Tesla PS Ratio & The Coming “Tax” on Index Fund Owners

The Persistence of High-Priced Stocks Sitting on High Hopes

Tesla Price to Sales Ratio: A Stock Price & Market Capitalization Problem Owned by the Many

I’m staring at a list of stocks in the S&P 500 Index. The results are sorted by their weighting in the index from largest to smallest. At a 6.97% weight, Apple is at the top.^[1]

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To the right of each stock are 100s of columns of data showing the various metrics we calculate to measure valuation and firm health. The spreadsheet is our most basic. The fuel for our model portfolios designed to exploit investors’ documented behavioral errors. These errors manifest themselves in inefficient markets.

Despite the recent correction, the opportunities for active managers are still vast. Predictably, the fanaticism of indexing has created a toxic brew for its adherents. We believe cheap beta is an incredibly important tool. But a disciplined active manager has only had it easier at the peak of the dot.com bubble. Let us explain:

The top 10 stocks in the S&P 500 represent 29.7% of the index. Nearly a third of every dollar you invest in that index is going into just ten stocks. The value-weighted average price to sales ratio is 7.3x.[i] Madness.

Tesla stock price to sales ratio is the number one contributor to that offensive valuation metric. The vaunted maker of electric vehicles sported a 14.5x multiple with a 2.44% weight in the index. What follows is not an indictment of Tesla. Instead we take umbrage that the Tesla PS ratio and that of other overpriced stocks in the index.

We offer another simple question to the index-funds-only crowd: why the dogma?

This newsletter has generated massive empirical evidence around the idiocy of paying 10x sales for a stock. Scott McNealy’s quote on Sun Microsystem’s stock is the “anchor” concept.^[2] Very simply: Tesla’s PS ratio of 10x is too much!

The chart below shows the weighting in the S&P 500 Index of stocks valued at over 10x P/S. For any advisor or FA who has bought into the dogma of “only indexes” we ask you: do you think having dot.com levels of painfully inappropriate valuations in your clients’ portfolios is a good idea? If so, why?

Tesla’s Valuation Today: The Price to Sales Problem Looms Large

As most investors have noticed, markets have begun to fall. After what some have suggested are 40 years of ever-larger policy mistakes, the bill is coming due. With CPI soaring, the Fed halted their “QE” and suggested they would be selling $95bn of assets per month in a tapering function to shrink their bloated balance sheet.

$95bn sounds like a lot of money until you remember their balance sheet is $9 trillion. Just hitting the “pause” button on the buying with a miniscule rate hike has sent stocks and bonds into a spiral. We are glad we are not the Fed. Recession, inflation or some ugly combination seems increasingly likely.

Cramer hosts folks calling a market bottom while others suggest the losses will continue. This newsletter and the investment products run by the Fund Managers who author this work, do not time markets. Plenty of other ways for us to look foolish. We do, however, believe in algebra and the lessons of financial history.

Valuation is a horrible timing tool but, as we have shown, it has been a remarkably effective forecaster of realized 10 year forward returns. By November of 2021, Buffett’s market cap to GDP metric had hit an incredible 234%. A level that swept past the previous peak of reckless speculation in 2000.

As the chart below shows, the sell-off to date has cut valuations to 184% of GDP. That is still a level well above the peak of the dot.com mania. The Fed may need to buckle to the recessionary pulses we see around us, but as George Noble explained at minute 8 in this video, the choices in fixed income are as difficult as in equities.

Why Is Tesla Worth So Much?

Tesla’s valuation has been a source of extreme controversy. For the Teslarati and acolytes of Cathie Woods and other forecasters like her, there seems to be no price too high. In KCR’s view, Tesla’s valuation is indefensible and sets investors up for potentially sharp losses. Right now, investors are being regaled with fantastic stories about the companies yet-to-be built businesses around driverless taxis and, incredibly, insurance sales.

With valuations still above dot.com levels and over 20% of the S&P 500 Index weight in stocks priced at a level with little if any precedent for generating durable returns, we believe this matters. A lot.

For the purposes of the table above we did use the latter method. Specifically, we took all the stocks with a sales to price ratio of 0.10 or less, calculated a value-weighted average and then using the reciprocal to get the 13x you see above. Were we to use a method of value weighting P/S multiples, the value would have been 14x.

Tesla Valuation vs. Other Car Companies

One of the things that we find to be a simple truth is that Tesla is a car company. With that in mind, we find it nothing short of stunning that the firm is valued at nearly 4x that of Toyota. As the world’s largest, most profitable car maker, Toyota has also built and sold over 15 million hybrid vehicles with bullet-proof reputations for quality. For similar context, Tesla is valued at over 11x that of Volkswagen. VW is the world’s largest car maker and owner of premium brands like Porsche. The company has launched a barrage of brand new vehicles designed to take the EV crown from Tesla in short order. One of the fund managers on KCR’s Equity Research team covered auto stocks for years and believes investors are underestimating the tremendous competitions coming out of Ford, GM, VW, Kia and others. Our team would also note that Toyota continues to quietly make progress on a solid state lithium ion battery. Toyota’s engineering prowess is not to be underestimated and, assuming they close the production gap, it will instantly render the vast factories recently build by Mr. Musk obsolete. As one industry observer put it “Tesla is like Microsoft, except instead of focusing on the software, they went all-in on building factories to manufacture 5.25 inch floppy disks.” We cannot help but agree.