Tesla Inc. (TSLA, Financial)is set to join the S&P 500 stock market index on Dec. 21. Tesla bulls have revelled in the index inclusion victory, which was officially announced on Nov. 16.
Yet, as I noted in a previous article for GuruFocus, the upstart electric vehicle company only managed to demonstrate the necessary string of quarterly profits by throttling back capital expenditures, foregoing investment in much needed support and service infrastructure for its rapidly growing fleet.
While Tesla stock has enjoyed a strong tailwind driven by index funds compelled to buy shares in order to rebalance their portfolios, this effect is necessarily temporary. When the dust settles, Tesla will have to face a new reality, one that could prove troubling for the EV pioneer.
Index inclusion brings fresh scrutiny
When a stock is added to a major index, its underlying financials tend to face more and deeper scrutiny from a wider audience of analysts and investors. As part of the S&P 500 index, Tesla's financial performance will be judged not just in terms of the growth narrative that has fueled its meteoric rise, but also on the consistency and profitability of its core business.
Yet Tesla's auto business is heavily dependent on regulatory credit sales, a profit stream set to evaporate in the coming years in response to the forthcoming deluge of new EV offerings set to come to market in the next couple years. That could prove problematic for Tesla, as credit sales accounted for all of its operating profits during the first half of the year and were by far its biggest profit driver in the third quarter as well.
Moreover, increased investor attention may raise some pointed questions about Tesla's vaulting valuation, as Trefis, an investment research firm led by MIT engineers and Wall Street analysts, pointed out on Nov. 18:
"Index inclusion doesn't change the fundamental picture for Tesla. The stock appears pricey in our view, trading at about 110x consensus 2021 earnings, compared to about 26x for the broader S&P 500. At these valuations, Tesla will need to execute very well – banking on new launches such as the Model Y, its international expansion, and higher software sales – to justify its stock price."
Tesla is already priced for perfection, which means it has little in the way of wiggle room for error in the execution of its growth strategy. If Tesla stumbles, it could find the market to be much less forgiving than it once was.
Index investors brace for impact
Tesla bulls are not the only investors who may be forced to contend with the double-edged sword of index inclusion. Index fund allocators are also set to be affected by the addition of the richly valued automaker to the ranks of the S&P 500.
Of particular concern is the potential that exuberance-fueled Tesla could add further fuel to an index already showing signs of overheating. As The Wall Street Journal's Jason Zweig explained on Nov. 20, the S&P 500's latest upward surge has exceeded historic norms by a wide margin:
"In proportion to market size—which weights giant tech stocks heavily—the companies in the S&P 500 recently traded at 21 times expected earnings over the next 12 months, according to Matarin Capital Management, an investment firm in New York. That's about 24% higher than their average over the past quarter-century."
Adding high-flying Tesla to that mix could be a recipe for trouble. The company's historical market volatility, in addition to its questionable ability to deliver positive earnings sustainably, could end up impacting the performance of the S&P 500 index as a whole. Indeed, as asset manager Michael Lebowitz observed on Dec. 3, Tesla's impact could be far greater than investors might initially assume:
"The S&P 500 will see its P/E rise by about 6 when Tesla is added to it. That assumes Tesla's P/E is 500, even though it is currently 1000. Even if Tesla's P/E falls to 100 it still adds 1.5 to the index P/E."
Lackluster performance on Tesla's part could reverberate widely, weighing on the performance of the trillions of dollars invested in index funds tied to the S&P 500.
My verdict
Tesla's bulging market capitalization, which currently stands around $600 billion, gives the company a huge earnings multiple even compared to the most richly valued of its new index peers. Consequently, as energy historian Ellen R. Wald explained on Nov. 17, Tesla could have an outsized impact on the S&P 500:
"If EVs do not take off, or if the competition proves more formidable than expected, or if the luster just comes off of Tesla, its sky high market cap and P/E could prove trouble for the S&P 500 and the U.S. stock market as a whole."
Ultimately, I think Tesla bulls and index investors alike may end up regretting Tesla's addition to the S&P 500.
Disclosure: Author is short Tesla.
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