- Rob Arnott pioneered the use of fundamental indexing as a market-beating investment strategy.
- He believes that the electric-vehicle market is in the midst of ‘big market delusion.’
- Arnott recently discussed the rise of EV stocks and why Tesla may be in trouble.
- See more stories on Insider’s business page.
Rob Arnott is the founder and chairman of Research Affiliates, where he spends his days developing investment strategies used by some of the largest wealth management companies in the world.
The pioneer of fundamental indexing joined Bloomberg Radio’s Barry Ritholtz on a recent episode of “Masters in Business” to discuss the delusions of the electric-vehicle market and why he thinks incumbent automakers pose a big threat to Tesla‘s future.
Delusions of EV grandeur
It’s never a good thing when an investing legend calls out an entire industry, but that’s precisely what Arnott did in a recent report from Research Affiliates. In the report, he explains that so-called ‘big market delusion’ occurs when innovation or disruption opens up opportunities in a new or existing market.
“The hallmark of a big market delusion is when all the firms in the evolving industry rise together even though they are often direct competitors,” Arnott wrote. “Investors become so enthusiastic that each firm is priced as if it will be a major winner in the evolving big market despite the fact this is a fallacy of composition: the sum of the parts cannot be greater than the whole.”
Arnott believes that the EV market is a perfect example of an industry clouded by big market delusion. Investor hype surrounding Tesla reached new heights last year, as the company achieved its production and profitability goals and joined the S&P 500. Shares of Tesla rose over 700% in 2020, and by the end of January 2021 Tesla‘s market cap hit $752 billion.
“At that market capitalization, Tesla accounted for about 75% of the total EV group’s market value and 35% of the market value of the entire auto industry,” Arnott writes. “Such an immense market capitalization makes sense only if the expectation is that Tesla will come to dominate the entire auto industry, not just the EV market.”
As Tesla established its dominance last year, shares of its competitors should have declined. After all, with Tesla taking the lion’s share of the market, newer EV companies would be forced to fight over the leftovers.
Instead, as shares of Tesla rose last year it pulled the rest of the EV market up with it. Investors enthusiastically poured money into EV companies across the board — regardless of the actual valuations of these companies.
Arnott goes into detail on this in his research report, writing that as of the end of January 2021, “the total market value of the eight EV specialists in our universe was $1.0 trillion, after year-over-year growth of 618%, almost on par with the $1.1 trillion combined value of traditional automakers.”
A rising tide lifted all boats last year, with Tesla acting as the catalyst that propelled the rest of the EV market skyward. But eventually the hype of the EV industry seemingly eclipsed Tesla, as the growth of newer EV stocks like Nikola and NIO outpaced Tesla.
“At their peak, during this last quarter, Tesla was priced at 34 times its annual run rate sales,” Arnott says in his interview with Ritholtz. But compared to the seven other EV specialists that Arnott watches, Tesla was the second cheapest, while the price-to-sales ratios of the other companies ranged from 20 times sales to over 10,000 times sales.
And that, Arnott says, is the problem.
“I have no idea if Tesla will be worth its current price,” he said. “I very much doubt it. But I have absolute confidence that the collective EV market is not worth its current price.”
The road to EV dominance
Arnott believes that the EV market is overpriced compared to its current level of production — especially when you consider the output of conventional car companies.
“If you look at the electric vehicle industry in aggregate, it’s worth about 80% as much as all other vehicle makers combined,” says Arnott. But over 50% all EVs are made by the existing players in the auto industry, like Toyota and Volkswagen.
“So, the EV specialists comprise less than half of the EV market and have a total valuation very nearly that of companies that collectively produce nearly a hundred times as many vehicles.” In Arnott’s mind, that makes no sense.
In short, says Arnott, the future of the EV industry doesn’t necessarily lie with EV-only companies like Tesla. In fact, he thinks that “Tesla‘s an extravagantly overpriced company that investors will be very lucky to have a positive return over the next 10-20 years, very lucky indeed.”
Arnott doesn’t deny that Tesla has been a pioneer in the EV industry, but he doesn’t know if the company can maintain its current lead forever — not when incumbent automakers such as Toyota can simply out-spend newcomers like Tesla.
“When Toyota decides to spend more on electric vehicle innovation than Tesla could plausibly take in as gross revenues over the coming three to five years, and to do that every year, OK, Tesla‘s going to have some serious competition.”
While investors might be enamored with Tesla today as it shakes up the stodgy old automobile industry, the extremely competitive and capital-intensive nature of the industry favors the bigger, better-established players. Tesla might have a head start, but companies like Toyota and Volkswagen are quickly shifting their focus to the growing EV market. Eventually, warns Arnott, the pendulum might swing back in their direction.
“The whole notion of big market delusion is that people look at disruptors and say these disruptors have the future in their sights, they know what’s coming, they’re positioned for it beautifully, and they overlook the fact that disruptors get disrupted. It happens again and again and again.”