote: “Investing is simple, but not easy.” Investing is simple in theory because you just need to value how much a stock is worth, and buy those that are undervalued. I recently wrote an overview of my valuation method here. However, investing is hard because as long as you’re human, you’ll feel the forces of emotion sway you up and down, and emotion often leads you to make wrong decisions.

Under my assumptions, my valuation method shows that all of my oil and gas stocks are significantly undervalued. In fact, all but one of these stocks are trading below half of what the models say they’re worth. As long as the assumptions on my models hold, I’ll be rewarded for holding them in the end. However, my investment journey is proving to take much longer and be more volatile than I had anticipated.

That’s my brief commentary on my TFSA portfolio. For the rest of this article, I’ll talk about a decision I took that affects another of my accounts - namely, my decision to short Tesla.

 

Revisiting My Thoughts On Elon Musk

I’ve been thinking about Tesla for some time, and wrote an article about it in the summer of 2016. In the article, I highlighted the challenges facing Tesla, but I also expressed my reluctance to short the stock based on my belief that I think Elon Musk is a genius. Since then, my thinking has evolved and some events have come to pass to change my mind.

Let me start by revisiting the reason I held back from shorting Tesla before. Any realistic financial projection shows that Tesla will keep losing money in the foreseeable future. I won’t belabor this point since many analysts, including those on Seeking Alpha, are already doing a great job of illuminating this point. In fact, even most Tesla bulls (fans of a stock are called ‘bulls’) won’t dispute this. But rather, the argument of Tesla bulls rests on the belief that Elon Musk, since he is a genius, will eventually turn the situation around and Tesla will become the next Apple.

While I still agree with the bulls that Elon Musk is a genius, I’ve come to grow skeptical about the difference that even genius CEOs can make. I came to this realization after reflecting on Buffet’s quote that says, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

In any decent sized corporation, most of the work is done by the employees of a company, not the management. Let me illustrate this point using numbers.

Suppose that a genius CEO can achieve what 100 workers can achieve in the same time period. Would this CEO’s input make a difference? Not if the CEO leads a big company.

At current count, Tesla employs about 30,000 full time workers. If Musk’s work equates to the output of 100 workers, we would expect the company to function as well as a normal company with 30,100 workers. In this case, the advantage of having a genius CEO would be marginal.

But if that’s true, you may wonder how a CEO like Steve Jobs was able to make such a big difference to his company. I think the answer lies in the particular type of genius that CEOs possess. Some types of genius can’t be replicated by hiring 1,000 or even 10,000 workers.

The main reason Steve Jobs was so successful was because he knew what people wanted before they knew it themselves. For example, there was no established market for something like the iPad before Apple debuted it. If you threw 10,000 professional marketers to come up with something, I doubt that they would have independently come up with the iPad.

Another way that CEOs seem to make a big difference is through financial skills. This point becomes apparent in a book called “Outsiders”, which documents 8 management teams that enabled their companies to achieve outstanding performances. A common theme among these management teams is that they knew when to sell or buy their own stock, and they knew when to buy or sell business units. Because these are the types of decisions that only CEOs can make, you can’t replicate their results by hiring more workers.

In contrast to these CEOs, Elon Musk’s genius seems to lie in his engineering skills. His biography shows that he has an incredible memory, which allows him to do complex calculations in his head. But unfortunately, engineering skills are usually something that competitors can replicate by hiring more engineers.

Furthermore, even if Tesla gets ahead of its competition with the help of Musk’s genius, there’s little he can do to prevent competitors from catching up. As with most companies these days, Tesla’s workers tend to move on after spending a few years at the company. When these workers leave, they take all their knowledge and experience with them, often to direct competitors.

Of course, if Musk were a genius in some of the other areas I talked about, it would be a different story. However, his performance to date isn’t convincing. While he has the ability to dream up desirable products, those products have tended to cost too much. In other words, he has yet to dream up a product that’s both desirable and profitable.

Because of these reasons, I’ve become more comfortable with the thought of shorting a company with Musk’s particular type of genius. More comfortable, but not completely; if this were the only reason, I think I would still have hesitated. But then, Tesla bought SolarCity.

 

Why Tesla Is Vulnerable

When Tesla announced its decision to acquire SolarCity last year, many investment managers were incredulous because they thought it was such a terrible decision. As with Tesla, SolarCity was a perpetually money losing company operating in a tough industry (rooftop solar installations, in this case).

Tesla’s official reason for buying SolarCity is that it wanted to become a champion of renewable energy. However, this reason alone doesn’t stand up to scrutiny because there are other solar companies that have healthier operations. I say this as someone who’s invested in a healthy solar company.

In fact, the real reasons that Tesla appeared to be buying SolarCity were because (A) SolarCity was headed by Elon Musk’s cousin, and (B) Musk had a 22% stake in the company prior to the acquisition. Thoughtful analysts gave a good chance that SolarCity would go bankrupt without outside help.

Tesla’s acquisition of SolarCity did three things to make me more confident about shorting Tesla. One, it ensured that Musk’s attention would be further divided. Two, it caused Tesla to issue more shares to acquire SolarCity, diluting the stocks of its shareholders. Three, it meant that Tesla would bleed even more money going forward. On this last point, famed investor Jim Chanos even went as far as to say that Tesla is now a “walking insolvency” (insolvency is another word for bankruptcy).

Now, because Tesla is losing a lot of money, it needs to continuously raise more money via share issuances. Indeed, Tesla has raised significant amounts of monies in each of the past 5 years, and the company is widely predicted to do the same this year. This has important consequences.

A company’s ability to raise money heavily depends on the conditions of the stock market. If the stock market is hot, as it has been for the past few years, companies like Tesla will generally have few problems raising money. However, if the stock market crashes, Tesla will face two great difficulties.

First and foremost, Tesla will have a hard time finding investors to buy the new shares. When stock markets crash, they generally do so because more people want to sell their shares than there are those willing to buy. Given that Tesla probably needs to raise billions every year to keep going, it will be difficult to find enough investors in this environment.

Two, even if Tesla manages to find enough investors, it will be forced to issue shares at a much lower price. This compounds the share dilution problem for existing investors, because the company would need to issue more shares to raise the same amount of money. For example, at $250/share, Tesla would need to sell 10 million shares to raise $2.5 billion. But if Tesla’s stock price goes down to $100/share, it would need to sell 25 million shares to raise the same amount.

As if that’s not enough, Tesla also operates in industries that are highly cyclical. In other words, if the economy goes into a recession, people will delay purchases of cars and solar roofs before they cut out other, more basic needs like toothpaste. This means Tesla’s business likely suffer greatly at the same time that the stock market crashes.

Because of these reasons, Tesla makes for an excellent short if you are afraid that the stock market might crash. Now, I’m not betting big against Tesla because I’ve learned not to underestimate how far investors can push up a stock like Tesla. Rather, I’ve positioned my short such that a doubling, or even a tripling of Tesla’s price won’t make me want to give up. As long as I don’t give up, I believe that I’ll eventually be rewarded for betting against Tesla.

Disclosure: I’m short Tesla (NYSE:TSLA)

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