I was on top when this shit meant a lot
We lost money and reputation this year. The mechanics of loss are the same as the mechanics of gain. To understand the driving forces we look back at the origins of the first modern stock market.
When a car breaks down you better understand its mechanics. The same applies to financial markets. So what happened this year? Narratives like the Fed, China, Covid, Elon Musk’s impulses or Jeff Bezos’ new girlfriend are making the airwaves. In order to come back, we need better explanations for what happened in 2022. One useful way is to look at the financial markets from an engineering perspective. How does this stuff actually work? What are the mechanics of financial markets? We discuss the mechanics of stock markets through the lens of Tesla shares, since that is our largest position.
The three vectors of wealth
Markets are messy. They’re not like airplanes or Teslas. You can’t treat them like a work of engineering. Markets are like biological systems with lots of complexity and dynamic interactions. But unlike biology, financial markets offer the ability to go back to the origins, back to where it all began and build up from there. So, let’s look at the world’s first stock market and peek at its daily operations. Interestingly, most of the fundamental drivers from back then still apply today. The three vectors of wealth are 1/3 interest rates 2/3 longterm earnings and 3/3 competition.
Amsterdam invents the modern stock market in 1602
The first modern stock market was founded in 1602 in Amsterdam. Back then its sole purpose was to trade shares in the Dutch East India Company. Individuals were able to trade shares in the Dutch East India Company on the secondary market which became the Amsterdam Stock Exchange. Prior to establishing the secondary market another important innovation was necessary, which was the introduction of the limited liability joint stock company. With this type of legal entity its owners (i.e.investors) had limited liability. Another innovation was that the company issued shares to raise capital. Those shares became the primary subject of trade on the secondary market in Amsterdam. And with that the modern stock market was born.
Historians debate about the reasons for why the Dutch made those innovations in corporate control. One factor must have been the amount of capital required and the risk of operating in the East Indies (modern Indonesia). Dutch rulers and aristocrats were not as wealthy as European peers such as English, French or Spanish lords. They couldn’t just raise the necessary funds by themselves. In other words, the capital requirements of the Dutch East India Company were so large that a new form of financing had to be invented. Others point to the tradition of Holland in crowdfunding dams and other infrastructure projects to protect the population from floods. Holland's unique topography forced people to deal with natural risks such as floods for centuries and develop creative financing for protective infrastructure. Since the Dutch had experience in using crowdfunding techniques to get stuff done, the invention of the joint stock company and the subsequent establishment of the Amsterdam Stock Exchange can be viewed as a natural evolution of this process.
Limited liability and fungible shares
Let’s recap. We have two major inventions. First, the joint stock company, a legal entity whose capital is paid in by shareholders. Those shareholders are only liable up to the amount of capital invested. Second, the establishment of a secondary market where these shareholders can freely trade their shares with third parties. But why would anybody want to invest in the Dutch East India Company? Well, it was a lucrative business. What was the business? Initially the Dutch East India Company set out to establish trade routes for the spice and silk trade. Buy this stuff in Indonesia and ship it to Europe. For that to happen you needed ships, ports, traders and a sales network in Europe. All this had to be financed. Hence the stock market.
Louis Culvert, the Dutch investor
The best way to illustrate the mechanics of trading on the first modern stock exchange is to tell the story from the perspective of an investor in the Dutch East India Company. So let’s zoom in to a regular trading day on the Amsterdam Stock Exchange around 1610.
It’s a foggy, frigid morning in Amsterdam and the cobble stone covered streets are still moist and slippery. Louis Culvert is a successful merchant dealing in silks with Italy and Germany. He used to buy merchandise from traders in Antwerp and Amsterdam. However, since the establishment of the Dutch East India Company he has been buying directly from them. Louis is in close contact with cloth makers in Venice and Bologna and feels that the market for silk is going to grow fast. His intention today is to buy shares in the Dutch East India Company. Last year he bought silk worth 100,000 Guilders directly from the Dutch East India Company, which was about one third of their supply. He estimates that the Dutch East India Company makes about 10% net profit on the silk. Based on this math Louis estimates that the Dutch East India Company sold 300,000 Guilders worth of silk and made about 30,000 Guilders net profit in the silk business. But that’s not all. His uncle Robert has a friend who imports spices from the Dutch East India Company. Robert’s friend estimates that the Company could net an additional 100,000 Guilders in the spice trade. Louis is intrigued. Upon entering New Bridge, which is the location where the secondary market for shares in the Dutch East India Company takes place, Louis can’t help but wonder. “What on earth is going on here?” he asks himself. Hundreds of men shouting, sometimes even screaming. And what’s with all this handwaving?
