A couple of weeks ago, we wrote about valuations for stocks, explaining how they are dynamic (not static) and constantly changing, depending on where enterprises are in relation to their S-curve. We have also been writing a lot on S-curves lately, using them to explain the various growth stages of a company — from infancy (low growth) to expansion (rapid growth) to maturity (low growth and decay).
Every product (services or business) must follow the same life cycle, whether its lifespan is long or short, whether it is a roaring success, run of the mill or downright mediocre. We created a simple matrix table as a tool for investors to determine the implied PER (price-earnings ratio) valuation for a stock based on their expectations of the company’s growth in perpetuity (g) and discount (r) rates at any point in time (you can read the details in our article, “Do you really understand what PER in stock valuations means?”, The Edge, July 29, 2024).
The S-curve is not just a theoretical concept. We witness it in real life, except that it takes time to play out and, because of this, sometimes people lose sight of it, especially when one gets caught up in the hype of the moment and “shiny object syndrome”. Of course, the reality is that nobody knows for sure what the actual g and r will turn out to be in the future. Everyone has his or her own beliefs and expectations. So, there is no “precise” or “real” valuation. There is just the market clearing price, based on supply and demand for the stock.
Very good analysts, salespersons and CEOs can make outrageous promises and get the market to believe in an exceptional story — thereby pushing the shares to lofty valuation levels. And stock valuations can stay elevated for an extended period. Stock prices do not fall because of “overvaluation” (great stories are the spice of life) — they fall when sales and profits do not live up to these promises, whether because of overall economic conditions or industry-wide and/or company-specific factors.
One of the most common justifications for excessive valuations for high-growth companies — especially during the early and rapid growth stages of the S-curve, when there is little or no profit — is by exaggerating the total addressable market (TAM). TAM represents the total market demand and revenue opportunity available to the company. The larger the TAM, the bigger the growth potential and, therefore, the higher the valuation. In just the past few years alone, we have witnessed the TAM hype in environmental, social and governance (ESG), in electric vehicles (EVs) and, currently, in artificial intelligence (AI). Tesla is a very good example of how outrageous promises can boost valuations and stock prices.
In 2020, Elon Musk announced Tesla’s ambitious goal to produce and sell 20 million EVs annually by 2030. This target was repeated in Tesla’s annual reports in 2021 and 2022, propelling Tesla’s share price to an all-time high. Back in November 2021, we highlighted that Tesla’s market capitalisation (US$1.2 trillion at that point) was more than the combined market value of the world’s 10 largest legacy carmakers (including Toyota Motor, Volkswagen, Daimler AG, General Motors, BMW AG, Stellantis, Honda Motor, Ford Motor and Hyundai Motor) — even though its car sales (half a million in 2020) was just a tiny fraction of their total sales (of more than 31 million that year). As we said then, the potential size of the global car market (the TAM) is mature and fairly known. Thus, for Tesla to achieve its sales target and justify its valuations, it must take market share from the others AND maintain its margins while doing so, even though this must lead to greater competition as these carmakers defend their markets. And this is exactly what happened — Tesla is losing amid intense price competition among carmakers. Yes, Tesla is losing!
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Despite price discounting, volume sales totalled just 1.81 million in 2023 (the 20 million sales target was notably omitted in the 2023 annual report) and were down 6.6% year on year in 1H2024. Gross margin is getting squeezed as the company scales production while cutting prices to compete for sales. In fact, absolute gross profit is also declining as operational costs continue to rise. Net profit was down 45% y-o-y in 2Q2024 (albeit including some one-off restructuring expense) — and profit margin fell to just 5.8%, versus 7.65% to 15.5% between 2021 and 2023. Unsurprisingly, its share price has fallen well off its highs — as reality fails to live up to lofty promises and expectations (see Charts 1 and 2).
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Here’s another truth. Economics was always going to be the biggest driver of consumer adoption of EVs (and, indeed, every other product or service). In other words, for demand to keep increasing — to reach the vaunted TAM — prices must fall. Case in point: Tesla is now slated to launch a cheaper, more affordable model (or models) targeting the mass market, perhaps in mid-2025. While the lower-priced model is likely to boost volume sales, it is also expected to be less profitable than existing high-end models — that will add further downward pressure on overall margins.
