Story Stocks Tell Tall Tales
A ‘Story Stock’ refers to shares of a company whose value is driven by expectations of outperformance, usually due to the commercial application of a new technology and intense media coverage, rather than a company’s underlying fundamental value, such as its earnings, assets, and profitability. With expectations of outsized profits, a Story Stock’s market valuation may be out of line with its fundamentals and can approach bubble status, where assumptions are needed to justify those valuations, and market interest is based on a narrative rather than a conventional business model.
A narrative we have seen attract attention on both Wall Street and Main Street is associated with clean energy and electric vehicles, as both industries’ advancement could help pave the way to a greener future by reducing our reliance on fossil fuels. Although the social benefits and commercial application of new technologies in this space are clear, in our view, both industries contain companies that could fit our definition of a Story Stock. For instance, QuantumScape, the solid-state lithium battery developer backed by Bill Gates, joined the NYSE in November 2020 and climbed over 450% following the release of compelling performance results for a prototype battery. Despite boasting several patents for its solid-state battery technology, QuantumScape has no revenue, recorded a $51m loss in 2019, and faces fierce competition from several conglomerates, including Samsung and Toyota. Investors appear to be betting big on QuantumScape’s success despite the commercial viability of their offering being unproven at this stage.
Tesla is another company benefitting from this narrative. Spearheaded by business magnate, Elon Musk, Tesla’s goal of transforming the electric vehicle and clean energy industries attracted widespread attention in 2020, leading Tesla to climb 9-fold from its 2020 lows and become the largest ever addition to the S&P 500. At Tesla’s December 2020 valuation of $705bn[i], Tesla was worth more than the top seven global car manufacturers’ combined, which valued each Tesla expected to be produced over the next year at approximately $1.4m. Additionally, with a price-to-earnings (P/E) ratio of 130.72[ii] times earnings, Tesla’s valuation relative to its earnings is over eight times the industry average of 15.86 times earnings. Although clean energy has clear commercial applications to a greener future, investors appear to be betting big on this narrative and ignoring conventional valuation models, where eyewatering valuations are approaching bubble status.
Of course, future expected growth is incorporated into the share price, so basing Tesla’s valuation on past performance may not be indicative of future results. However, the growth required to justify Tesla’s valuations in the context of the automotive industry should give us pause to think. Based on December 2020 valuations, Tesla would need to sell 100 times as many cars as they do currently and maintain the highest profit margin within the automotive industry. We believe that could be challenging.
Should we find all this surprising? In short, not really. Whether it be the “Dot-Com bubble” of the late 1990’s, early 2000’s or the “Tulip Mania” of 1637, where the price of a single tulip traded at more than 10 times the annual income of a skilled craftsman, marketable assets or securities have deviated from their intrinsic value for centuries . Where asset prices deviate from their intrinsic value, efficient markets are likely to produce one of two outcomes; 1) the company must grow in line with expectations, or 2) the share price must fall. To mitigate a portfolio’s exposure to a correction within a specific sector or asset class, a portfolio’s asset allocation should be carefully structured to consider valuations (and their relation to expected returns) and appropriate diversification.
Quantumscape - https://www.forbes.com/sites/petercohan/2021/01/05/three-reasons-to-steer-clear-of-quantumscape-stock/?sh=2b81ff461045
Quantumscape second source - https://www.ft.com/content/c31ca3ce-5e83-452c-86cb-3d1646490c7a
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The partners are Mr J E Matthews and Mr J R D Sellon; Mr D R B Dorman, Mr H Q A Findlater, Mr T Flonaes, Mr N B Tissot, Ms A L Solana.