Join our community of smart investors

Tesla, electric vehicles and the big market delusion

The electric vehicle market could be heading for a sharp correction, study suggests
March 30, 2021
  • Valuations of electric vehicle companies rose sharply last year
  • Study argues this is a prime example of market delusion

It’s been a tough few weeks for Tesla (US:TSLA), Nio and other electric vehicle (EV) names, following sensational gains over the past year. While the prospect of an economic recovery has taken the heat out of a number of high-growth stocks that had done well during the pandemic, a recent study argues that valuations across the EV sector may have a more serious correction to come. 

There’s no doubt that the future of transport is electric. As we noted in Race to Riches on 29 January, just 4 per cent of new light vehicle sales were electric last year, following a 43 per cent year-on-year increase, and Bloomberg New Energy Finance predicts that they will account for half of new sales by 2037. 

However, the rise of electric vehicles doesn’t necessarily make the companies selling them good investments, according to Big Market Delusion: Electric Vehicles by Robert Arnott and Lillian Wu of Research Affiliates alongside Bradford Cornell, professor of economics and finance at UCLA.

The crux of the paper’s argument is that the auto industry has historically been a competitive, capital-intensive business (hence why traditional carmakers have tended on average to trade at book-to-market ratios near or below one). The researchers say that from an industry perspective, we have “little reason to believe that a change in the propulsion system from internal combustion engines to electric motors should have a pronounced impact on market competition or on the total industry valuation of the companies”.

This is at odds with how the market has backed electric vehicles. The paper examines the recent growth in market value for the global auto industry, focusing on the 37 largest public auto companies by market capitalisation, eight of which specialise in EVs. 

In their research, as of 31 January 2021, the total market value of the eight EV specialists was $1.0tn, after year-on-year growth of 618 per cent, almost on par with the $1.1tn combined value of the 29 largest traditional automakers. Meanwhile, the revenue ratio has not substantially changed over the past three years, the paper says, with EVs only making up a tiny fraction of the industry compared with traditional automakers: 1 to 42 on average. In aggregate, the global auto industry gained 70 per cent in market value last year, while total revenues fell. 

 

 

Much of the increase in the industry’s market cap was thanks to the massive rise of Tesla. As of the end of January 2021, Tesla’s market cap had risen to $752bn, placing it in the top 10 companies in the world by market value (it has since scaled back to $618bn as at 29 March). 

At its valuation at the end of January, the paper says, Tesla accounted for about 75 per cent of the total EV group’s market value and 35 per cent of the market value of the entire auto industry. Such an immense market cap makes sense only if the expectation is that Tesla will come to dominate the entire auto industry, not just the EV market.

If the scenario of Tesla’s dominance were reflected in its price, in a rational market you would also expect falling valuations of other competitors, including competing EV specialists, whose market share will presumptively decline in favor of Tesla. However, the reverse has happened. 

The paper says the market value of all eight of the EV specialists more than doubled over the 12 months ending 31 January 2021, and the market value of three of these – zero-emission truckmaker Nikola, China’s EV maker Nio and three-wheel EV maker Acrimoto – all rose more than tenfold. 

The prevalence of competition also presents a headwind to these companies. As the paper puts it: “Competition drives profits toward the cost of capital unless new firms face daunting barriers to entry. Simply higher sales will not lead to higher profits if auto manufacturers face strict competition.” 

The paper builds on a study published in December, also co-authored by Cornell – The Big Market Delusion: Valuation and Investment Implications – which argues that the allure of big markets and a promise of easily scalable revenues often leads to initial overpricing and an inevitable correction that brings the pricing back to earth. 

As Cornell and co argue in the EV paper, an example of a big market delusion was in the invention and development of aircraft (capital-intensive and highly competitive – much like the auto industry), which became a huge business but did not necessarily provide a wealth bonanza for investors.

Tesla’s valuation may be justified by its ability to disrupt other markets (batteries, solar panels or perhaps even space?) but currently most EV makers, especially the new entrants, are being priced as winners. 

The paper concludes: “We suspect that as EV competition heats up, many companies will fail, as was the case in previous industry booms – whether autos, airlines, or technology – and with time the total value of the industry will recede to more reasonable levels.”