The stunning rise of Tesla (“TSLA”) stock price in the last three months, has made Tesla fans (yours truly being one of them) jump for joy, while creating, as Elon Musk promised, the “short burn” of the century for the “haters”.
Whether or not you like Mr. Musk or his grandiose plans, once you drive a Tesla, you realize, as I did, that what you are driving is car 2.0 (and yes, to fans even the best internal combustion car is only 1.x). Reluctantly, but inevitably, many analysts steeped in traditional metrics for the valuation of companies have thrown in the towel, and in some cases even doubled or tripled their price target after advising their clients just a few months ago to the contrary.
Last week’s earnings release from TSLA, once you dig into them, weren’t all that amazing from an absolute, traditional point of view. But the earnings and second quarterly profit in a row was way better than the still pessimistic prognostications of some experts, and overnight the stock was up over 10%! (Source: Bloomberg, January 30, 2020) . But we all know that stock prices respond to such surprises, so what’s so different about Tesla that the stock gains keep accelerating?
If, as Keynes said, the price of a stock is a beauty contest, then we need to apply an entirely different metric to the pricing of Tesla and other similar companies. In a world of ample liquidity and an easy Fed, when beauty happens, stock prices can indeed reach for the moon. In short, it’s the phenomenon of “Beauty Happens”, a term used by Professor Richard Prum of Yale.
In his fascinating book titled “The Evolution of Beauty: How Darwin’s Forgotten Theory of Mate Choice Shapes the Animal World and Us”, we find some parallels. His view is that in addition to the many features that species evolve due to pure Darwinian natural selection, Darwin’s other, dangerous and forgotten theory of “sexual selection” also expresses itself through “The Taste for The Beautiful”.
If we apply this theory to the automotive industry, it seems that the extant ecosystem of “car 1.0” has evolved primarily due to natural selection, i.e. car companies battle it out on price, traditional quality, value, profitability etc. etc. and the winner of the evolutionary battle survives. On the other hand, and what has shocked the car 1.0 manufacturers and has vaulted Tesla into the second most valuable car company in the world (with a market capitalization of over $115 Billion as per Bloomberg, January 30, 2020) is the beauty of its cars to its customers.
Despite making only a fraction of the cars that traditional automakers manufacture every year, and barely turning a profit, for aficionados one ride in a Tesla can make these statistics irrelevant. It happened to me about five years ago, and a 3 minute test drive converted me to “I have to have one” (really). Like the peacock’s feathers, a fully electric car five years ago was not only impractical, but also a hindrance for long distance driving. For fans this fully electric feature was an “ornament”, not unlike the male peacock’s long tail feather. But it was also very much a handicap. However, this very handicap resulted in its attractiveness, and resulted in the evolution of an ecosystem that has made the impractical practical and expected. For instance, before Tesla who would have expected “free” supercharging for some models. The fact that Tesla survived the handicap and the test has proved to its fans that despite the handicap it was so much superior to the less handicapped car 1.0. And out here in Southern California, Teslas are now everywhere, as many believe they will be in China once they start to roll out the cheap model 3s from the Shanghai factory.
This aesthetic evolution theory also proposes that species co-evolve once this process gets under way. In other words, once the object is perceived as beautiful, a positive feedback loop between the “ornament” and the preference for it begins. Just the presence of a fully electric car in the global ecosystem can amplify the mechanism of co-evolution and result in the kind of evolutionary runaway that we see in nature.
As this feedback results in a run-away, we will find other companies (yes, I mean the auto giants around the world), see that the evolution of the auto industry does not simply mean optimizing on tangible metrics. They have started to reluctantly adopt fully electric technology. But given their roots are in traditional technologies, they cannot completely abandon the old for the new without cannibalizing themselves. And the muddled middle is likely going to be the siren song for a majority of them. Some, like Volvo, have abandoned the fully gasoline cars, trying to straddle between fully electric and electric-gas hybrids. Natural evolution is generally not kind to these me-too strategies.
How does this apply to broader financial markets? In a nutshell, modeling financial markets (and stock prices), using purely quantitative statistics such as price to earnings ratios, profitability, current market share, distribution etc. argues that maximizing such metrics is critical, and the dominant feature for companies whose stocks should be owned. And in a purely adaptive market it certainly is. As such, it is akin to the pure Darwinian theory of Natural Selection, i.e. survival of the fittest. But as Tesla shows, Darwin’s other, forgotten theory, shows that aesthetics, or “beauty”, which of course is in the eye of the beholder, is equally responsible for evolution. Many Tesla enthusiasts believe that its pioneering battery technology and driving performance further enhance this perception. If such a parallel, aesthetic theory applies to financial markets, as we suspect it should, then don’t be shocked if market participants believe that Tesla’s stock price is not only “right”, but could continue to surprise.
This article was previously published on Monday February 3, 2020 on Forbes.com