Electric Car Stocks: How To Use Finance Theory To Profit

Here’s a basic concept for how speculative sectors of the market work. A hot trend develops, whether it’s sports betting, cannabis, electric cars, space tourism, or SPACs. Investors trip over themselves to throw money at it, and sponsors want to raise as much money as possible. The companies then go into the financial markets to raise debt and equity.

But here’s where things get interesting. Equity is essentially a claim on the cash flow of a company after expenses and debt is paid. Where retail investors often go wrong is in not understanding who has claims on the cash flow of a company before they do.

Principle #1: Capital Structure Is Key

As such, a consistent theme of speculative areas of the market is that sophisticated institutional investors have been able to make sharp investments via junk bonds and convertible debt in electric cars, SPACs, cannabis, etc., that profit off of unsophisticated retail investors.

These issues have been compounded by the proliferation of SPAC deals. In the case of SPACs, the SPAC sponsors and institutional investors in their corner tend to take a substantial chunk of the deal for themselves and have little to no downside. This is something that’s nearly invisible to retail investors – as is the dilution from convertible debt. This has led independent legal observers to question the few dozen hedge funds that traffic heavily in SPACs on account of the gray area of the deals they do.

Lucid Motors (LCID), Nikola (NKLA), and Lordstown Motors (RIDE) all went through the SPAC process to go public. Of these, only Lucid is still above its initial SPAC price. Lucid reports earnings today so they’ll be able to fill investors in more on their plans.

Said the researchers behind the largest study to date of SPACs:

A SPAC is formed by a sponsor, which engages an underwriter to issue shares to investors in an IPO. In exchange for their roles in establishing and supporting the SPAC, the sponsor, the underwriter, and the IPO investors receive generous compensation. The sponsor takes a “promote” of 20% of the SPAC’s post-IPO shares for a nominal price; the underwriter receives a fee typically equal to 5.5% of IPO proceeds, which is typically not adjusted for later redemption of shares; and investors in the IPO receive free warrants along with their shares, which dilute the value of a SPAC’s shares and provide the IPO investors with an 11.6% average annualized return between the date of the IPO and the date of the merger. The sponsor’s essentially free shares and the IPO investors’ free warrants dilute the value of the SPAC’s shares, the underwriting fees, and additional advisory fees that SPACs incur at the time of their merger, further deplete the SPAC’s cash. SPAC redemptions then amplify the effects of dilution and dissipation of cash on a per-share basis.

Time and time again, we’ve seen that sophisticated institutional investors, banks, and hedge funds do well in speculative or distressed areas of the market, while retail investors tend to do poorly. In the case of speculative investments, favored institutions tend to use their close relationships with investment banks and SPAC sponsors to make money by flipping shares nearly risk free to the public.

As a general rule, profitable/healthy companies tend to have two ways to invest in them. You can either buy the equity or buy their senior debt (a.k.a. bonds).

Speculative/distressed companies tend to have all kinds of layers and tranches, ranging from bank debt with tight covenants, secured debt, unsecured debt, convertible debt, and finally equity. Sometimes there will be dozens of tranches, like in the case of post-bankruptcy airline debt and the infamous subprime mortgage bonds of yesteryear.

The academic research is pretty clear on how this affects shareholder returns. Stocks in the highest decile of credit quality return a little over 1% per month, while stocks in the lowest decile of credit quality return about -0.2% per month. What makes this worse is that the bad returns for low-quality companies tend to happen during bear markets when you want your portfolio to hold up. This is the basis for a well-known investment strategy called quality minus junk. I’m not aware of any electric car stocks that have investment-grade credit ratings, although as the biggest winner in the sector Tesla (TSLA) may soon be upgraded. Even Ford (F) bonds are junk rated.

On the subject of Tesla, the stock has been a huge winner, but the same factors were at play here with institutional investors concentrating in Tesla convertible debt over the years while retail investors bought common shares. This meant the institutions shared in the upside but would have been paid in full before Tesla shareholders got anything had Tesla been less successful. This is a textbook case of the exception proving the rule.