After a strong coffee Louis calms down. One of the traders offers him a block of 1000 shares at 5 Guilders per share. Louis brought his nephew Markus with him. Markus is a trained accountant and was recommended by Jasper, Louis’ brother. Markus quickly starts to scribble on a piece of paper. “5 Guilders per share. Let me see. The company is expected to net 180,000 Guilders this year. There are a total of 200,000 shares outstanding. That’s a profit of 0,9 Guilders per share. “If you buy 1000 shares you are expected to earn 900 Guilders.” Markus says with a straight face. “Now, let’s assume they pay half of that in dividends and reinvest the rest in the business. That means your initial investment of 5000 Guilders (1000 shares * 5 per share) is expected to earn a dividend of 450 Guilders 1000 shares * 0,45 Dividend per share). Which is good. But what’s even better,” so Markus, “is, that you will also participate in the future growth generated by the reinvestment of the profit.” Louis is skeptical. “How do I know they actually do something useful with the reinvestment? What if they just squander it?” “Well, Sir, that’s the beauty of this new type of legal entity they created for the Dutch East India Company. You see, as a shareholder you don’t just participate in the profit, you also have a say in the company by ordering the board of directors to steer management in the right direction. “ Louis jumps up in his chair. “You mean I can buy 5000 Guilders worth of shares in the company and tell them what to do?” he asks with a skeptical smirk on this face. “Well, not exactly.” counters Markus. “You will have a say, but it’s proportional to the stake you own. 5000 Guilders worth of capital will only buy you a tiny portion of the company, 0,5% to be precise. There are 200,000 shares outstanding and you’re buying 1000 shares, that is 0,5%. But think about it this way. There are many small shareholders like you. And they have all similar incentives. Together, as a collective, you will have influence on the board. It’s like when you financed the construction of the dam in your village. All the villagers together had the same goal and the project got financed and built. Think about it this way.” Markus says with traces of triumphant sharpness in his eyes. Louis let’s that sink in. “Hmm, not bad. So we all chip in and then together have a say in the company. And then they do what we want them to do, which is make money. Not bad, not bad…” he whispers.
A week later Louis travels to Italy to visit his contacts in the cloth business. They are excited about the quality of imported materials from the East Indies and expect to buy more than double the amount of silk in the coming years. Louis does quick mental math. If his Italian friends are right, the Dutch East India Company will soon make at least 100,000 Guilders of profit just from silk. Let’s assume they can grow the spice business, too and expand in other areas such as coffee and cocoa. The business, so Louis, could earn 350,000 Guilders in 3 years. At a 50% payout ratio this would net him 1,75 per share in dividend or 1750 Guilders for his initial investment of 5000 Guilders. Adding all this up Louis concludes that his initial investment of 5000 Guilders could be payed back through dividends in less than four years. And after that he still keeps his ownership and keeps earning ever increasing dividends. He is excited and buys 1000 shares at 5 Guilders per share. In fact, he sells his stake in the silk manufacturing operation he co-owns in Venice and buys even more shares. His total investment amounts to 10,000 shares for a total of 50,000 Guilders.
