The standard method of determining what industry a company is in is by looking at its underlying business. By that standard, Tesla is clearly in the auto business. Virtually all of the company’s revenues and costs are related to building, selling, and servicing automobiles. But there is another way of checking whether a company is an industry that has implications for investors. The idea is that if two companies are in the same industry, then their stock prices should tend to move together. For example, when the Covid-19 crisis arose, the stocks of all major airlines collapsed together. This raises the question of whether using this second criterion Tesla is in the auto industry. Before turning to the results, a couple caveats are in order.
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Q2 2020 hedge fund letters, conferences and more
The Stock Market Is A Tide
First, all stocks tend to move together. The overall market can be thought of as a tide which raises and lowers all boats. Furthermore, during sharp declines and times of crisis, stocks move together even more closely. During the market decline from mid-February through the end of March, 498 of the 500 stocks in the S&P 500 dropped. The subsequent recovery was similar with all 500 stocks in the index posting a gain the month after the March low. Therefore, when looking at correlations between the returns on individual stocks, the impact of the market should be netted. There are a number of sophisticated ways to do this, but the simple method of simply subtracting the market return from the company’s return is a good approximation and I use it here.
“Surreal doesn’t even begin to describe this moment,” Seth Klarman noted in his second-quarter letter to the Baupost Group investors. Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More
Second, even if all stocks are in the same industry, some types of news will cause their stock prices to move in different directions. A prime example is the announcement of a new innovation or a new product by one company. For instance, if Apple introduces what is seen as a particularly attractive new iPhone, its stock price is likely to jump while Samsung’s is likely to fall. Even though both companies are major players in the cell phone industry, they are competitors so good news for one may be bad news for another. This is in distinction to an overall industry effect, such as the announcement of a new 5G standard, which would increase the demand for new cell phones generally. Because events that cause the stock returns of companies in a given industry to move in different directions are relatively rare, when correlations of net of market returns are calculated for companies in a given industry, they tend to be significantly positive.
The airline industry offers an example. Exhibit 1 below shows the correlations between the daily net of market returns for the major U.S. airlines, United, American, Southwest and Delta, over the period from July 31, 2019 to July 30, 2020. Given the vagaries of daily stock price movements, correlations of the net of market returns in excess of 0.35 is high and in excess of 0.60 is very high. By this standard, Exhibit 1 makes it clear that the stock market is treating all the major airlines as an industry group, the lowest correlation is 0.63.
Exhibit 1: Airline Net of Market Stock Return Correlations
Tesla’s Market Return Correlations vs The Auto Industry
Turning to the auto industry, the results for the major US producers, reported below, are similar with one glaring exception, Tesla. In Exhibit 2, all of the correlation exceed 0.35 except those involving Tesla. For Tesla, the highest correlation is with GM, but that is only 0.18. Tesla’s net of market returns are virtually uncorrelated with those of Chrysler and Ford.
Exhibit 2: Auto Net of Market Stock Return Correlations
The Tesla correlations in Exhibit 2 show that the company’s stock price dances to its own tune – it does not behave like a car company. There are a number of possible explanations for such behavior. One possibility is the stock is influenced by ebbs and flows of the sentiments of the legions of day traders who buy and sell the stock. Another is that the stock rises and falls with the mercurial statements and action of its CEO, Elon Musk. Yet another is that Tesla is somehow interpreted to be a “tech” stock so that it moves with major tech companies like Amazon and Apple not with other auto manufacturers. Related to this, some investors may think that Tesla is on the road to be some type of diversified energy/technology company and are buying the stock on this basis. It is worth noting in this regard that Tesla solar and storage revenues have been falling as a percent of total revenue. Whatever the explanation, investors should be aware that although Tesla’s profits are almost exclusively dependent on manufacturing, selling, and servicing cars, at this point in time it is not trading like a car company.