Over the past decade, I have watched Tesla (TSLA, Financial) go from being a market outcast to one of the most sought-after stocks in the world. I have found the company's rise fascinating. Despite continual criticism, a lack of funding and competition from deep-pocketed competitors, the company has gone from strength to strength.
It does not look as if this growth story is going to end anytime soon. One of the primary bear arguments for the stock has always been that Tesla will never be able to generate enough cash to be able to fund its growth ambitions. Now that the group's market capitalization has surpassed $1 trillion, this is no longer a concern. The company could choose to do an At The Market (ATM) offering of stock for 5% of its market value tomorrow, and that would generate enough cash to cover its cost of goods sold for two years at current production rates ($25 billion per annum) assuming revenues dropped to zero.
Before I continue, I should say I have no position in the stock. I have been watching Tesla closely for over a decade and think the company is an interesting growth story. However, I have never been comfortable with the valuation. With the benefit of hindsight, it turns out that this was a mistake.
This error aside, I have learned a lot from the business. In particular, I think it has been a great example of George Soros' (Trades, Portfolio) general theory of reflexivity in action and proves why investors should not ignore this theory.
Soros' theory of reflexivity
Reflexivity is the theory that a feedback loop exists in which investors' perceptions can affect economic fundamentals, which in turn changes investors' perceptions.
Soros's theory of reflexivity is based on these ideas. It basically runs counter to the traditional economic concepts of rational expectations and the efficient market hypothesis.
According to the billionaire investor's theory, whereas in mainstream economics equilibrium prices are implied by the real economic fundamentals that determine supply and demand, in a market, prices can deviate from equilibrium values because the process of price formation is reflexive and dominated by positive feedback loops between prices and expectations.
Using the example of Tesla, here we have a company that analysts might argue is not worth $1 trillion compared to its peer group given spotty track record profitability.
However, investors are willing to pay more because the process of price formation is being dominated by the expectation that the company is changing the world and is targeting output of 20 million vehicles by 2030.
The overwhelmingly positive sentiment among investors is driving a positive feedback loop, whereby the company has become financially sustainable thanks to the optimism. To put it another way, one can speculate that Tesla has become successful in large part by saying it will become successful.
Low cost of capital
Without the vision and drive of its CEO, Elon Musk, the company might not have been able to inspire investors to drive the valuation higher. This would have increased its cost of capital and reduced the chances of success.
As Musk has laid out plans for growth, investors have rushed to buy. This has, in turn, reduced the cost of capital and increased the company's access to financing, thereby acting as a positive feedback loop.
Tesla is not the only example of Soros' theory of reflexivity. Over the years, I have watched countless startups grow into something based on nothing but positive newsflow alone.
It is particularly common in the resource sector. Strong investor sentiment allows a company to raise money with a low cost of capital, enabling it to fund a project it would never have been able to by itself.
As such, when investors are evaluating the potential opportunities, they should consider the risks, challenges and opportunities posed by Soros' theory of reflexivity.
