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Index fund or “passive” investing is perhaps the most popular form of retail investing today. Most investors have exposure to the S&P 500 through an index fund. The advice from investing legends like Jack Bogle and Warren Buffett have driven home the belief that nobody can consistently outperform the market. This advice has been mostly true. Most - but importantly not all - active managers cannot “beat” the market after you net out fees.
One must wonder if Jack Bogle or Warren Buffett could have accounted for an event like Tesla joining the S&P 500 on December 21st. For many average investors this event may seem innocuous, but it is certainly worth a closer look. There are $5.4 trillion in index funds that track the S&P 500, including the world’s largest mutual fund, the Vanguard 500 index, and the ETF SPDR 500. When Tesla joined the index, these funds had to purchase tens of millions of Tesla shares and sell shares of other indexed companies in order to reflect the change.
The addition of Tesla to the S&P 500 brings the concentrated nature of the index to light. Nearly a quarter of the index is made up of the top five holdings, and 28% is comprised of the top ten. This is not a referendum on any of these companies, but it does question whether investors are getting broad equity exposure. Tesla has surged 667% year to date and has risen 59% since the S&P 500 committee announced its addition, so the stock will only bring more concentration and volatility to the S&P.
Tesla currently trades at 161 times next year’s earnings. A closer look at the character of those earnings is warranted. “Tesla’s addition to the S&P 500 followed its reporting of a requisite four consecutive profitable quarters,” Vicki Bryan wrote in the Bond Angle, “which can be traced entirely to energy credit sales plus noncash account and unusual items - none of which are its core business.” “Once Tesla has been fully incorporated into the index, if it were to fall back to its valuation at the start of 2020, an 87% decline, it would pull the entire S&P 500 down by a notable 1.3%,” writes Evie Liu in Barron’s. Many active managers find themselves in an odd position as well. They are routinely compared to the S&P 500. If they do not take a position in Tesla, they run the risk of being beaten by index funds if the stock continues to overperform. This is not outside the range of possibilities. On the other hand, many active managers and analysts might not view the stock as a “buy” using traditional valuation measures. As we previously noted, a part of the recentearnings produced by Tesla have been from activities outside of its core business.
The interest in Tesla could bring us to a broader conversation about why growth stocks have so thoroughly outperformed value stocks over the past 10-15 years. Writing for the Investments and Wealth Institute, Baruch Lev, PhD, and Anup Srivastava, PhD, argue that value investing worked wonders until 2007. Since that time, they claim, it “appears to have lost its magic.” One of the reasons they believe this occurred is accounting deficiencies causing systematic misidentification of value. The researchers note that “book value, the denominator of the market-to-book ratio, is measured with considerable error.” They cite “the immediate expensing in income statements of all investments in internally-generated, value-creating, intangibles, such as R&D, IT, brand development, and human resources” as an “increasing source of book value mismanagement” and a “major contributor to the failure of value investing.” Accordingly, “a firm investing heavily in R&D, IT, brands or business processes may appear to be an overvalued company, due to its understated denominator in the market-to-book ratio, whereas in reality its valuation isn’t excessively high when book value is properly measured.”
Where does this leave our everyday indexers? Tesla joining the S&P 500 and thus being integrated into the trillions of dollars of index funds following the S&P 500 is not a non-event. Investors, using traditional measures of valuation, might have reason to believe Tesla is overvalued. The possibilityfor a single stock to drag the S&P 500 down by 1.3% by returning to a price it traded at less than one year ago could certainly cause concern. However, Lev and Srivastava make a salient point: perhaps some are looking at Tesla the wrong way. Perhaps the intangible value the man behind the curtain, Elon Musk, brings to Tesla is being reflected efficiently and accurately in the market price.
The reality for owners of index funds linked to the S&P 500 is inescapable; you will own Tesla at or near its current price as of December 21st. Buying a stock that has surged nearly 700% over the year and nearly 60% after the news broke of its integration into the S&P 500 may seem dubious. According to Barron’s, it is likely Tesla will match the largest weighting ever added to the index.
This brings us back to our question; would Jack Bogle and Warren Buffett still advise going long on the index? I suspect that Tesla might make them think twice about that strategy.IF2020-1230