#47 Reflections on Investing : Back to the Future – The Automotive Industry

Prof. Bradford Cornell explains how fundamental valuation analysis can potentially uncover market inefficiencies. As an example, Prof. Cornell revisits our publication "Valuing the Automotive Business" from November 2021.

Hello, welcome back to reflections on investing with the Cornell Capital Group. Today we're going to return to two themes that have resonated throughout our series of reflections on investment that we think are particularly important. The first is an observation by Ben Graham, when he said in the short run, the market is a voting machine. But in the long run, it is a weighing machine. And we think that quote is particularly applicable to one market that we analyzed on a number of occasions, the auto industry, and in particular, the electric vehicle segment of the auto industry.

So what I'd like to do is take you back to the publication of our major report on the valuation of the auto industry in November of 2021, when the market for EV stocks was booming, and here's what we said at that time. And then there's a number of quotes here, so but stick with me, I'll read them.

The first is this. Without significant barriers to entry, none of the firm's in an industry can create significant value, so that the enterprise value will be only slightly greater than the capital supplied by investors, commonly referred to as the invested capital. A new technology does not translate into value creation for a company that adopts it, unless it produces returns on invested capital, in excess of the cost of capital. To earn excess returns, there must be barriers to entry that prevent competitors from adopting the technology, entering the business and driving down the return on invested capital to the cost of capital.

To say that historically, the auto industry has been competitive and capital intensive, is an understatement. As epitomized by the airline industry, the auto industry prior to the electric revolution, value creation does not depend on technology. It depends on barriers to entry in deploying technology. If an industry remains capital intensive, and highly competitive, then rates of return will eventually be driven down to the cost of capital, and the value of most if not all firms in the industry will approach the invested capital. Viewed in this light, there is no reason why transition to electric propulsion should change the valuation dynamics of the auto industry. If anything, the electric revolution has led to increased competition. Furthermore, the electric car explosion has gone global with entrants from companies around the world, particularly China.

And finally, we concluded over the next decade, it will be difficult for investors and auto manufacturers during meaningfully positive stock returns, with the outlook for investment in electric vehicle specialists being particularly bleak. Now all that was done as of November of 21, applying fundamental valuation analysis.

Now let's fast forward to the current time. And there's one other thing that I should stress about the capital intensive nature of the business. If a business is capital intensive, then economies of scale become very important. And economies of scale are critical in the auto industry. If you cannot produce large numbers, then you're very unlikely to be able to compete unless you're a highly specialized luxury brand like Ferrari. So in the case of these exciting new startups, many of them such as canoe, Lordstown, were colors and Nikola never achieved any scale and are now hanging by a thread. And barring a possible takeover, it looks like all of them will fail.

Even better known and larger companies have undergone a massive devaluation. Look, for example at the chart currently on the screen. It shows the price changes between the date our report was published in November of 21. And the close of the market on Friday, April 20. And you can see that all these leading electric vehicle specialty companies are down 80% or more, Tesla's knocked down not quite so much. If you check in compared, it's down about 56%. But in our view, Tesla still remains overvalued.

With respect to market efficiency, I answered yes and no. And my answer goes back to work published by Larry Summers more than 20 years ago, Professor summers noted that the market is highly efficient when it comes to responding quickly to new news, when there's an earnings miss the company stock price responds almost instantaneously. It's highly efficient. But Professor Summers showed that the evidence was very inconclusive with respect to long term Miss valuation, and that's what we're talking about here with, with Ben Graham's quote, and the electric vehicle stock stocks. The mispricing was not a short term fluctuation, it was a fundamental viewpoint of investors. And then I swapped the motor and I actually call it a big market delusion on the part of investors that the electric vehicle market was so big, so new and so exciting than any specialist in that area warranted a premium valuation overlooking the impact of capital intensive madness and competition. So, yes, in our view, the market was inefficient with respect to the long run valuation of electric vehicle stocks.

Now, it is our view that it has washed out and the big market delusion has passed. Company stock prices have tumbled, many companies have failed or are about to fail. And we are now in market equilibrium. So we have reached if you like Ben Graham's weighing machine. I know that's been a lot to cover. But I think it tells a very important story for investors, that to the extent that there is mispricing in his mispricing in the long term, and that you have to be willing once you believe there is mispricing to take a position and stay with it. And incidentally that can be particularly difficult. When the mispricing is overpricing that means the position you feel you have to take is short. You can do that either from shorting the stock or there's more efficient ways to do it in the options market. But either way, you have to be willing to bet against the market over extended periods of time and that is not for the faint of heart. I know this has been a lot but I hope you found it interesting. This is Reflections on Investing with the Cornell Capital Group.