If you’re reading this and it seems really complicated, I’ll summarize.

• For most speculative companies, common stock competes for cash flow with a lot of debt. As such, the risk-adjusted returns for common stock in speculative companies tend to be poor. The next recession will likely reveal the true extent of how much fake value is floating around the stock market right now. For more on this, look up the Merton model. His theory: Equity is a call option with a price of zero. Another way of saying this is that equity is a call option over the value of debt.
• As such, a general rule of thumb is to try to buy the senior debt or convertible bonds of speculative companies, whether it’s the airlines, AMC Entertainment (AMC), Netflix (NFLX), cruise stocks, or electric car stocks. You don’t need a relationship with an investment bank to do this, as most brokers support your ability to buy bonds, although you’ll need to trade at a minimum in blocks of $1,000. Research shows that junk bonds have dramatically better risk-adjusted returns than the stocks of the companies they correspond to. There’s a new ETF product from Simplify (CDX) that aims to employ this exact strategy.
• If you can’t do this, either avoid them altogether or treat it as a short-term momentum trade.
• Being aware of ways that hedge funds and banks are able to essentially rig the system in their favor is a good argument for investing in index funds or long-term dividend stocks rather than pursuing short-term strategies.

Principle #2: Go With The Momentum

There’s a good chance many of you reading this will ponder this article and then go put a bunch of money in Nio (NIO) ahead of their delivery numbers tomorrow. If you do so, there’s another tip that’s extremely helpful for investing in speculative areas of the market.

Momentum is probably the oldest trading strategy in the market. It means you buy what’s going up and sell what is going down, with the timeframe applied generally being measured in months rather than years. Most investors do the opposite, taking profits in stocks that go up while plowing money into falling stocks. I myself have to fight the human tendency to want to take profits and plow into losing positions, but being aware that it’s a bias is 80% of the battle towards stopping it. I almost always take losses in losing stocks and buy them back 31 or more days later if I still believe in the story. I employed this strategy twice in Alibaba (BABA), helping to unlock tax losses and avoid some economic losses (also, you can always put the money into an index fund or competitor in the meantime). Understanding momentum also helped keep me in Apple (AAPL) years ago far longer than I would have stayed otherwise.

Try applying momentum to your portfolio for yourself, it’s one strategy that can offer immediate benefit to your portfolio for little to no cost or risk.

The two main types of momentum are cross-sectional momentum and time-series momentum. Cross-sectional momentum says that the areas of the market that are doing the best will generally keep doing the best for the next year or so (this is also known as relative strength). Time-series momentum says that if a stock is going up, it will keep going up.

Momentum is so powerful that it trumps long-term business potential in the short run. Eventually, however, if a stock has poor business fundamentals, the stock will reflect it. Sometimes it takes 10 days for this to happen and sometimes it takes 10 years, but it eventually does happen.

When thinking about electric car stocks or any other speculative area of the market, ask yourself a simple question. Is the momentum in my favor? If it is, you can probably buy and flip for more than you pay no matter how high a price you pay. If you’re in stock down 50% off of its 52-week high with poor fundamentals, however, you’re probably never going to get it back. Sometimes you will, but you’re better off selling losers and letting winners run for the most part. Momentum explains why some stocks have done so well despite serious questions about their future business performance and obvious flaws in their capital structure.

To summarize.

• Buy stocks that are rising in price and sell stocks that are falling unless you have reason to believe that they’re significantly undervalued. This is helpful for both tax and economic purposes.
• If business fundamentals aren’t driving the bus, then eventually momentum will always eventually turn against speculative companies. Be ready to sell for when this happens.

Bottom Line

Momentum is currently against electric car stocks, and retail investors’ position low on the capital stack leaves them vulnerable to disappointment or loss of capital. With valuations high and prices falling, I’d steer clear of their common equity. If you can find them for sale, the bonds of said companies are likely to be a better play than equity. We’re all aware of the meteoric success of Tesla over the last 10 years, but in this case, the exception proves the rule.