Two years pass by and the Dutch East India Company is literally sailing at full speed. Annual profits have exceeded Louis’ wildest expectations and came in at 550,000 Guilders. It’s another misty morning and Louis is sipping his coffee when Markus comes rushing. “Dear uncle, I was just at New Bridge and the traders tell me the shares of the Dutch East India Company trade at 90 Guilders a share. That is eighteen times more that you paid for them. You should sell them!” “Why should I sell them?”, asks Louis somewhat annoyed. “I have this incredible cash cow. Every year the company keeps raising the dividend and you want me to sell.””Sir, you should sell because you can do other, more lucrative investments with the capital. Selling at 90 Guilders means you forgo a dividend of 2,75 Guilders. But that is barely 3%. You can get 4% return if you buy the debt issued by the King of France or 5% for debt issued by the King of Spain. That’s a better return.” Louis smirks. “You want me to give those parasites money? Are you out of your mind?””But sir, with all due respect, why invest in something that yields barely 3% when you can invest in something that yields 4% or more?””Because the 3% will grow my friend. Because the Dutch East India Company is actually doing something useful. Adding value to people in Europe. That’s why their business is so successful. What if they keep growing the profit and pay 5 or 7 Guilders per share in dividend. What then? I am sure the King of Spain won’t increase his interest payment voluntarily. And on top of that I might be financing that bastard’s campaign to attack our country. No thanks.” Markus thinks for a moment. He agrees with Louis that the growth prospects of the Dutch East India Company are real. Markus leaves the coffee house and let’s Louis finish his morning ritual.
Another two years go by and now it’s Louis who walks restlessly in circles. “They are selling Dutch East India Company shares for 200 Guilders. Markus, we need to sell.” Markus looks at him with astonishment. “But Sir, the company has been growing profits so consistently, why sell now?” Louis doesn’t care about the past. He’s heard from his contacts in Italy that the price of silk demanded by the Dutch East India Company is so high that competitive products are entering the market form India and the Far East. The quality of this silk is questionable but the price is so low that lots of cloth makers are considering to switch. “Oh my god Markus, do you have any idea what this might do to the profits of the Company?” Louis decides to sell his hares for 200 Guilders each. He’s been invested for 4 years. His initial investment of 50,000 Guilders has yielded a total cash on cash return of 235,000 Guilders including cumulative dividends.
Now back to today. Every investment in the stock market can be viewed through the lens of Louis and his stake in the Dutch East India Company. Eventually it all comes down to how much cash you put in and how much you expect to get out. Your payout depends on how much cash the company can generate. And this is the single most important factor to consider when investing in a company. How much cash can the company generate? Louis has a good grasp of the future prospects of the Dutch East India Company. Other important factors are competition and alternative investments. When Louis feels that the Dutch East India company is going to face more competition he decides to sell. By contrast, the high return offered by the Kings of France and Spain doesn’t appeal to him since the prospects of the Dutch East India Company are much more lucrative. Now let’s go back to Amsterdam around 1620.
High prospects at a high price
Louis put all the money he made from his stake in the Dutch East India Company in stores around Europe where he specializes in spices and cloth. He spends most of his time traveling. Towards the end of the year Louis returns to Amsterdam to celebrate Christmas with his extended family. He passes by New Bridge and peeks into the trading floor. To his bewilderment he hears that Dutch East India shares are changing hands for over 1000 Guilders. “What happened here”, he shouts at one of the traders. “Why on earth is the stock up so much?””The company just announced the opening of trading posts in Indian ports and Guangzhou. They are developing port access and inland shipping routes to all major sources of spice and silk around Asia. The prospects are now even greater.” Louis let’s that sink in. He was wrong about the competition. Yes, there was a threat by competitors entering the market. But Louis underestimated the nimbleness of management. They didn’t just sit still and watch others take market share. They acted and not just increased their share but also increased the whole addressable market for the Dutch East India Company. What should he do now? Buy the shares or stay put? Louis talks to one of the prominent traders at New Bridge. “What do you expect the company can earn next year?” he asks somewhat nervously. “Listen, I have no idea whether the new trading posts will materialize for the company. But management told us they expect to make at least 1,000,000 Guilders in profit.””Wow”, Louis is usually subdued and keeps his emotions to himself. But this number almost made him fall off his chair. “One Million Guilders in profit. That’s amazing”, he exclaims. “How many shares are outstanding?” The trader yells at one of his clerks with the same question. “250,000”, is the answer. So at 1000 Guilders per share that makes the company worth 250 Million Guilders.” Louis thinks for a moment. One Million in profit at a payout of 50%, that gives you and expected dividend of half a Million Guilders. “Hmm, “ Louis frowns. “Not such a great return, is it?”. “Common Louis,” the trader lifts his coffee cup and sets himself up for a lengthy monologue. He talks about prospects in India, China, Thailand and of course the East Indies. How big the market is and how little competition the Dutch East India company faces from English or French competitors. “This is going to grow like grass on a lush Dutch meadow,” he concludes. Louis thinks more and decides to take a walk. He struggles with the price and the prospects. ‘What if they don’t succeed in securing trade routs in China? What about India? The Brits are there and they won’t just let Dutch competitors take market share. Louis decides to pass.
