Tesla: ‘Converting’ disruption into profit

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. 

Key risks

Convertible securities risk

Convertible bonds can earn less income than comparable debt securities and less growth than comparable equity securities, and carry a high level of risk.

Credit risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Illiquid securities risk

Certain assets held in the fund could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 20 November 2018. Unless stated otherwise any views, opinions and future returns expressed are those of Aviva Investors and based on Aviva Investors internal forecasts. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.  Past performance is not a guide to future returns.

Some of the information within this document is based upon Aviva Investors estimates. It is not to be relied on by anyone else for the purpose of making investment decisions.

Issued by Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority.

In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of  any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration Number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583. In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only.

Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000.

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