The ZIRP Paradox


Elon Musk's Tesla Roadster - Wikipedia
Source: Tesla, SpaceX

It is the Christmas season, which means that it is time for your usual obligatory reminders and warnings about consumerism. It is also Christmas in a pandemic year, so those warnings will come with an additional “Hey, we know your kids are upset about 2020 but don’t make it worse by trying to make it better with a boatload of crap they don’t need” on the label. That, and “Hey, maybe a year in which a lot of people are hurting would be a good one to teach what generosity really looks like.” And they’re all good warnings. The problem, of course, is that consumption really does make us happier, at least for a while. Then, inevitably, we do what humans do best. We adapt. To trigger the same chemical and emotional response, our brain tells us we need new consumption. Something bigger and more exciting.

The hedonic treadmill is real.

It isn’t possible to avoid the chemical impulse. On the other hand, it is possible to manage whether and how we respond to it. The latter is something my friend Brian Portnoy wrote wonderfully about in his book from a couple years ago, The Geometry of Wealth. As gifts to FAs or multi-generational wealthy clients go, it usually tops my list of recommendations.

So I’m good at talking about the hedonic treadmill. I’m good at recommending books about it. At actually avoiding it? Eh. Hit and miss. I have discovered I am not very good at it when it comes to buying whisky. Or BBQ equipment. Or Lego sets for my sons. But in one major expense area, I’m pleased to say that I have been on a reverse treadmill for my entire adult life. Cars.

I didn’t actually buy my first car until I had been out of college for almost four years. It was, by far, the most expensive car I would ever buy, a fancy, brand new all-wheel drive sedan. When I moved to Texas a few years later and no longer needed all-wheel drive, I traded slightly down for a coupe from a more ordinary brand. After being sick of payments and moving to Houston (where I lived rather close to the office), I traded in its equity for an 8-year old car with 90,000 miles on it. When Hurricane Harvey buried the old girl under water, I used the insurance money to buy a base model pickup truck. That’s what I drive today.

But I have a confession: since the days when they only offered a Roadster, I have really wanted a Tesla. I’m more than a decade and a half past caring very much about what people think my car says about me. I’m under no delusions about their build quality. I’m not really convinced that electric autos are going to have any near-term influence on climate change that isn’t just going to be swamped by the middle-classification of India and much of the rest of the emerging world. I like the basic technology of electric motors. I like driving a car with a lot of torque.

I have another confession: for a long time, I have thought Tesla – the stock – was a long-term zero.

That obviously isn’t because I didn’t like the product. It also isn’t because I dislike Elon Musk. I will not ingratiate myself with most of our readers by admitting that I think Elon Musk is akshually net good, but God help me, I do. Warts and all. And this? I don’t just like this. I LOVE this.

It also isn’t because I dislike the company’s piggy bank-and-kinda-sorta-affiliate-slash-cousin in the rocket and satellite business. On the contrary, I consider getting humanity off this rock to be one of the two or three most important things we must get done as a species. No, I have long thought Tesla stock was a zero because the trajectory of their revenues, regulatory sensitivity, capital structure and fast-and-loose approach to accounting and operations led me to believe it would, to use the highly technical jargon of our trade, completely run out of sources of money to build factories, design cars and pay people.

A funny thing happened between when I decided I thought Tesla stock was literally worth zero dollars and today, however: it became worth $600 billion.

I’ve never been short the stock. I’ve never been long the stock (other than, perhaps, through long-term diversified index instrument positions in retirement accounts). I haven’t made any recommendations for or against the stock. We don’t even allow partners here to have positions on individual securities. Still, emotionally, I was absolutely invested in the community of investors who thought TSLA was a zero. Okay, I’m exaggerating a bit here, but in context of $600 billion, what we all thought it was worth might as well be zero. Oops.

But another funny thing happened, too.

As Tesla stock rallied by 400, 500 and then 600%, the company sold shares. A lot of them. Last week it announced it will raise another $5 billion worth. That’s a little less than half of what its market cap would be if the stock traded on its most recent quarter at the typical multiple of Ford or GM over the last few years. It doesn’t sound like a thrilling amount of money in context of Tesla’s lofty market cap today, but in context of the real-world threats to deploying adequate capex, making payroll and keeping the thing a going concern for the next few years? It is a lot.

And make no mistake, given where we are at, it is exactly what management should be doing.

But how and why we got to a place where management can do this still matters.


Reality is that which, when you stop believing in it, doesn’t go away.

Philip K. Dick, in 1978 speech “How To Build A Universe That Doesn’t Fall Apart Two Days Later

I’ve always liked this famous Dickism about reality. I just wish it weren’t completely wrong.

