Focus on the Fundamentals, not the Story
Thursday, May 30, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 36.0%, down 13.0 points
  Neutral: 34.4%, up 4.9 points
  Bearish: 29.6%, up 8.1 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »




Every so often a stock with a good story catches the eyes of traders and experiences a price spike in response. Tesla Motors (TSLA) is currently that stock. Since the end of April, shares of Tesla have approximately doubled in price, soaring from $53.99 on April 30, 2013, to $104.95 today. When hoopla such as this occurs, it is easy to forget that good stories do not always result in good investments.

Tesla certainly has a lot going for it right now. The high-end electric car company delivered better-than-forecast first-quarter results earlier this month. The company paid back an Energy Department loan last week. Earlier today, its CEO announced plans for a nationwide system of supercharging stations. And Tesla’s main competitor, Fisker Automotive, has hired bankruptcy advisers.

The underlying fundamentals are not favorable, however. Tesla is valued at 71 times book value (total assets less total liabilities). Its current market capitalization of $12.1 billion ranks among the top 10% of all stocks in our Stock Investor Pro database. Tesla is not projected to be profitable until 2014, with forecasts ranging from a loss of $0.15 per share to earnings of $2.26 per share. In other words, analysts are extraordinarily divided on how profitable the company will be next year. The difference in forecasts is even wider for 2015. Plus, Tesla has never generated positive cash flow from operations.

Pay attention to two particular points in the last paragraph. Companies expected to achieve strong future growth are often valued based on assumptions about future cash flow. Analysts project results out for several years and then discount the future cash flows using a rate of return intended to compensate investors for the perceived risks. An inherent problem with such models is “garbage in, garbage out.” If the forecast growth rates prove to be incorrect—and there have been studies showing analysts projections become less reliable as the length of the forecast period is increased—the calculated valuation will be wrong. Even if the forecasts for the next two years are in the ballpark, Tesla will still have to spend significant sums on increasing production. Unlike software, each additional car sold requires the sourcing of materials and the use of labor to produce it.

Adding to the complexity of the problem are the logistics of electric vehicles themselves. Tesla’s Model S sedan will need to be recharged every 200 to 300 miles, depending on battery size and other factors. Though some infrastructure exists, charging machines are scarce overall. Tesla announced plans today to expand its supercharger network nationwide, but the charging stations still won’t be as ubiquitous as gas stations. Patience is also required on the part of the car owner, since even a supercharging station requires a wait of 30 minutes to get enough power to cover 150 miles of driving range.

Then there is the current limited market for Tesla’s vehicles. Pricing for the Model S starts at $62,400, after factoring in a $7,500 federal tax credit. The forthcoming Model X is expected to be similarly priced. Buyers also have to consider the potential hassles of servicing the vehicles, since only 37 service centers nationwide are either currently open or listed as “opening soon.”

The idea behind a low-to-no emissions vehicle is a good one and Tesla certainly has an interesting story. But, what makes for a good story often does not make for a good stock. Much money has been lost over the years to good stories. Look past the headlines and consider what could go wrong, what the potential hurdles are and how reasonable or irrational the valuation is. A company with a less interesting story, but good financial strength and an inexpensive valuation can make you a bigger profit than a company with simply a good story but not strong financials or a reasonable valuation.

Addendum Added to My Retirement Withdrawals Article

A few members requested I rerun the numbers used in my retirement withdrawals article (“Taking Retirement Withdrawals from a Fund Portfolio,” May 2013 AAII Journal) using an inflation-adjusted withdrawal amount, as opposed to an inflation-adjusted withdrawal rate. An addendum with the new data has been posted to AAII.com.


More on AAII.com


The Week Ahead

Just four S&P 500 member companies will report earnings next week. They are SAIC (SAI) on Monday, Dollar General (DG) on Tuesday, Brown-Forman (BF.B) on Wednesday and J.M. Smucker Company (SJM) on Thursday.

The May ISM manufacturing index, the May PMI manufacturing index and April construction spending will be the week’s first economic reports, all released on Monday. Tuesday will feature April international trade. The May ISM non-manufacturing index, the periodic Beige Book, the May ADP Employment Report, revised first-quarter productivity and April factory orders will be released on Wednesday. Friday will feature May jobs data, including the change in nonfarm payrolls and the unemployment rate.

June is historically the second-worst month of the year for the Dow Jones industrial average, with an average decline of 0.3%. The month is also the third-worst for the S&P 500, according to the Stock Trader’s Almanac, with a very slight average decline. Certainly not significant drops, but the month’s reputation should be considered if any weakness in stock prices should occur.

AAII Sentiment Survey

Individual investors’ short-term enthusiasm for stocks waned, as a greater percentage expect stock prices to remain unchanged over the short term, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 13.0 percentage points to 36.0%. This is a four-week low. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 4.9 percentage points to 34.4%. Not only is this an eight-week high, it is also the fifth time in six weeks and the seventh time in 10 weeks that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 8.1 percentage points to 29.6%. Even with the increase, pessimism remains below its historical average of 30.5% for the fourth consecutive week.

This is the second time in three weeks that both bullish and bearish sentiment are below their historical averages. This is the first occurrence of where both optimism and pessimism have been below average for a second time in such a short span since March 2010. Between February 25, 2010, and March 18, 2010, both bullish and bearish sentiment were below average during three out of four weeks.

The drop in optimism coincides with the recent speculation about whether the Federal Reserve will reduce its bond purchases sooner rather than later, and the resulting pullback in stock prices. Though individual investors have been encouraged by the current rally, the first quarter's better-than-expected earnings, signs of continued economic growth and the presence of potentially negative headlines dampened their enthusiasm, at least temporarily. Prior to the recent Fed chatter, some AAII members had been concerned about current valuations, the actual pace of economic growth and a lack of progress on key issues by the White House and Congress.

This week’s special question asked AAII members how a change in the Federal Reserve’s bond buying program would impact their six-month outlook for stock prices. More than 40% of respondents said a reduction in or an ending of the program would cause them to be more bearish about the short-term outlook for stocks. The range of pessimism varied from slight—a small pullback in stock prices—to high—a correction or worse in stock prices. Approximately 25% of respondents said their short-term outlook would be unaffected by a change in the current Fed policy. A small number, about 10%, said such a move would help stocks or at least create a buying opportunity.

Here is a sampling of the responses:

  • “The market is a balloon held up by the hot air from the Fed. Take this away and the party ends.”
  • “Reducing the program will temporarily and negatively affect the stock market.”
  • “Not at all—any correction would be over within a six-month time frame.”
  • “It would depend on the rate of the decrease in bond purchases.”
  • “It would not change my allocation. I can’t predict the market and don’t try. I just keep a balanced portfolio.”

» Take the sentiment survey