If you thought 2020 was a weird year for the stock market, welcome to 2021. Short squeezes initially fueled by Reddit users have driven massive gains in various heavily shorted stocks, most notably the troubled video game retailer GameStop. While each mania is different, they all end the same way. GameStop stock is almost certain to eventually crash.
While GameStop is an obvious bubble, there are plenty of stocks that soared last year to levels that make little sense relative to their fundamentals. Two examples are electric car maker Tesla (TSLA 0.10%) and insurance company Lemonade (LMND 8.39%). Both have valuations that raise some serious eyebrows.
Shares of electric car company Tesla have soared more than 500% over the past year. Tesla is now worth close to $800 billion, just about quadruple the market value of Toyota. Tesla makes half a million cars a year and can't turn a profit without selling regulatory credits, while Toyota churns out around 10 million cars annually.
Telsa's ratios are really something. Price-to-sales stands at roughly 24, price-to-earnings is over 1,000 (using generally accepted accounting principles net income), and price-to-book value is 34. I'll remind you this is a capital-intensive, low-margin car company. Excluding regulatory credits, Tesla's automotive gross margin was below 20% in 2020.
Valuations can remain detached from reality for a long time. Something must change about the narrative to bring Tesla stock back to earth. Competition may be what does it. Legacy car companies aren't messing around anymore. General Motors plans to be fully electric by 2035, and it's pouring tens of billions of dollars into its plan to launch dozens of electric vehicles over the next few years.
You can try to justify Tesla's crazy valuation by assuming the company will be able to derive excessive profits from its self-driving technology, or launch a robotaxi service, or do any number of things that it does not yet do. Tesla's total addressable market is as big as your imagination allows.
The cold reality is that Tesla is a car company, and the economics of making cars is unlikely to dramatically change just because those cars are electric and can (sort of) drive themselves. Enjoy the ride while it lasts.
The stock market is awfully excited about insurance upstart Lemonade. The company aims to make buying insurance and getting claims paid as quick and easy as possible for its customers using AI chatbots. In Lemonade's S-1 filing, it states that it can get renters and homeowners into a policy after a two-minute chat, and that claims can be paid in as little as three seconds.
Lemonade stock has soared since it went public last year as investors bought into the story. The company is valued at over $8.3 billion despite third-quarter revenue of just $17.8 million and a net loss of over $30 million.
Lemonade's strategy is to cede 75% of the premiums it collects to reinsurers under proportional reinsurance agreements, wherein the reinsurers pay all claims on that 75% and Lemonade collects a commission. The remaining 25% of Lemonade's premiums are covered under different types of reinsurance agreements that aim to protect the company from big losses while keeping its gross margin stable.
Lemonade began using this strategy in July 2020, so there's not much of a track record. The company believes this plan will make it capital-light, protect its gross margins from the volatility of claims, and allow for its gross margins to grow over time.
One statement in Lemonade's S-1 rubbed me the wrong way: "...based on our current book of business, our probability models suggest that we have crafted a ±3% collar around our gross margins, with underwriting results expected to impact our gross margins no more than ±3% in 95 years out of 100."
Two things. First, all models are wrong. Sometimes models are so wrong that they lead to catastrophe. The failure of Long-Term Capital Management in the 1990s is the quintessential example of what can happen when people mistake models for reality.
Second, what happens in the other five years when gross margin isn't expected to be collared? That's kind of important for an insurance company. Picking up pennies in front of a steamroller looks like a great strategy until the steamroller arrives.
I don't know whether Lemonade's strategy will deliver the results they expect. If it were this easy to produce consistent results without taking on a bunch of tail risk in the insurance industry, it probably would have been done before. When I see a statement like that above, I run away as fast as I can.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.