Electric car group Tesla attracts a diversity of opinions. There are equal numbers of buys and sells among analysts. Price targets from US$200 to US$550. The convertible bond structure lends itself to this style of company, where there is broad range of potential outcomes and thus more volatility.
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We are positive on Tesla. We see a disrupter; an auto business that is effectively a software company. For example, those who bought a Tesla three years ago have enjoyed software upgrades that have made their car better. The shift to autonomous vehicles is further progressed than many believe. Today, cars are semi-autonomous and in three to five years they will be fully autonomous.
Tesla is also building a mega autonomous database. With its fleet of vehicles the company has already captured 7.5bn miles of road data. The nearest competitor – Google – captures 8m miles a month; Tesla is gathering 8m per day. Again, underappreciated by the markets. The company also has an impressive energy business of solar and energy storage. The energy storage or battery business has shown impressive results producing back-up power for utilities. This business can’t even keep up with demand and will experience exponential growth over the next several years. Underappreciated.
CEO Elon Musk can be described as a visionary and a genius. More an engineer than a manager, he is not without controversy – all of which well-documented. However, he is the backbone of the company’s knowledge base and the inspirational leader for a disruptive the technology company.
Electric vehicles are only two per cent of global demand, but it is important to remember that, when you have disruptive technology, mass adoption takes time. It’s all about the experience – and it’s a better experience than an internal combustion engine car. Other companies are still way behind. And while leverage remains high, the third quarter was transformational and we see leverage falling from here.
Convertible bonds aim to provide participation on the upside, protection on the downside, with two-thirds of the volatility of equities. They have an asymmetric return profile and it is one of the main reasons they are useful in portfolio construction or asset allocation. They also tend to be short duration assets. Successful convertible bond investing leverages these short bonds, which provide a ‘floor’, to returns. Yet, upside can still be obtained from the equity optionality in the convertible structure. We can take advantage of the convertible structure through three distinct investment styles. Long only investing that focuses on the asymmetry of the asset class, short duration yield investing as a low risk/return profile and convertible arbitrage that takes advantage of asset mispricing and equity volatility.
Tesla provide examples in all three of these strategies. Tesla’s short duration yield convertible in fact yield more than Tesla debt. They also come with the added bonus that if the stock were to soar, there is a little bit of additional upside to the base case 8% return. In the convertible bond arbitrage example, we are long the convertible bond and short the equity. We see an option value that is mispriced and equity volatility that will allow us to realize profit opportunities from the structure. Additionally, this approach offers a similar return whether a rising or falling share price; we simply want the stock to move. Finally, an investment the ‘balanced’ Tesla convertible bonds will capture approximately 70% of the upside of the equity, but only participate with approximately 50% of the downside.
Hopefully we have shown that convertible bonds can be an effective way to invest in more volatile companies, such as Tesla. They limit an investor’s downside, while allowing participation in any share price appreciation. Attractive option values can be capitalized on via convertible arbitrage and occasionally short duration yield opportunities also present themselves. An actively-managed portfolio of convertible bonds can therefore be an important diversifier to a portfolio in a more volatile environment.