Sunday 18 March 2018

Tesla driving disruption for equity markets

First-half sales of plug-in electric cars in the US totaled fewer than 90,000 units against 8.4m total vehicle sales
First-half sales of plug-in electric cars in the US totaled fewer than 90,000 units against 8.4m total vehicle sales

Equity investors know they must incorporate the risk of innovative disruption into everything from individual stock valuations to the attractiveness of initial public offerings. Historical growth in revenue and earnings with a rosy near-term outlook isn't enough any more.

Companies must demonstrate their ability to withstand competition from disruptive new entrants, even when they currently possess clear advantages of scale and scope.

A great case study is Tesla's competition against traditional carmakers such as Ford and General Motors. Even though it loses money and produces far fewer vehicles, Tesla's market capitalisation is equal to or larger than either of the other US carmakers. Why? Equity markets believe the upstart has the right template for future growth in electric and self-driving cars and trucks, and the old-line carmakers do not.

The fear of potential disruption is casting a shadow over a variety of equity market sectors. For example, Uber-phobia hurts investor sentiment for car rental chains and, to a lesser degree, carmakers. Mall and retail store-focused REITs are under pressure from the consumer shift to online shopping. And active equity money managers have been affected by ETFs.

At the same time, the current fixation with the power of technological disruption leaves two large blind spots in market sentiment: We worry both too much and too little about the changes in commerce and society as a whole.

How are we worrying too much? Consider the example of the car industry.

Designing and manufacturing passenger vehicles is a fantastically complex undertaking. It is a heavily regulated industry, capital- and labour-intensive, subject to cyclical demand and long product cycles, with a fragmented distribution network and an even more dispersed system of after-market support. Nothing happens quickly in this business.

Although self-driving, possibly electric, vehicles will one day be popular offerings, that date is almost certainly further off than current market valuations imply. First-half sales of plug-in electric cars in the US totalled fewer than 90,000 units against 8.4m total vehicle sales. Government regulation of self-driving cars has been slow and fragmented on a state-by- state basis. As a result, the feature (or a semblance of it) remains limited to a handful of high-priced vehicles.

The upshot is simple: markets may punish legacy carmakers and reward disruptors, but the facts don't fit neatly into that paradigm.

There is still time for old-line producers to leverage their market power and develop competitive responses to the challenges they face. If that fails, their installed base of design, manufacturing, distribution and service will still be attractive to tech-savvy rivals. If Amazon can buy Whole Foods, who is to say that "Google/Apple/Tesla buys Ford/GM/BMW/Honda" is not equally possible?

How are we worrying too little? If the recent increasing pace of technological change has taught us one thing, it is that century-old business models can fail in a decade or less when faced with overwhelming disruptive change.

Is that observation consistent with an S&P 500 trading at unusually high earnings multiples?

The answer is a resounding "no." Equity valuations are always and everywhere a function of future cash flows and interest rates. While the latter remains low, the uncertainty around the former in the face of an onslaught of venture-capital-funded disruptive change is clearly rising.

Disruption is messy and unpredictable. That is not the recipe for structurally predictable corporate earnings. At the same time, societal change rarely happens at the pace the pundits predict.

One day we may all well share a fleet of self-driving electric cars, but that day is not today, tomorrow, or in the next few years.

For equity investors who feel inclined to worry about what could go wrong with US markets, I would suggest that the answer lies along this path.

So far, "Amazon-ing" has been limited to bricks-and-mortar retailing, and the enthusiasm over Tesla has only hurt carmakers' valuations. But what happens as VCs privately fund more disruption everywhere from financial services to health care?

Such investments are largely unavailable to public market investors, who can generally only hold only the targets of an ever-increasing cycle of disruptive innovation. Equity markets have seen the shadow of disruption grow over the last few years. They know the effect it can have, and that trend still has further to go. (Bloomberg View)

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