Over the last couple of years, Tesla and Musk managed to do something pretty remarkable. Not with the company or its products, really. Not directly. They realized that the best way – maybe the only way – to keep their dream alive was not to suspend ambitious capital plans, to partner with a better capitalized peer or to simplify a sprawling business plan. It was to create a narrative about what Tesla was and what it meant for the long term of humanity. A narrative that, under the right set of circumstances, would permit the company to access capital at a cost and scale defined not by the market’s assessments of risk-based discounting of future cash flows, but by the Tesla Story.

A Platform Story.

This obviously isn’t just a Tesla thing. It’s part of what’s happening with DoorDash. And Airbnb. Even Uber, although that seems like ages ago now. In narrative world, they’re not companies. They’re certainly not consumer stocks. They’re not even tech stocks. They’re Platform Stories.

A Platform Story tells investors that what matters is the full range of outcomes for the numerator of the most distant conceivable year of a theoretical DCF.

It’s not a new idea. It’s a tried-and-true page straight out of the growth stock playbook. And when it hits its stride, it is more than enough to produce manic investor behaviors on its own.

What IS new, however, is that there is another narrative that emerges from the transformation of capital markets into public utilities, the emphasis of political powers on the level of the S&P 500 as the sole measure of economic health, a thing which must not be allowed to fall. What is that narrative? That everyone believes everyone else believes in a central bank put. That everyone believes everyone else believes in zero interest rates over any time horizon that matters. In short, a ZIRP Narrative.

Under a ZIRP Narrative, everyone believes that everyone else believes that the denominator in that DCF above doesn’t matter.

Perhaps, sane and well-adjusted as you are, dear reader, you’ve forced any memory of high school or college calculus out of your brain. Maybe a DCF model sounds to you like something out of science fiction. So I’ll be nice. I’ll give you three guesses what happens when your numerator approaches infinity and your denominator approaches zero.

In short, if everybody knows that everybody knows that a discount rate will be functionally zero over any horizon that matters, and if there is an audience willing to bet on a Platform Story, and if your Platform Story is literally the Jetsons, there is NO price, NO valuation that is too ridiculous.

I’ve heard more than a couple people in the industry tell me in recent weeks they think the ZIRP Narrative as a proximate cause is overstated. “It’s just a mania.”

Yeah, no kidding.

But y’all, the narrative clothes we drape over our decisions matter. They matter if we choose them intentionally as an ex ante model for the aggregate belief systems of others. They matter if we choose them as part of a post hoc rationalization. The pressures we face as investors are nearly the same as those we face on the hedonic treadmill in our own lives, and the pursuit of nearly every short-term desire depends on us telling ourselves a good long-term story about it.

How do we justify a Peleton? We tell ourselves that it will pay off in the long term, and not just as a place to hang towels and dirty clothes.

How do we justify spending an increasing amount on art, or an expensive watch or jewelry? We tell ourselves that it will be an heirloom, maybe even that it will appreciate in value.

How do we justify upgrading to an extravagant home? We tell ourselves that it is a long-term commitment. An investment.

How do we justify shoveling out more and more free capital to a $600 billion company that doesn’t really make any money?

We tell ourselves that we’re going to the moon. You know what? Screw it. We’re going to Mars.

Even if greed and fear are always the same, it matters to understand the narratives we are collectively draping over them. Because those are the stories that must break if we expect anything to change.


This is what makes the Tesla story so interesting: they shrewdly used the tireless cultivation of a Platform Story to insulate themselves from their chief threat, namely, that liquidity would make it impossible for investors to maintain the infinite potential in their numerator and infinite indifference in their denominator.

In other words, Tesla’s success depended completely on three necessary conditions. First, it depended on the emergence of an audience of investors willing to allow their imaginations run truly wild about what a company with a 50-year vision could do. Second, it depended on the emergence of common knowledge that we were living in a world of ZIRP. Third, it depended on Tesla using the existence of #1 and #2 to substantially improve their liquidity situation to keep the Platform Story alive.

The world of 2020 gave Tesla each of its necessary conditions, and the bet paid off. It is good news for Tesla. It is great news for TSLA investors. And it is spectacular news for Musk. For now, anyway.

I think the news is not so great for the rest of us.

No, not because there’s any harm done to anyone today by any of this, other than the hurt feelings and bruised egos of those who shorted or missed its historic run. Or those who missed recent IPOs. Or those who didn’t leave their current business model to sponsor some absurd SPAC or other. And not really because of Tesla itself, which is one company in a sea of many, and nothing to get too worked up about. Not because any of this is permanent, either. The Tesla Story could still absolutely break, because it remains dependent on each of the necessary conditions above.

