Why These Tesla Investors Got Burned

Tesla's Model S sedan. Photo credit: Tesla Motors.

Tesla Motors (NASDAQ: TSLA  ) is a stock that many people -- including quite a few professional investors -- love to hate.

Whether it's because of the politics of electric cars, because billionaire CEO Elon Musk's brash and snarky manner, or simply because its valuation sparks comparisons to the wilder stocks of the old dot-com bubble era, plenty of folks either don't want Tesla to succeed, or just honestly don't believe that it can.

Many of those folks have put their money where their ideas are, by investing in a short position in Tesla's stock.

And at least this week, a lot of those folks got burned in a big way. Here's what happened.

How a short position lets investors bet against a stock
First, let's explain. When investors take a short position, what they're doing is borrowing someone else's stock and selling it, betting that they can buy it back later (to repay the loan) at a lower price.

If investors think that a company's stock is overpriced, they can ask their broker to set up a short position that will give them a profit when the stock price falls. The farther it falls, the bigger the profit.

But whether the stock price goes down or up, the investor still has to pay back the loan. And the investor has to pay interest on the stock he or she borrowed in the meantime, which typically isn't cheap.

If the stock skyrockets, the investor can lose a lot of money -- far more than the original investment. And the longer that person waits to close their position, the more interest he or she has to pay.

In other words, selling a stock short is a risky move. That's why smart investors save it for cases when they think a stock is wildly overvalued, where its price is so high that it doesn't seem to make sense.

Where it seems like a sure thing to crash, in other words.

Now let's look at Tesla.

From this perspective, Tesla looked like a classic short candidate
There's a case to be made for Tesla, but it's the case against Tesla that we're interested in right now. It's easy to sum up: Here's a company that has been around for a decade but hadn't had a quarterly profit ever until this past week. It's selling a new kind of product -- electric luxury cars -- that competes against massive global companies, and it's unclear that enough consumers want that new kind of product to make the business worthwhile.

I mean, would you pick some unproven California startup to go up against the likes of Ford or Toyota (NYSE: TM  ) ? (Yes, Toyota is actually a Tesla investor, but bear with me here for a minute.)

Whether you would or not, a lot of people have chosen to invest in Tesla, and that meant that Tesla's stock price went way up -- even though the company hadn't yet earned any money.

That was an irresistible situation for many investors, who opened up big short positions on Tesla. And when I say "many investors," I mean many: As of a few days ago, about 40% of the Tesla shares on the open market had been sold short, according to The Wall Street Journal.

That's huge. And it set the stage for what happened next.

A textbook "short squeeze" was like rocket fuel for the stock
That big percentage, what we call a high short interest in Tesla, meant that the stock was primed for a short squeeze. That's what happens when there's a big positive development on a stock with a high short interest that drives the price up.

When there's a high short interest on that stock, the price can go up very very quickly. That's because all those short investors are rushing to buy the stock to cover -- close out -- their investments before the stock gets even more expensive.

In other words, those short investors get squeezed.

That looks like exactly what happened. Tesla's stock closed at $55.79 on Wednesday. After that, two things happened:

  • Tesla announced a profit. After the market closed on Wednesday, Tesla announced its first-ever quarterly profit. It was small -- only $15 million or $0.12 a share excluding some special items -- but Wall Street had expected just $0.04 a share. The stock went up big in after-hours trading.
  • Consumer Reports threw fuel on the fire. The next morning, Consumer Reports announced that Tesla's Model S sedan, shown above, had scored 99 out of 100 in its testing. That's equal to the best cars the magazine has ever tested. That's a big, big seal of approval for a start-up carmaker, and it added even more fuel to the rocket driving Tesla's stock price higher.

So even though its price was already high,Tesla's stock soared on the one-two hit of great news. That probably led many shorts to rush to close their positions, and that in turn drove the stock up even higher: Tesla closed at $69.40 on Thursday. And it kept going: Tesla stock closed at $76.70 on Friday. It might go even higher next week.

But won't it eventually come down?

Tesla could return to Earth ... eventually
Sure, it might. While Tesla has done a very impressive job of executing on its business plan, there's still a long way to go before it will make enough money to justify anything like its sky-high stock price. And it may never get that far, for two big reasons.

First, electric cars are still a niche market, and that might not change. Tesla might be able to sell enough cars every year to make a profit, but it might be a small profit that only justifies a share price of $10, not $70.

Second, if electric cars do start to get popular, there are massive competitors waiting to step in: all of the world's big automakers. They all have research resources and economies of scale that absolutely dwarf anything Tesla will be able to muster. How Tesla will survive and thrive when it's competing against the big automakers is an open question, and a daunting one.

All of that could drive the stock down in time. Probably will, say some analysts.

But there's an old saying among stock traders: The market can stay irrational longer than you can stay solvent. Short sellers who are making big interest payments may not be able to afford to hang on until Tesla's price falls -- if it ever does.

Long story short (so to speak), they're getting burned. If you own Tesla stock, enjoy the ride.

