Despite a slew of macroeconomic challenges such as inflation and rising interest rates, Tesla's (TSLA -3.55%) 2022 performance was nothing short of incredible. It included a scorching hot growth rate, record revenue, profit, free cash flow, and an all-time-high operating margin.
Tesla proved a company can make a lot of money off electric vehicles (EVs). And that recipe for success has accelerated an industrywide shift toward EV investment. But even as the largest legacy automakers roll out massive EV budgets, there are still red flags investors need to consider when investing in electric car stocks. Here are a few red flags that are worth watching now.
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The EV sector won't look the same moving forward
Howard Smith: Bubbles are part of markets and investing. In the mid-1600s, speculation drove the value of tulip bulbs in Holland to an extreme level before the market collapsed. More recently, seemingly any company with ".com" in its name soared in 1999 as investors wanted to be in on it before the internet took over the world. Well, the internet did pretty much take over the world, but many of those investments crashed and burned.
The electric vehicle sector went through a similar cycle last year with sky-high valuations assigned to companies that didn't even yet have a product to sell. The market has corrected itself to some extent, and smart investors should be looking at this growth sector as a years-long, if not decades-long, investment anyway. That's how the businesses themselves are approaching it, but that's also where a red flag lies.
Tesla has invested billions of dollars and is already seeing handsome returns on those investments. That helps explain why investors have been compensated for early investments in Tesla. The stock has returned 400% over the last three years while the S&P 500 and Nasdaq Composite indexes grew by just about 50%.
TSLA Total Return Level data by YCharts
But Tesla's success has other automakers pouring money into the sector and that may not end well for some. General Motors has committed to going all-electric by 2035 with tens of billions invested. Global auto leader Volkswagen recently said it plans to invest a whopping $130 billion in just the next five years to develop its EV business and related technologies.
Those massive investments assume the rapid growth in EV adoption will continue for years and be a permanent shift for consumers. That may be why Ford Motor Company is hedging its bets with a strategy that maintains its internal combustion engine segment as well as a commercial vehicle segment alongside its new EV lineup.
That doesn't even include the billions that start-up EV makers are investing. That's a lot of money that needs to provide returns for investors. There are many risks that come with nascent industries and new technologies, and investors should recognize those risks and allocate funds accordingly.
The risks of widespread EV adoption
Daniel Foelber: In September 2022, the International Energy Agency (IEA) released a report that projected EVs would represent more than 60% of vehicles sold globally by 2030. It's a meaningful jump from present-day EV market penetration. According to the World Economic Forum, there were 10.6 million passenger EVs sold globally in 2022, representing 16.1% of the total 63.2 million passenger cars sold.
For EVs to go from a small percentage of new car sales to the dominant share would take a great degree of consumer adoption as well as massive manufacturing and supply chain feats. Emissions reduction goals, tax credits, and aggressive public and private investment in EVs could help make this transition a reality. But it remains to be seen if automakers can actually make money on EVs in the same way that Tesla has proven it can.
The simplest and most scarlet of the red flags facing pure-play EV companies and legacy automakers is the long-term profitability of EVs. Profitability could prove inconsistent for a number of reasons -- such as a shortage of rare earth metals that impedes battery production. Or just poor execution by an independent company. Or too many product rollouts all at once that overwhelm the consumer and lead to stiff competition and price wars among automakers.
Inconsistent profitability could also come from an even more unpredictable source, such as ill-prepared electric grids that are not ready for the strain EVs would have on peak power loads. It's not known how the 2030 grid would be able to handle hundreds of millions of Americans all charging their EVs at once when they get off work or at night. Especially if that peak charging load comes during a time when the sun isn't shining or the wind isn't blowing in areas heavily dependent on renewable energy.
The EV industry is no different from other rapidly growing industries in the sense that there will likely be a lot of trial and error before it gets to something that sticks and is sustainable. This doesn't mean that EV stocks aren't worth investing in. But it does mean that someone interested in investing in the industry should be aware of overarching headwinds and how they could impact a particular company's investment thesis.
An investment opportunity for the bold and patient
The transition from the internal combustion engine to the electric motor is the biggest personal ground transportation evolution since the transition from horse to buggy. Like most major shifts, there will likely be some unbelievable success stories, and many failures as well.
As far as EV adoption has come over the last five years, it will take a lot more for EVs to surpass internal combustion engines as the dominant passenger car format. From a company standpoint, it takes a lot more than a strong brand or impressive product to make a company last over the long term. Therefore, the best way to approach investing in the EV industry at this time is likely to have a diversified portfolio of EV stocks, as well as focus on companies that have a strong balance sheet and a path toward profitability instead of getting whisked away by an exciting story.
