4 months ago we closed at about $130 on July 12th, when TESLIVE weekend started. People were quite exuberant at the stock price.
Now 4 months later we're back at almost the same price.
During times of unbridled enthusiasm people tend to focus on the potential and forget about the risks.
During times of depression people tend to focus on the risks and forget about the potential.
Ironically, if the company is truly a stellar company the unbridled enthusiasm (albeit as dangerous as it is) is usually closer to the truth/reality than depression. With a stellar company, the unbridled enthusiasm will come back at some point and we'll break through new ATHs. It's the timing that's the difficult part, and sometimes the periods of depression can be much shorter than expected or much longer than expected.
On Exuberance
Forecasting where a stock is headed is very, very difficult… especially in the short-term. That’s why people tend to rely on the past (ie., trends, charts, prices, etc) to give them hints as to where the price might be headed. The stronger the historical precedent is for a trend, the stronger people tend to believe that the trend will continue. For example, when TSLA experienced it’s historic uptrend from $35 to $190 (with a few rests along the way), the exuberance continued to grow.
Exuberance in of itself is not a bad thing. What exuberance does is it extracts value from the future and adds it into the present value of the stock today. So, at $190 investors were just looking further into the future with Tesla as a company and attributing that value into the stock today. This is what a stock price is; namely, it projects into the future the earnings of a company to determine a price today.
The tricky thing about exuberance is that it can keep on going higher than what most expect, or it can stop suddenly and reverse as well. With TSLA, I think the exuberance could have continued as long as Tesla was able to scale production in an exciting way (ie., 6500 deliveries in Q3 and 7500 in Q4). We could have seen the stock continue it’s trek into the 200s to 300 over the next several months.
However, Tesla experienced production constraints greater than investor expectations and was hit with a few fires. Now, the exuberance has turned to anxiety, fear, and a depression of sorts. Rather than focusing on the potential of the company (which exuberance does), the focus has turned to the risks. What if people don’t buy Tesla’s cars because of these fires? What if another fire happens? What if Tesla doesn’t adequately address this 3rd fire? Etc.
On Depression
When depression hits, it only is accentuating the risks that were already present during the times of exuberance. Or sometimes the risks that were already there are just realized to a certain extent (ie., 3rd fire). During exuberant times, risks are often overshadowed and overlooked because there isa stream of good news like growing demand, awards, and growing belief in the company’s long-term prospects.
It’s extremely difficult to accurately assess the risks during times of exuberance because often exuberance is contagious. One can look at the past charts and price history and see that the stock is rising and will continue to rise. The greater/longer the trend, the more confident people feel about the present. However, we need to be careful during extended exuberant times. The reason is because during exuberant times investors are extracting future potential/earnings of the company further down the road than they normally would if the exuberance wasn’t there. Meaning, if the exuberance disappears then investors no longer extract as much future potential/earnings of the company into the present stock price. And this leads to downward pressure.
Handle with caution
When a stock rises on extended exuberance, I’m not suggesting to completely stay away from the stock. But I think you need to handle it with caution. The reason to not completely stay away is because the exuberance can continue for a very long time, much longer than one expects. All it means is that investors are extracting more and more future value into the present. As long as the company is growing fast, then it will likely eventually meet or beat those expectations and justify the stock price even without the exuberance extraction of future potential. But the reason to handle with care is because the exuberance can be reversed if the company misses a step or a few steps in a row. Investors don’t extract the same amount of future value into the present and the stock price contracts.
The stellar company
The great thing about investing in a stellar company is even if the stock goes through a period of depression it will return to exuberance at some point. The reason being is because the stellar company is growing at a very fast growth rate (ie., 100% annual rate with TSLA) and when a few months pass, often the company has already grown their revenue 20%. Another quarter passes and their revenue is 20% higher than the previous quarter. At some point, people realize there depression (or overly focusing on the risks) is unjustified and they’re drawn into the potential of the company once again. This starts the exuberance period again. And as long as the company can surpass investor expectations, the exuberance will likely continue until the company can no longer beat investor expectations. Then, a period of depression can ensue.