Obviously, Musk is an exceptional entrepreneur, a smart analyst and an even better one-man marketing machine. He has since pivoted from shrinking EV profits to AI, full self-driving and robotaxis, as well as humanoid robots. In other words, a promise of new engines of growth. A new story, a new S-curve. According to Musk, Tesla’s robotaxi network is “a US$5 trillion to US$7 trillion market cap situation”, while autonomous robots will one day lift its market cap to US$25 trillion. For perspective, that is equivalent to one quarter of GDP for the entire world in 2022.
Musk envisions the TAM for his Optimus robot to be eight billion, one for each human alive in the world today, plus another 12 billion, at least, for industrial uses. We wonder, when and why would each and every one of us “need” a robot and, most critically, can we all afford one? It comes back to our point on economics. According to the World Bank, 47% of the world’s population lived on less than US$6.85 a day in 2022. Picture this: the hungry, homeless child in Africa standing next to his Optimus robot! To make Optimus affordable to everyone, prices would have to fall off a cliff. What would that mean for Tesla’s margins then?
The argument is similar for AI. AI applications start at an extremely high cost, driven by huge computational power needs (GPUs [graphics processing units] and specialised hardware), infrastructure costs, massive data and continuous training and maintenance that require highly skilled talents.
Enterprises must be able to make the required return on investment (ROI) to justify investing in AI applications, that is, finding sufficient new revenue streams or substantially improving productivity to more than offset the high costs, both of which are far from certain for the foreseeable future.
Therefore, for mass AI adoption, costs must fall quickly and significantly. In particular, GPU prices must fall sharply — but this necessarily means lower margins, and likely even absolute profits, for Nvidia Corp. If, on the other hand, the cost to develop and use generative AI stays elevated — Nvidia maintains high margins to sustain its current lofty valuation — then adoption will be slow. The point is it cannot be both. Yet, Nvidia’s prevailing valuations are based on huge expectations for sales growth as well as margins and profits. Those were the same expectations for Tesla a few years ago, until reality set in. Will we see the same trend repeating for Nvidia?
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So, why do investors repeatedly get sucked into this hyperbolic exaggeration? The answer is actually simple and classic — greed and fear, including the fear of missing out! And it has proven extremely profitable for those who peddle fantasies — and it is not a crime to do so.
The Malaysian Portfolio fell 6.5% for the week ended Aug 6 amid the steep global stock-market selloff. All our stocks ended lower save for UOA Development, which traded unchanged. Insas – Warrants C (-21.7%), KSL Holdings (-19.4%) and IOI Properties Group (-10.8%) were the biggest losers. Last week’s losses pared total portfolio returns to 194.1% since inception. Nevertheless, this portfolio is outperforming the benchmark FBM KLCI, which is down 14% by a long, long way.
The Absolute Returns Portfolio also suffered heavy losses last week, falling 5.4% and giving back nearly all the gains we have made since inception. Only Swire Properties (+3.6%) closed in positive territory for the week. The top losers were Itochu (-14.8%), DBS (-9.7%), and OCBC (-6%). In view of the heightened near-term market uncertainties, we decided to reduce our investments in both the Malaysian and Absolute Returns portfolios. We locked in gains on our stakes in Insas (+31.3%), Maybank (2.3%) and CCK Consolidated (+37.8%) and disposed of our entire holdings in Home Depot and Microsoft. Following the sales, we raised cash holdings in the Malaysian Portfolio to 70.1% and Absolute Returns Portfolio to about 20%.
We think the risks for global stocks are still biased to the downside in the near term. The unwinding of the yen carry trade, following the currency’s sharp double-digit appreciation against the US dollar in less than a month, may not be over. Some market analysts estimate the total yen carry trade could be as high as US$4 trillion. Borrowing cheap yen loans and reinvesting them in high-yielding currencies as well as US stocks, including Big Tech, had been an extremely popular trade for hedge funds. We will sit on the higher cash in hand for now.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