No, I think the news is not so great for the rest of us because bad capital allocation today is bad for prosperity tomorrow. I believe that companies are raising and deploying new capital on the shoulders of the infinite horizon of Platform Stories and the infinite risk-indifference of ZIRP. I believe that capital will be less productive than the other uses it might have been put toward. And yes, those are beliefs, not facts. That we can observe presence of these narratives, however, is.

We talk a lot about the Long Now, the term we use for the optimization of the appearance of the present at the cost of the reality of the future. It is seductive to believe ‘infinite horizon’ thinking of this kind might be a cure for the Long Now. It isn’t. It IS the Long Now. The story may be long-term value creation, but the objective is artificially cheap capital in the short term.

It may seem ironic that a narrative about the long-term could be deployed to distort the rewards of effective, market-based long-term capital allocation for short-term benefit. Yet that kind of sophistry is precisely what we mean by Projection Rackets.

Don’t you believe in long term investing?

This is, I think, the heart of The ZIRP Paradox:

The myth of infinite horizon, infinite risk tolerance investing is the enemy of long-term investing.

To learn more about Epsilon Theory and be notified when we release new content sign up here. You’ll receive an email every week and your information will never be shared with anyone else.

Comments

  1. I find this Tesla review very interesting but it also misses one of the major factors in Tesla’s growth. It is truly one of the best pure play climate change companies in the market. To accelerate the transition to sustainable energy is a great narrative for our times. It is how I can use my money to forward my desire during the world of trump and leaving the Paris accords (which are necessary but nowhere near sufficient). I would much rather put my money in Tesla than Exxon or SP500 or the value dividend stocks (fossil fuel energy company dominated). Yes, the climate change narrative has exceeded all expectations when added to our DCF and ZIRP for Tesla. I have a Tesla since 2017 and it only made me more willing to invest in the company when the shorts caused the stock price to drop way more than necessary. I now see the irrational exuberance of the Tesla crowd and wonder when the merry go round will stop. But woe to me every time I have sold a bit of my Tesla stock because it had shot up like a rocket. It has just kept defying gravity. Perhaps this SP500 addition will be the last major phase of this massive run, But I would hate to bet against Tesla, but I would never purchase the stock at current prices and have accelerated my desire to sell but will never go all in or all out.

  2. Avatar for rguinn rguinn says:

    With respect, I’m not sure how the piece misses that factor at all, because that’s the entire focus of the piece! A “pure play climate change company” is exactly the kind of platform story we are talking about - an abstraction from the company as a cash-generating construct to a grand concept that investors believe other investors want exposure to.

  3. Energy is quantifiable. Let us define energy as sustainable, unsustainable, or not defined. Then, not unlike the thousands of pages of the tax code, let us, in good governance, require all energy users to report their energy use down to the last joule/calorie and give tax deductions or credits as ‘deserved’. So when a Peloton user burns calories while using ‘unsustainable’ energy electricity, that would not qualify for favored tax treatment. Similarly, a solar panel may have components which were not obtained ‘sustainably’. And so on. Ultimately, the energy on the planet is what was created by the fusion of the contributing stars prior to earth’s formation combined with the cummulative energy of the sun as absorbed since that formation. I would bet that only Buddha has maintained a ‘sustainable’ energy use minimum. Tesla - that’s funny Nanny!

  4. Zimbabwe Industrial Average has been kicking butt too! Yay 800% inflation!

  5. Rusty… using this same myth… now do Bitcoin! I’m a bull, and I think this is the best bear case.

  6. No doubt ZIRP is a major influence in risk markets today. Probably THE major influence . There’s a reason for this latest financial bubble the Fed has “engineered “, 3rd one in 20+ years ( how proud they must be)
    Yet the “ZIRP mystique” is completely and totally dependent on a quiescent inflation rate.
    This bet that inflation will be quiescent for, well, forever seems unlikely to me.
    Anyone ever hear of Milton Friedman? Anyone? If not, “Free to Choose” is a first rate TV series ( and book) and a must see/read for economists/investors.

    Anywho, +25% Year over Year M2 growth ( far surpassing anything seen in the inflationary 1970s) is one of several reasons to argue for the end of passive inflation, probably beginning to show next year.
    BTW, those that argue low money velocity offsets extremes in money supply growth, well velocity was low in that decade too, yet inflation became oppressive and was seen as the scourge it really is.

  7. It all makes sense but I prefer Occam’s Razor - in this case, good old fashioned stock price manipulation through offshore options buying.