Forced seller
As the years go by Louis regularly checks in at New Bridge. And to his consternation the price of shares of the Dutch East India Company just keeps rising. He feels bad about not investing. One morning Markus, his nephew, comes over sweaty and full of nervous excitement. “Sir, the director of the Bubbenberg trading house is asking to meet you urgently. Bubbenberg is one of the most prominent trading houses in Europe. Their base in Hamburg has allowed them to take advantage of port access and trading routes in Germany and Scandinavia. Their most important products are cocoa, coffee and tea. As Ulrich Bubbenberg, the patriarch of the family and director of the trading house, enters Louis’ office he can’t help but notice a slight fear in Bubbenberg’s face. “Sir, I am here to propose an important piece of business. I am offering you 5000 shares of the Dutch East India Company at 5000 Guilders per share. That is 20% below the current market price at New Bridge.” Louis offers him coffee and a seat. His instincts tell him to take his time at this meeting. While Ulrich Bubbenberg seems to be in a rush, Louis believes that his best course of action is the exact opposite. “That’s quite a generous discount”, he says after taking a sip of coffee. “Oh, by the way, how do you like the coffee? It’s Sumatra.” Ulrich Bubbenberg is in no mood to discuss coffee. He presses on.”Sir, I am here to propose a lucrative trade for you. As I said, I am offering shares of the Dutch East India at a 20% discount. My contacts in Holland recommended you as a potential buyer. Your reputation as a successful merchant is excellent even beyond the borders of Holland. And you seem to be one of the few wealthy merchants left in this country that hasn’t put all his money in the Dutch East India Company.” “What makes you think I am wealthy?” Louis shoots back. Bubbenberg waves his right hand while sweat drops start curling down his large chin. “I am not here to discuss your personal wealth. I am told you have the money. Are you interested?” he shouts. Now all the niceties are gone. The two men face each other and tough negotiation seems to be the only course of action. “Dear Mr. Bubbenberg, my contacts in Oman tell me that two of your ships have been seized by pirates and that the cargo has been lost. They further tell me that you weren’t able to insure the shipments and hence face a massive loss. Now, I don’t know about your finances but the word on New Bridge is that you need to sell your stake in the Dutch East India Company to cover the losses. Is this accurate?” Bubbenberg nods with a sad face. After another hour of negotiation the two men strike a deal. Louis buys half the stake outright for a 30% discount and lends Ulrich Bubbenberg the rest of the necessary funds against his remaining shares as collateral.
When the shit hits the fan
Within five more years Louis accumulates a 3% stake in the Dutch East India Company now worth a hefty 37,5 Million Guilders. Thanks to the amazing growth of the Dutch East India Company Louis is not just one of the richest men in Holland, his family is estimated to be one of the wealthiest in Europe. His wife Marie-Clare, a French women with roots in Switzerland, holds his hand while strolling along one of the beautiful Amsterdam canals.”Dear, are we going to Switzerland this winter. I’d love to hike in the snow,” But Louis is not in winter vacation mode. His thoughts are half a world across the globe where the Dutch East India Company faces obstacles in the China silk trade. Chinese traders have lobbied local rulers to block the Dutch East India Company from accessing lucrative trading routes. Louis, now board member, is scheduled to attend the board meeting tomorrow to decide a course of action. The stakes are high. The board has two choices. One is to raise more capital, put together an army and technically start a war with China. The other is let the Chinese take over and hope to buy product from them. Louis leans towards the first option.
