Last week, one of the hottest growth stocks in my portfolio took a sharp nosedive following its quarterly results. While much of Wall Street is busy looking at microscopic details of financial guidance for next quarter, I'm much more interested in how well the long-term story is playing out, which keeps me feeling very optimistic about my investment.
The company, Tesla Motors Inc., represents a whole new model for manufacturing, selling and recharging electric cars in a world dominated by gasoline-powered cars. Watching its stock dive almost 10 per cent following last week is also a perfect demonstration of why I don't try to predict where a stock is going in the short term. I think it's a total waste of time worrying about volatility because, as I'll explain below, I believe huge stock-price volatility is ubiquitous and unavoidable among fast-growing companies. If you want to invest in growth, preferably for the long term, get yourself very comfortable with big stock-price swings.
Allow me to quickly sketch out Tesla's recent volatility. I added the stock to my Strategy Lab portfolio at $120 (U.S.) last November, having watched the shares collapse from highs over $190 a couple of months earlier. In the six months since then, it's rocketed up to $265 and, following last week's earnings announcement, crashed down to the low-$180s.
If you happened to read any of the headlines about Tesla last week, I'd forgive you for thinking the company was in some sort of trouble. Unless you read the Tesla earnings report yourself, you might not understand that this Silicon Valley car company still can't make enough electric sedans to satisfy global demand despite ramping up production about 70 per cent in the past year.
Tesla said last week it would be ramping up R&D as well as selling and administrative expenses, and increasing capital spending. It said this would mean the company would be only "marginally profitable" next quarter.
When analysts have to lower near-term earnings estimates, growth stocks tumble. But when you have the luxury of time and aren't forced to spend so much time worrying about the earnings forecast for the current calendar year, it's easier to see the incredible progress Tesla is making. They're expanding internationally, including selling into China this quarter. They're opening sales and service centres in a large number of countries. They plan to triple the number of Telsa Supercharger stations in existence, from 100 to 300, this calendar year.
For a fairly new car company to be operating close to break-even despite these incredible investments for growth is nothing short of impressive to me. Sure, they could post much higher profits if only they didn't spend money on all of these growth initiatives. But without growth, the company would be valued at much less.
Tesla is also in the midst of planning to build the world's largest battery production line, which they've aptly named a "Gigafactory." When the factory is operating at full capacity, planned for 2020, it should allow Tesla to sell half a million electric cars per year. My rough guess is that this would support about $30-billion in sales. If Tesla posts 10-per-cent net profit margins, it will earn $3-billion in annual profits. Considering they'd have less than 0.5 per cent share of market for passenger vehicles at that point, I believe the stock would have enough growth left to justify a P/E well above 20, or a market capitalization well above $60-billion. In other words, the stock could triple or more within five or six years.
Obviously there are other less attractive scenarios. Tesla's battery factory could fail to reach its goals. Perhaps Tesla will only ramp up to 200,000 cars by the end of the decade, reaching a lower profit margin of 5 per cent. This would lessen the market's growth optimism, and the stock may not trade at a price-earnings ratio above 20. I could easily put together numbers that would show the stock declining by 50 per cent over the same five- or six-year period if this lesser-growth scenario plays out.
I was comfortable adding Tesla Motors to my model portfolio at $120 and I'm still very comfortable with the stock above $180, considering the progress they've made in that short time.
The bottom line is that hyper-growth stocks are highly dependent on how much growth people think will materialize. Small changes in near-term analyst estimates cause people to make much larger changes to their valuation models, and volatility is unavoidable. If you're going to own high-growth stocks, you have to assume volatility is omnipresent, and it's not worth worrying about. Only sell when you aren't comfortable with the stock's valuation or company's long-term strategy.
It may seem like the market hates Tesla based on last week's results. But the business is performing very well and Wall Street has justifiably rewarded shareholders over the last six months. I think long-term shareholders of Tesla will continue to be rewarded.
Disclosure: The author owns shares in Tesla, both personally and in his Strategy Lab model portfolio.