  8. If I was Musk, I would announce another 5-for-1 stock split tomorrow under the guise of “making it more accessible to individual investors”. Then have another capital raise 2 weeks later. It would just be a fitting finale for 2020. I’ve never shorted the stock, seem like there’s always been something hanging (buyout, partnership, we’re going to power your home with our battery, yada yada yada) that just made it too hard for me. Read all the stories, TC charts, podcasts, etc., still don’t see it blowing up. I’m convinced there will be a movie and I’m rooting for blowup, but I wouldn’t put my money there. #ThisAintHowCapitalismIsSupposeToWork #MercyIsStillHard

  9. I’m a software guy, not a car guy, but this topic is up my alley. An anecdote: I was seriously ready to buy a Volt for the climate benefit, but GM messed that one up as well. Too cramped, too meh. Instead I put myself on the Model 3 waiting list for 2+ years. There’s a lot I could say about driving a Tesla, but when people ask me I generally refer to it as an iPhone on wheels.

    I have had serious misgivings about Musk and the stock valuation for a long time, but I also believe people are discounting the software angle. It’s not just by about Autopilot. You can even purchase software upgrades for your car, much like in a video game. That is the definition of the hedonic treadmill, is it not?

  10. Why don’t I have access to this liquidity? I am an individual, therefore I have an end date. I am required to pay principal and interest back on my loans. It seems infinity players are only required to pay interest and can roll principal forever. Yeah, ZIRP, MMT, National Debt! To infinity and beyond!

  11. Tesla looks so much less ridiculous when compared to Snowflake and their CEO’s $95,000,000 per month options grant. We truly live in the dumbest timeline.

  12. Avatar for bhunt bhunt says:

    Good point.

  13. Avatar for bhunt bhunt says:

    You need a Brian Scaletta IPO!

  14. Avatar for rguinn rguinn says:

    Yeah, I’ve wanted to look a bit more into when/how those options grants were determined, and haven’t had the chance yet. Pretty amazing stuff.

  15. Avatar for rguinn rguinn says:

    Yeah, I mean, I think that’s exactly what you have to convince yourself of on Tesla. Not any specific fundamental scenario on software, but the “general” idea that software represents an almost undefinable upside opportunity over the very long run.

  16. Avatar for rguinn rguinn says:

    And yet I find it hard to get furiously angry at Musk for some of this - I’m angrier that this is where we are at collectively, that this IS the optimal executive behavior. And it is. That’s exactly what he should do. A ton of capital at practically no real dilution to the fundamental value of the business? It’s the best thing he can do for his S/H at this price, even if it’s a lousy aggregate use of capital for America/World (again, IMO)

  17. Avatar for rguinn rguinn says:

    Haha. Little bit of column a, little bit of column b, perhaps.

  18. Any discussion about it, btw, causes the bulls to immediately explain why it’s an important platform. Like clockwork. This particular note is absolutely right over the target.

  19. The long Now is an absolute masterpiece, I read it about once a month.

    I sold my puts on Tesla last week because I needed the losses.

    I honestly don’t know how this ends , but it does feel very familiar. I remember telling clients in early 2000 , either everything we know about how you value a business is wrong or these stocks are too high. I feel the same way now , but ZIRP has changed the game and needs to be factored. But this market does value future cash flows over present cash flows - and the further they are in the future the more they are valued.

    Its like living in the Twilight Zone.

    Great article Rusty —-but I love my Peleton.

    Merry Christmas to all the pack!

  20. Avatar for 010101 010101 says:

    The self-driving aspect of the Tesla software must be phantastery. There are alot of obvious changes that would be
    inevitable to the understanding of distribution of goods and labour. With mass adoption of robot transport networks
    the ability to receive the benefit of industrial production too easily becomes a “social right” granted by the few,
    to the many. The potential for political polarisation, geographic centralisation and aggregation of power is
    breathtaking.

  21. Avatar for Pat_W Pat_W says:

    I’m curious about the actual carbon footprint of a Tesla. This argument is pushed, in general, on the merits of electrical energy vs. gas. But how much carbon is produced in the production of the car and battery? How much is burned up building those giant battery factories? how much to recycle the batteries, and how long do they last? It is a new enough car those questions perhaps cannot be answered with precision, but I’ve seen nothing about it.

    Back in the early 'oughts, Toyota hybrids were extremely popular among the woke crowd with enough money to overpay for a car. “Fabulous for the environment!” Within a few years a team of guys studied and compared all aspects of carbon emissions, from production to the end of the expected lifespan of the vehicle. Who had the lowest overall emissions? The Jeep Cherokee. It was relatively simple and cheap to manufacture and people kept them running for 20 years and sometimes more. I regret I do not remember the name of the auto magazine this was printed in, but it’s probably not hard to find.