These periods of exuberance and depression can be very short or very long. But with a high-growth stellar company, the periods of exuberance tend to out shadow the periods of depression. The is due to the fact that the stellar company’s potential eventually shines through the depression periods by posting some kind of exciting news (ie., accelerating revenue, earnings, demand, market size, etc.).
So to recap, during times of extended exuberance one should be aware that the exuberance can end and turn to depression and the extracted future value that investors are adding into the present stock price can be retracted. It doesn’t mean to stay totally away; it just means handle with caution.
Assessing a company
Now during times of depression, it can be difficult to know what to do because the risks surrounding the company are often highlighted and focused on. Usually during times of depression most investors want to stay away from the stock (or short it). But at some point, the value of the company becomes attractive again to the investors who believe in the company. In other words, enough of the future value that was extracted into the present is retracted back to the future so the stock price becomes appealing once again to savvy investors looking for value and an attractive opportunity to get into a stock that will return to its high-flying days at some point.
During times of depression, it’s also important to assess if the company’s fundamentals have weakened in a significant manner or not. If the company’s long-term prospects have been fundamentally altered in a negative way, then the downward pressure of the stock is not just the result of depression but it’s the result of a true downtrend where the fundamentals are driving the downward pressure of the stock, not just sentiment. In that case, the stock can go to lows beyond what most people might expect. It can be a long road down, and you probably don’t want to be on it.
Some of the greatest investment decisions have been made by investing in stellar companies that are going through a period of depression. Not only do you get to invest in a stellar company, but you are able to do it with a steep discount.
The battle of investing
One of the fundamental ideas behind investing is to buy something today that people will want more in the future. That way it’s worth more later. This is why when you buy a stellar company during a time of depression, you’re betting that because it’s a stellar company the exuberance will return at some point and people will want to own a part of that company a lot more than they do right now.
In a way, great investing can be psychological warfare. If you’re going to invest in stellar company during periods of depression, you must overcome the fears, doubts, real risks, and uncertainty that is prevalent during the period of depression. That’s not easy. One key skill that can help is to develop a system where you can come up with valuations on your own, not relying on analysts and others. Meaning, you can look at a company’s financials and determine what you are willing to pay for the company if you were to buy the company outright. Normally, this entails looking at their revenue, margins, growth rate, earnings, addressable market, competitive advantage, etc. to come up with a sum of money you’d be willing to purchase the company for (note: the challenge is most people use over-simplified methods and aren’t very good at this). Now when you do this, you want to reach a sum that is fair to both sides. Now, armed with this valuation you are able to enter the battlefield. If the company’s market cap is significantly lower than the amount you’re willing to purchase the company for, then it becomes a candidate to buy shares. Of course, there are other factors in making a decision but at least now you’re armed with numbers as you evaluate the market cap of a stellar company you have your eyes on, and this can help you pull the trigger during the turbulent periods of depression surrounding a stock.
Coming up with your own valuations is not easy. In fact, I’m not sure most people have the skills or discipline to do it effectively. That’s why the risks of investing are amplified for most people. Personally, I learned the example of this method from Warren Buffett. He says that his hobby is reading annual reports and he’ll read through hundreds (or thousands) every year. He’s looking for a business that he understands and that is being valued significantly under his own constructed valuation given on the company. But he’s not looking for a ton of them. He’s got very high standards and is looking for that 1 out of 1,000 company, and will keep searching until he finds it. That's part of what makes him a great investor.
Last Words
Periods of depression and exuberance are normal parts of the experience of investing. Don’t be surprised by either, but rather be prepared. When in periods of exuberance, be aware of the risks involved. And when in periods of depression, don’t forget the potential of a stellar company whose long-term fundamentals are in tact.