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Read/Post Comments (8) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 11, 2013, at 9:10 AM, Pondee wrote:

    " That probably led many shorts to rush to close their positions..."

    What is the current short interest after the "short squeeze"? Wouldn't this number help us tell if the squeeze was over? Wouldn't this number make your story more complete?

  • Report this Comment On May 11, 2013, at 10:02 AM, cottagetrees wrote:

    I think everyone is sorely underestimating how disruptive this company is.

    Years ago, a new employee at a little known storage startup told me that all the company needed to do to sell product was give companies a free test drive. One the companies tried the product, they didn't want to give it back. That's all i needed to hear. I invested. That little company was Network Appliance, and I turned $35,000 into $1,500,000 in about four years.

    On the call, Elon mentioned that 25% of people who test drive a Tesla place an order for one. That's an absolutely amazing conversion.

    They'll do around 20,000 units this year. This is only the tip of this iceberg's potential. Tesla is poised to blow away these numbers in the next few years. Imagine millions of units sold. It's not such a leap when you're selling a car that 25% of test drivers want to buy.

    Tesla could station a fleet of cars in every major US city and offer test drives 7 days a week. That's all the marketing they need to do. Already, they've seen what happens after they sell a car to a new geography. More orders come in from that geography. This is a viral word of mouth company. When consumers love a product so much, and that product is not going to be imitated any time soon, it's time to think much much bigger.

  • Report this Comment On May 11, 2013, at 10:08 AM, TMFMarlowe wrote:

    @pondee: Because it wouldn't mean much yet. It looks like the reported numbers haven't caught up to what's been happening over the last couple of days. We'll have a better view by midweek or so.

    John Rosevear

  • Report this Comment On May 11, 2013, at 10:37 AM, Rockthebest wrote:

    That is correct. We will have a better idea when mid May report is published. Great article. Thanks

  • Report this Comment On May 11, 2013, at 4:52 PM, stra6128 wrote:

    I have both a Tesla Roadster and Model S - bought them for the innovation/performance and the long-term goal of Tesla to eliminate use of fossil fuels to "gas-up" cars by sparking a viable electric car industry with multiple players. While Tesla makes a great product - by any metric of stock-picking - Tesla is a lousy choice. The market cap of Tesla is now around $8B - for a 10-year-old company that just reported quarterly earnings of $11M (much of profit is from selling EV credits). The P/E is in the stratosphere. Momentum plays are risky - the timing has to be exact - or one can lose their shirt. Most retail investors are not capable of such timing and good luck. Let's see where the stock is in 5 years and then declare Tesla a great investment (or not).

  • Report this Comment On May 11, 2013, at 6:23 PM, jimmy4040 wrote:

    "Tesla is poised to blow away these numbers in the next few years. Imagine millions of units sold. It's not such a leap when you're selling a car that 25% of test drivers want to buy. "

    You'll have to imagine it, because at an average sale price of close to $100,000 that's the only way it will ever happen.

  • Report this Comment On May 13, 2013, at 12:36 PM, Pricha100 wrote:

    Gimme a break dude, do you really think Tesla will only sell luxury cars and that's it forever? The whole point of selling the high value cars is to subsidize the eventual production of the cheaper models of which they will sell a whole lot more. Their whole vision is to bring these cars to the people. If i'm correct, home computers used to be expensive luxuries for most people too. And what happened then? In the mean time, Tesla is building their reputation and brand name as well. Apple can attest to the power of a strong brand in generating lots and lots of cash.

  • Report this Comment On June 05, 2013, at 4:12 PM, joenjensen wrote:

    When I learned that Tesla was building Superchargers with FREE charging for the life of the car no matter who owns it, I thought WOW FREE mileage. Folks are paying 4 bucks a gallon and in some places in California it's over 5 bucks.

    These folks are sick and tired of paying for high priced gas just to get to work and in some cases they are working to support the oil companies because most if not all of their money goes right into the gas tank. I thought what a deal, sure the car is expensive, but two things for sure was a plus for me, the very first was I never have to go into a gas stations ever.

    Then the second was NO DEALERS, Tesla's price is the price, no deals necessary. These car dealers are crooks stealing your money and trade in even before you get in the drivers seat.

    The third plus to me was no tailpipe, a zero emission vehicle with lots of power as soon as you touch the power pedal (I won't call it a gas pedal)

    The fourth was the car is a beautiful seven passenger with a fronk instead of an engine compartment.

    There are many more pluses but these 4 are the ones that hit me the most.

    There are several magazines that concur with me and many more of me.

    When the Model X comes out, it will be less expensive, a little smaller but will give you virtually the same response as the Model S.

    Finally when Generation 3 comes out in about 3-4 years that car will be less than the Model X and will blow you doors off, I only hope I live long enough and have the funds to own one.

    The technology is here, it's supper, it's exciting, and will help all of us breath cleaner air, and make it much more affordable for all of us to own because the maintenance is almost non existent, and will be much more affordable to drive.

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