Eventually, the board decides to go with option one. An army of mercenaries is raised and shipped to the Far East. In order to finance this endeavor the Dutch East India Company issued 50,000 shares at 6500 Guilders per share, a discount of 15% to the current price at New Bridge. Louis participates in the offering and keeps his stake at 3%. With a market cap of 1,8 Billion Guilders the Dutch East India Company is now by far the most valuable legal entity in the world. Wealthier than any lord and even Kings. But despite the enormous wealth and power the directors of the Dutch East India Company have to deal with a mountain of new problems. The King of France, jealous as ever, suddenly increased the tax for all products imported to France. Later that year the same happened with Spain and some city states in Italy. Italy is particularly critical for the Dutch East India Company since most of the high end cloth trade was going through there. And if that wasn’t enough headache, traders reported rising interest for cotton imported from the English colonies in America, a competitive material for cloth making.
As skirmishes with local war lords in China increase the toll on the Dutch East India Company starts hitting their profits. For the first time in decades the company posts a profit decline. Panic spreads on New Bridge and the shares drop to under 2000 Guilders. “That’s almost 70% below the price they were trading a year ago!” Louis shouts at one of the traders on New Bridge. “What on Earth is going on?””Sir, there are lots of speculators, who bought shares with loans from banks and rich individuals. They are forced to sell now. This selling pressure is hurting the share price. If you have cash, I recommend you buy now. This is just forced selling.” Louis remembers his encounter with Ulrich Bubbenberg. The German merchant also was in dire need of funds. But those circumstances were different. Bubbenberg lost money due to pirates in the Indian Ocean. These traders on New Bridge were speculating and got caught on the wrong side of things. “Why are they forced sellers?” Louis asks. “Why don’t they just hold on to the shares?””Because their credit arrangements with lenders state that the shares have to be at least worth 50% of the loan value. If that number drops, they have to sell. We call this loan on margin. Margin loans are collateralized with shares. If the shares drop below 50% of the loan value the traders are forced to sell.” Louis thinks for a moment. This arrangement seems somewhat arbitrary. Obviously, loans are always collateralized with assets. For example, his trading partners extend loans against silk, coffee and other commodities. But the crucial difference is that Louis isn’t forced to sell the moment the price of a commodity drops on the exchange. He can wait until he gets the right price, sell the merchandize and repay the loans. This margin loan business seems disturbing to him. As he strolls back home he thinks about the stock market, margin loans and the speculators on New Bridge. “No wonder, all of Amsterdam is obsessed with the Dutch East India Company. Those poor bastards took the stock exchange as a casino and got way too excited.” As his wife serves the afternoon coffee she nods and kisses his cheeks.
Years later Louis reflects on those days at New Bridge. While two of his sons took over the business, one of them, Johan, replaced him on the board of the Dutch East India Company. The trouble in China got resolved and the shares recovered as the company opened several new business lines with suppliers in South East Asia, Central America and English and French Colonies in North America. The only contingent still closed to the Dutch East India Company is South America where the Portuguese and Spanish have a stronghold. Johan is also a manager at the company. He runs the silk business out of his office in Amsterdam. As Louis reflects on his career he taps on Johan’s shoulder. “Son, if we’re lucky, we get one opportunity to create wealth in life. Mine was the Dutch East India Company. What’s yours going to be?”
The three vectors of wealth are unchanged
It’s striking to me that 400 years after the establishment of the Dutch East India company the dynamics of wealth creation with stock market investing haven’t changed. If your goal is to create wealth by investing you are stepping in the footsteps of Louis Culvert. Tesla is our opportunity to generate wealth by investing. Why Tesla? Let’s look at Tesla through the lens of the three vectors of wealth creation.
Growth prospects. Tesla is developing products and services in the transportation and energy business. Those are large markets. Tesla has compelling products which drive demand. Even better, since lots of their products are disruptive they are also able to increase market size. For example, the self driving software is fundamentally changing the way people use, drive and enjoy cars. People enjoy more time driving longer distances while they’re spending less per mile. Another even more striking example is energy storage for utility scale. This product allows utilities to balance the grid more flexibly at lower cost. Most of the incremental profit generated by these products accrues to Tesla shareholders because Tesla is often the only supplier. And in cases where there is competition, Tesla typically offers a far superior ratio of value to total cost of ownership.
Competition. Tesla like any other technology company is ultimately defined by the speed of innovation. The purpose of innovation at Tesla is to increase value delivered to customers while simultaneously lower the total cost of ownership. In the car business this means less cost per mile driven. In the battery business it means lower cost per kWh delivered to customers. Disruption is fundamentally defined as having a lower cost structure than incumbents while delivering more value. It’s more for less.
