When Emotion Trumps Logic
I'd been planning on talking about this subject already. But after reading Briton's article from Wednesday, it seems even more fitting.
Today, I want to pose a hypothetical question similar to the one he asked you earlier this week…
I’m going to tell you about a company, and I want you to tell me if you’d invest in it. Consider it an exercise in rational investing.
For about seven years now, this company, we’ll call it Company X, has had publicly traded shares. Company X has never made a profit. It’s never even had an operating profit. That means, after accounting for the cost of materials, research and development, and advertising, administrative, and general expenses, it’s got no money left over.
It’s got nearly $5 billion in debt. It spends around $3 billion a year in capital expenditures. In the past 12 months, it’s had a free cash outflow of over $3.1 billion. And just to service the interest on its debt, it pays $320 million a year.
Both big ratings agencies have given it junk status. That means they consider it a pretty high-risk investment.
And from a valuation standpoint, its stock trades at an 815% price-to-book (P/B) and 1,040% price-to-sales (P/S) premium when compared to its peers.
Sound like a stock you’d want to own?
One Man’s Trash…
You know the old saying, “One man’s trash is another man’s treasure”? Well, that fits pretty well in this case. Except it seems like it’s everyone’s treasure this time.
Here’s a company that’s lost a ton of money every year it’s been in business.
Its management can’t even make an operating profit…
It’s spending more and more money every year…
And it’s spending money it doesn’t even have…
It’s got massive debt and an interest burden that just won’t stop growing…
And yet, if I told you the name of the company, there’s a good chance many of you already own shares. There’s even a solid chance you’d get angry with me for talking about it like this…
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That’s because the company is Tesla (NASDAQ: TSLA). And for some reason, despite every single fundamental pointing to a failing company that only deserves to be shorted, the stock has gone on a tear while the fundamentals have gone down the toilet.
People still give the joker running Tesla their money so he can burn that, too.
And now Tesla is testing the adage that the fixed income investors are the smartest guys in the room…
Expensive Junk for Sale!
Tesla just announced it’s going to raise another $1.5 billion by issuing corporate bonds. That will raise its current net debt to a whopping $6.5 billion!
Now, since the ratings agencies don’t have as rosy a view of Tesla’s long-term prospects as the fanboys do, these are going to be junk bonds.
Don’t get mad at me. That’s just the term used to describe bonds that have a higher likelihood of default…
A junk bond refers to high-yield or noninvestment-grade bonds. Junk bonds are fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor's, or Ba or below by Moody's Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds. — Investopedia
You might think that, with so much debt already, the company would want to issue shares instead. But Musk, who owns 20% of the company, doesn’t want to dilute his holdings.
So, junk bonds it is.
They’ll have a coupon rate (the interest they pay investors) between 5% and 6% (the average for junk bonds of this type is 5.5%). That’s because, hey, if you’re taking on more risk (which you are with these bonds), you’re going to want more potential reward.
Face-Melting Cash Burn
So why issue these bonds if there’s a chance they’ll lead to a default? Well, after burning through about a billion dollars in cash between March 31 and the end of June, Tesla still plans to spend another $2 billion at least by the end of the year.
That’s a lot of dinero. And without raising more of it, the company would pretty much have to spend every dime it’s got on hand. That’s not likely. Because without those big cash piles, its credit rating would drop even further.
In fact, according to Reuters, Moody’s went as far as to say the only reason Tesla isn’t rated lower is because if it “ends up in serious trouble, its brand name, products and physical assets would be of ‘considerable value’ to other automakers.”
The ONLY reason Moody’s even gives it a single-B rating is because it’s got cash on hand and stuff to sell when it goes bankrupt.
Not the Smartest Guys Anymore
When I worked at Morgan Stanley, it was commonly known that the fixed income sales and trading teams were the smartest guys in the room. They all came from highly respected programs. They all had math degrees. They could calculate complex equations in their heads.
But, judging from the warm welcome Tesla’s bonds are getting so far, that may no longer be the case. Investors are so starved for yield that they’re ignoring the fundamentals and trying to buy more of the bonds than Tesla is offering.
These bonds are basically a $1.5 billion bet that Tesla will be able to make money over the next eight years, or at least be able to take out new loans to pay back the principle and make the interest payments each quarter until then.
But, judging from past performance, that’s not likely to happen. At least the making money part...
Don’t Get Excited
I’m not going to tell you to sell your shares of Tesla. The market has proven that Elon Musk can package a turnip in a fancy box and sell it for billions.
And it’s still true that it can stay irrational longer than you can stay solvent. So, I won’t recommend shorting it, either. Although billionaire hedge fund manager David Einhorn has made a pretty big bet against the company.
In fact, one article’s headline about that trade pretty much sums up this whole piece and Tesla in general…
“David Einhorn Still Laboring Under Sad Misconception That Tesla Is Subject to Basic Logic”
But I will tell you to stay away from these bonds. If you’re looking for solid income-generating investments, check out The Wealth Advisory. We’ve got stocks that will pay you the kinds of yields these bonds will. Plus, our investments aren’t risking default.
I’ll also tell you to stay away from anyone using a narrative to sell you something and ignoring fundamentals. That goes for stocks, houses, cars, even newsletters.
Trust the fundamentals. Check out the neighborhood. Kick the tires. And ask to see the track record. If it’s a good investment, you’ll know when you see the facts.
And as a side note, if you’re interested in seeing the track records of any publication here at Angel, just call our customer service team at (877) 303-4529, and they’ll be happy to assist. Try doing that with some of our competitors and see what kind of runaround you get.
To investing with integrity (and without emotion),
Follow me on Twitter @AllBeingsEqual
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