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LESSON SUMMARY
In this lesson, we investigate risk. What is it, how it can affect your portfolio, and how to avoid it. We identify 3 red flags any value investor should always look out for.
LESSON TRANSCRIPT
Welcome to Lesson 5 pf the asset allocation course series. In today’s lesson, we go and talk about risk. Let me start by asking what is risk? We all know that we should have very little of it, and we know that perhaps there is a relationship between risk and reward. At least that’s what we hear. But what is risk really? Risk is not the volatility that most people in the financial industry are talking about.
If you ask me, risk is the permanent loss of capital. In other words, we don’t want to lose money. If we’re on a risk of losing money, then we incur risk. I know it sounds almost condescending that it feels rude to say, but don’t lose money. It’s fine if you value stock at $50 and the price, but not the value, drops to $40. If the value of that stock truly is $50, the price will eventually bounce back.
But if you permanently lose money, it takes a long time to recoup. Surprisingly, very little focus is on this. You always hear the stories about I made three times my initial investment, or I make ten times my initial investment, but you seldom hear the “I don’t lose money story.” How do we intensify that as investors? I would like to highlight three so-called red flags. If you recall whenever we talked about Southwest Airlines in Lesson 2 of this course series, we’re going to talk about some of the same things, but in a very different scenario.
Think about it like this: If you’re building a winning football team, it’s defense before offense. So, let’s take an example of what might be a risky pick. Let’s talk about Tesla. Now, the founder of Tesla, Elon Musk, is an unbelievable person. I read his biography not too long ago, and I was blown away. Elon Musk founded PayPal, and with the proceeds of his sale, he started SpaceX, a company that’s building rockets. I mean how awesome is that? Tesla plans to disrupt the car industry across the world. Some people might even say for good reasons that they have already done so. If that is all that you see, Elon Musk and Tesla sound like a great investment.
Now, let’s put a pin in Tesla. Let me ask how many of you would like to get into this deal with me. You can, right after this video, give me $50 and in return, you commit to giving me another two dollars every year. Okay? So, I’m not giving you a dime, but you’re giving me $50, and you commit to giving me another $2 every single year. No one in their right mind would do that. That is actually the deal the stock market if offering you for buying Tesla.
If you were to buy all the shares, you’d be paying around 50 billion dollars for a company that loses two billion dollars every year. Now there surely is an upside to Tesla, and if you followed another type of strategy than value investing, perhaps Tesla is a good investment. The first investors who bought into Facebook before it went public didn’t buy into a profitable company, and they still made a ton of money. There’s also a downside to Tesla and all the companies for that matter.
As a value investor, you’re looking at what am I paying and what I can expect to get back. You do not rely on heavy growth. Okay so, let’s take a look at Tesla’s numbers. As you can see here, the top line, the revenue it looks amazing. From 2008, it grew from 15 million dollars, and now over the past 12 months, we’re looking at more than 13 billion dollars. It looks absolutely amazing if that is the number that you’re looking at.
But if we dig more into it, if you look at the margins, we see here how the margins have been shrinking for quite a few years, and we see here and the net income. The company has never been profitable. So, how can the company continue to grow without being profitable? What is fueling that growth? Well, if you look down here, the number is yes, more and more shares have been issued. That might be a good thing it might be a bad thing, but it is financing the rapid growth, and it is diluting the existing shareholders.
Now, if that money is put into good use, it’s not necessarily a problem. But for me, as a shareholder, if the management keeps issuing new shares, I would like to see a profit at some point in time. Another way to finance this is to incur a lot of debt. Something that Tesla has also been doing. If you look at the interest coverage ratio, it’s negative, and it’s negative because the operating income here that you see is also negative.
They actually do not make any money on the products. So, our interest coverage ratio, as you might recall from the lesson before. We would like to be above ten. But these are all negative because the operating income is negative. Another thing that’s worrisome is if you look at the gross margin. So, the gross margin is only looking at if you bill a Tesla car, what are the direct expenses to that car. So, if you sold a car for a $100, you would get, in this situation, $18.90 back. But if you also take away the fixed cost, the operating expenses, so that’s paying the staff, the administration, that’s paying research and development, then you would lose $13.90 every time you would sell a car for $100. So, where does that leave you and where does that leave Tesla if that is a company that you’re looking into? Well, there is always a downside to a company like Tesla and all the companies for that matter. It could go bankrupt. Perhaps it will, perhaps it won’t.
But if we look at this a bit cynically, we would say that Tesla has never been profitable and it’s losing more and more money every year. So, if nothing changed, buying stocks in Tesla would ensure that you’re paying $50 upfront to lose another $2 every year. Always think like a value investor. What if nothing changed? This is really not to bash Elon Musk in any way. If I could buy stock in the person and none in the company, perhaps that would be along Musk. He’s created amazing products. But the point is, as a value investor, always remember, think of the downsides first.
