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This short piece is a continuation of our previous article challenging the obvious and critical flaws of the ‘efficient market hypothesis’- a theory which states that stock prices reflect all known information, and so always trade at their fair value. If true, that would make it impossible for active managers, such as us, to outperform the market- as there would be no overvalued or undervalued stocks in the market, only fairly valued stocks. The efficient market hypothesis also happens to be the theoretical foundation on which the massive passive industry rests.
The reason we keep returning to this point is that we continue to be in awe of how an idea so clearly ungrounded in reality can continue to not only be accepted by the mainstream but also be actively marketed as an investing strategy to an unsuspecting public.
We choose now to raise this issue once again as we are currently being given a fantastic live example of the theory’s failings: Tesla Inc. Consider the move we have seen in shares of Tesla this past year:
The price of one share of Tesla has increased from below $200 just 7 months ago, to over $900 today. A more than quadrupling of the company’s value, the total of which (it’s market capitalization) is now comfortably above $160bn. A greater than $100bn increase in just 7 months! To put that into perspective, the total market cap of UPS, a very well defended company with a long history of generating cash profits and high returns on capital (two things Tesla has never done), currently has a market cap of less than $100B.
Regardless of why the move has taken place (short squeeze, insider trading, china news, etc) for the efficient hypothesis to hold true (and therefore passive investing to make sense) every one of those price points on the chart above has to be an accurate representation of the value of Tesla on any one day. So apparently, in just 7 months Tesla has managed to add more in company value than an entire UPS; a company created over 100 years ago, generating annual sales of $78bn, profit of almost $1bn every month and employing over 480,000 people. To believe that to be the case is clearly nonsense.
We are not making a call one way or the other to say whether Tesla is overvalued or undervalued (it’s likely to be vastly overvalued) but what we are saying is that it is not possible under an efficiency market framework to reconcile the fact that the market thought Tesla was worth $30bn 7 months ago and today, with very little change to the business fundamentals, thinks Tesla is worth over $160bn.
Instead, it is clear to us that the market either got it wrong 7 months ago or is getting it wrong today (or likely both). It remains frighteningly obvious that we cannot rely on ‘the market’ to provide us with reliable or accurate information about what a company is worth- we need to establish that on our own.
And the good news is, that even in today’s world of ultra-fast information assimilation, there remain many opportunities for us as fundamentally driven active investors to capitalize on the market’s perpetually irrational nature.
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