4 questions for Catherine Wood on Tesla and EVs

By Morningstar |  18-10-21 | 

Catherine Wood, founder of ARK Investment and its CEO and CIO, is a concentrated, disruptive technology-focused growth-oriented investor. At the Morningstar Investment Conference 2021 held in Chicago, she shared her views on Tesla and Electric Vehicles (EVs).

Here are excerpts from the conversation.

Some consider the Tesla stock to be a high price relative to fundamentals. What are you seeing at that the rest of the market isn’t?

Exponential Growth.

Our research is centered around Wright’s law, a relative of Moore’s law. Moore’s law is a function of time. Wright’s law is a function of units. It basically says that for every cumulative doubling in the number of units produced--so one to two, two to four, four to eight--costs associated with these new technologies decline at a consistent percentage rate. Theodore Wright made this observation during the early days of airplane manufacturing, the new technology of that day.

In the case of the battery pack systems within EVs, that cost decline is 28% for every cumulative doubling. Last year, we globally produced and sold roughly 2.2 million EVs. Based on that cost decline in battery pack systems, the largest cost component of EVs, we believe that the average EV price will drop below that of the average gas-powered price in the next year or so and will continue to decline so that in the year 2025.

So we believe that the number of EVs sold will scale from 2.2 million last year to 40 million, which is almost half of total car sales globally that we expect in the year 2025. That’s a 20-fold increase. This is exponential growth, to be sure--89% at a compound annual rate--simply based on this notion that these cars are going to become more affordable than gas-powered vehicles.

What barriers to entry has Tesla created?

  • Battery costs. It built its cars on cylindrical batteries. Most other auto manufacturers base their cars on lithium-ion pouch batteries. The costs of lithium-ion pouch are much higher today--I think roughly 15%, 20%--than the cylindrical batteries that Tesla uses.
  • The artificial-intelligence chip designed by Tesla. Tesla is taking a leaf from Apple’s book. As you will remember, Apple created the concept of a smartphone. It believed that we would have a computer in our pocket. Nokia, Motorola, and Ericsson did not believe that. They did not design their own chips. And you know where they are today.
  • The number of real-world miles driven that Tesla has collected. It has more than a million robots out there collecting data and sending it back every day. My car is one of them. Therefore, it is able to discern corner cases and design its full self-driving system to incorporate these corner cases in a way that other auto manufacturers cannot.
  • The fourth barrier to entry--and it surprised me this one lasted as long, but I guess the dealer system was the reason--Tesla is still the only car doing over-the-air software updates to improve performance and prevent breakdowns.

Why won’t the more traditional autos or other EV manufacturers capture the EV trend?

The traditional auto manufacturers had to or have to make a major leap. The vast majority of their sales today are gas-powered vehicles. They need to transition to electric. Tesla’s already started electric and has created four major barriers to entry (mentioned above).

There may be a lot of EV manufacturers, but they are tiny. Tesla’s share is surprisingly high. We thought it would go down. I think at the end of 2018, it was roughly 17% of global sales. Instead, it went up.

We are looking at exponential growth opportunities that have evolved as these innovation platforms have started to mature and move into prime time. When I say mature, I mean from an innovation point of view.

So we are able to track whether or not we are right. I think the expectation out there is maybe 20% compound annual rate, and it’s come up quite dramatically from a consensus point of view. If we’re right on the unit growth dynamics, Wright’s law being a function of units means that the costs are going to come down. This exponential growth trajectory is going to be cemented.

Now, an example of the convergence among three of our platforms is autonomous taxi networks. This is the next big leg of valuation for Tesla, we believe.

Autonomous vehicles are robots. Energy storage will be electric. They will be powered by artificial intelligence. So we’ve got cost declines in these --robots, 58%. That’s more collaborative robots. Energy storage, the 28% on the battery. Artificial intelligence, 68%. You get the convergence of that, you have an explosion. We think no one’s even close to Tesla. The closest might be in China. But we think what’s going on in China right now is going to turn off a lot of innovation.

Demand is always been hard to predict. So when you’re thinking about the adoption of these disruptive technologies, how do you think about the range of possible outcomes?

Our investment time horizon is five years.

How do we value these exponential growth opportunities? In our 5-year time horizon, we are projecting out--again, based on Wright’s law, based on evidence, is the demand coming through as expected? Usually, by the way, demand does come through. Better, cheaper, faster, more creative, more productive typically works. The demand is there if the costs are right. And we project out the cash flows based on our Wright’s law and our cost trajectories to arrive at an EBITDA in year five.

For many of the categories that we invest in, except perhaps genomics, we will simply put a FAANG-type multiple, a mature innovation company multiple, on these stocks. So what we have, then, is significant multiple degradation relative to today’s multiples.

Our minimum hurdle rate of return is 15% at a compound annual rate. And right now, if you were to look at our flagship strategy, based on those cash flow assumptions and tremendous degradation of multiples, our compound annual rate of return expectation is 30% per year; 18-19 times EBITDA is a mature innovation company multiple. We do not believe our companies will be mature in year five.

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