    The story of the Cherokee has stuck in my mind as a very useful example of narrative as bunk.

  22. I agree, not sure anyone actually knows what snowflake does, but the narrative includes all the buzzwords for 2020. Throw in that it’s a sliver of a float at 24 million shares and uncle Warren owns it with a 30% short interest, how are you going to find a better story. Someone asked me a while back about bitcoin, my answer was that I thought it was going to $0, but it might go to $100,000 1st. Kinda have that same feeling about snowflake.

  23. Rusty, curious to get your thoughts on another paradox that may or may not be unique to Tesla. How do you reconcile Tesla’s ability to exist only in this specific set of economic conditions with the fact that they’re one of the few companies seemingly trying to innovate in an industry that lacks any kind of imagination or innovation recently?

    I find it very plausible that by keeping interest rates where they are and making capital easy to access, we’ve wound up in a world where capital is not deployed efficiently and we do not see the market discriminating against unprofitable investment ideas as harshly as it has in the past. But in an industry as capital-intensive, low-margin, and cutthroat as the car industry is, the barriers to entry are massive. Just name the last time we had an upstart car company that managed to even make a dent in the market for a 15-year period. I can’t recall any in the last 50 years. It’s a brutal business that no one wants to enter because it chews up cash and destroys it.

    The paradox with Musk is that despite cheap liquidity that would allow him to build a very staid an unadventurous company if he chose to, instead he’s gone out and actually built a car that has created a whole bunch of revolutionary ideas in an industry that is normally horribly afraid of change because of the costs associated with it mentioned earlier. I think there are reasons to have questions about some of the financial engineering of Tesla in 2017-2019 when they went through CAO after CAO, I think they obviously have quality problems that would be unacceptable in any other luxury manufacturer, but despite the infinite timeline they possess, they’ve innovated more relentlessly than every other company in the industry. Despite the questionable tweets and financials mentioned earlier, Elon Musk has actually done the one thing that we often note many CEOs are unwilling to do - he’s taken risks to build something new. With that, we get all of the good and bad of Elon, but as you mention in your piece, I think there’s an awful lot of good ideas mixed in with the bad ones here.

    But the other question that I raise based on this is that were it not for the current situation as it relates to liquidity, would Musk have even been able to get Tesla to this point? Not of the market cap they possess, but of the products they create. Would he have had to give up greater equity control to a PE/VC-run board that would have sold the tech to one of the Big 3 where it would have been buried in a 2014 Cadillac as the acquisition was written down by 80%? Would the initial cost of capital been too much to even get off the ground? We rightfully nail companies when they prioritize short-term decisions to maximize stock price, but aside from his unique qualities as a pitchman, Musk’s execution at Tesla can hardly be said to be trying to maximize stock price today at the expense of tomorrow.

    Now - man, this is really the interesting part to me - Musk’s success has absolutely bred a group of copycats. Whether it’s SPACs that push their trucks down hills or established automakers who want to see a little Tesla juice added to their stock, there’s no question that ther eis a whole bunch of capital following Tesla that looks like it has a chance to be horribly allocated. I mean, we’re talking dot-com era issues with companies worth billions of dolalrs with no revenue in an industry with 3-5% margins on a good day. And the SPAC craze isn’t likely to leave initial investors holding the bag for nearly as much as they put in, thanks to the wonderful service of public markets. So if we’re talking about the fact that Tesla is viewed as a success story that is now drawing capital into a business that eats it, then we’ve got some real issues. Because I’m not sure if I’d rather be forced to start an automaker or an airline if those were my only choices.

    I think it’s important to separate Tesla into 3 parts when looking at it - the product, the company, and the stock. The product has been fantastic though quality has been inconsistent to say the least. The company has lived on a razor’s edge and still exists in a business that may kill it at sometime in the next decade. And the stock price is untethered from reality and built upon the foundation that you noted allowed its growth. Weighin these three pieces separately, and their impact on the auto industry as a whole, is the industry better off for having Tesla in it than existing without it? I’m not sure I have a good way to weigh the force Tesla is exerting in a positive direction against waiting for the other shoe to drop on the EV SPACs over the next few years and the destruction of wealth that I see coming there, but curious as to your thoughts on it.

  24. Just for fits and giggles I bought what are now $1 puts on TSLA 01/21/22. I call it my “Musk in jail” investment…

Continue the discussion at the Epsilon Theory Forum

Participants

The Latest From Epsilon Theory

DISCLOSURES

This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.

Statements in this communication are forward-looking statements. The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein. This information is neither an offer to sell nor a solicitation of any offer to buy any securities. This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.