The anticipation around Tesla’s inclusion in the Standard & Poor’s (S&P) 500 index has been building recently and the announcement that the company will finally be included on 21st December, has caused some critics to voice their concerns that the company was not included sooner.
Tesla’s 464 billion USD market cap will make it the largest new entry to the index in history and will rank as the eight largest company by market cap, behind established industry titans such as Apple, Alphabet and Facebook. The company has had an extremely volatile history, with the firm entering 2020 with a market cap of 81 billion USD before skyrocketing 572% over the past 11 months. Consequently, Tesla stock now trades at double the valuation of the next largest automobile manufacturer, Toyota, which has a market cap of 200 billion USD. In addition, Tesla’s price to earnings (P/E) ratio, which is 101, is high when compared to Toyota’s P/E ratio of 15, despite the fact that Tesla is aiming to deliver 500,000 cars in 2020 compared to Toyota’s 8 million. Statistics such as these, coupled with the extreme volatility of the stock, has led some analysts to question the validity of Tesla’s valuation.
These concerns may contribute to the reasoning behind the decision to avoid adding Tesla back in September, despite the firm meeting the criteria. Instead, Etsy – a company 25 times smaller by market cap – was added to the index. One industry source told ETF Stream, an exchange traded fund news agency, that Tesla’s performance just is not ’justified by the company’s accounts’ with profits, apart from Q3, reliant on selling carbon credits rather than selling cars. The index committee is unlikely to risk the index’s reputation by including stocks with values driven by high expectations rather than financial analysis. On the announcement of this decision, Tesla’s stock plummeted 21% demonstrating the very volatility that ensured the stock’s exclusion.
Whilst Tesla’s volatility has not changed since September, delaying the firm’s inclusion in the S&P 500 bought more planning time for investors. The S&P 500 is weighted by market capitalisation and shares available for trading which means that, once included, Tesla will account for approximately 1% of the index. Tracker funds will have to rebalance their portfolio to include Tesla, an obligation that requires 53 billion USD of capital. This will of course mean that tracker funds have to sell off 53 billion USD of other S&P 500 stocks, a move which takes considerable planning and could potentially cause wider shifts in the market.
This is possibly the main reason for the delay. Tesla’s market cap is so large that it provides a unique challenge to tracker funds based on the S&P 500. Investors, who may actively limit exposure to volatility by investing in S&P 500 trackers, may also be worried that such a volatile stock will be automatically included in their portfolio. However, the reality is that accounting for just 1% of the index’s valuation means that even if the company went bust, the impact on tracker funds and therefore passive investors would be minimal.
The greater threat to investors may not be volatility, but rather the underperformance of the stock. Rob Arnott, founder and president of Research Affiliates, an asset management firm, published a research paper which found that the leader in any sector underperforms the average stock in that sector by 3.5%. Whilst this research was conducted before the COVID-19 pandemic and therefore doesn’t take into account the recent increase in technology stocks, it may be a key consideration for the long term investor.
However, Tesla’s volatile history, coupled with its ambitious targets means that it is one firm which remains unlikely to follow convention. The delay in adding the stock to the S&P 500 has given fund managers additional time to strategise and many investors will be closely monitoring the stock’s performance now that it is now in the index.
By Taylor Alexander
Sector Head: Daniel Aliwell