Interest rates. The risk free rate acts like gravity to financial markets. Higher interest rates pull stocks down.
Where do we stand today? Why did Tesla stock sell off 60% in 2022.
First, the risk free rate shot up, which puts pressure on valuations. In particular, higher interest rates reduce the value of cash flows in the far future. Tesla is a high growth company and most of its current market value is determined by cash flows in the far future. Higher interest rates make those future cash flows less interesting, hence the massive multiple compression. Here is an illustration.
At the beginning of 2022 Tesla was expected to make 3.5$ a share which as of the first trading day of 2022 corresponded to a PE of over 100. The 10 year Treasury yield back then was 1.5%. As 2022 comes to a close Tesla is expected to make 3,55 $ a share in 2022 which as of the last trading day of 2022 corresponds to a PE of 35. This is a multiple compression of over 65%. In the meantime the 10 year Treasury yield rose to 3,82%. Those are the mechanics of financial markets. While the risk free rate more than doubles, the multiple of stocks declines. My point here is that most of the stock decline of Tesla is driven by the action in the Treasury market. But what about the future prospects of Tesla? For that we need to look ahead. Let’s assume Tesla grows sales by 40% annually. That would correspond to sales of approximately 217 Bio. $ in 2025. At a 16% operating cash flow margin this would correspond to 34 Bio. $ in operating cash flow. Let’s assume the company invests 10 Bio. $ in capex, that leaves a free cash flow of 24 Bio.$. This year the company is expected to generate roughly 10 Bio. $ in free cash flow. Hopefully, this math illustrates the importance of future cash flows.
Second, the competitive situation is in flux. Demand is weaker than expected. For example, the company announced 405k deliveries for Q4 in 2022. That is 40% growth and falls short of the 50% growth guided by the company. However, since 2020 the compound growth has been over 60%. The company has never guided year over year growth but only stated that over the longterm they expect to growth 50%. That number is still in tact. Nevertheless, investors are not sure whether the current slowdown is driven by 1/3 macro headwinds, 2/3 real competitive threats or 3/3 a slowdown due to the large base (it’s harder to grow 50% from a base of 1 Million than 100,000). Another scare factor is the Biden administration actively trying to hurt Tesla. Recently the IRS announced EV tax credits and the scheme seems to be designed to hurt the sales of Model Y in the US. Model Y is on track to become the best selling car in the world. In particular, the car is rapidly taking market share from other mid sized SUVs, which hurts the cash flows of legacy manufacturers. The rise of the Model Y is toxic for legacy automakers. That’s precisely why the Biden administration is working hard to protect its main constituency, the unions, by trying everything to at delay Tesla’s dominance. Those are real concerns that hurt the company. Nevertheless, we believe the current demand issues will be solved and Tesla will keep its annual compound volume growth of 50%. We are optimistic about the prospects in China, since the country is reopening and should get back to better economic growth and increased pent up consumption. Further, we expect US interest rates to plateau and eventually decline in 2023, which will boost the multiple of Tesla shares.
Conclusion
So why the title “I was on Top when this Shit meant a lot”? Replace shit with future. When the future means a lot to investors, they pay higher valuations for companies. When it doesn’t, they don’t. Currently, Tesla’s future is in flux and investors are not willing to pay much for future prospects. It’s the job of an investor to assess the future prospects of a company. When fear creeps in, prices fall. This was true for Louis Culvert in 17th century Amsterdam and it is true for Tesla today. Lower future prospects lead to a multiple compression. But Tesla is the ultimate antifragile company, which means it gets stronger with volatility. We expect Tesla to make at least 5$ per share in 2023. At the current stock price this corresponds to a PE of roughly 20, which is similar to the PE of the S&P 500. Given that Tesla grows 3 to 4 times faster than the S&P the company deserves a higher multiple. We expect the stock to recover throughout the year as fundamentals in China get better, Europe ramps up and the US tax confusion gets resolved. Further, we expect US interest rates to plateau and eventually decline in 2023, which will boost the multiple of Tesla shares.