Last week I visited one of the popular investing message boards, where investors were debating the latest news from electric vehicle (EV) maker Tesla Inc (NASDAQ: TSLA).

Feelings about Tesla are as polarized as today’s political viewpoints. Both bears and bulls are absolutely convinced of their case, and they can be insufferable when arguing it. But this overconfidence is resulting in some risky behavior by investors.

Investors Make Their Case

The bearish case for Tesla is it has burned through an incredible amount of cash without turning a profit, the quarterly losses continue to worsen, and many competitors are beginning to appear in the market. 

In addition, a number of executives have recently left the company, and this week Bloomberg reported that Tesla is producing fewer than 750 Model 3 cars a week. Last summer Tesla had predicted that it would produce 5,000 Model 3s a week by the end of 2017.

Tesla CEO Elon Musk has repeatedly overpromised and underdelivered. He has assured investors that there wouldn’t be a need to raise more capital, only to announce afterward that more capital would need to be raised.

The bullish case for Tesla is simple. Elon Musk is a visionary (“carnival barker” — according to the bears), EVs are the future of transportation, and Tesla is poised to dominate that future. 

There are a couple of gaping holes in the bull case, but there is one thing on which we can all agree. Tesla shares have risen by more than 700% over the past five years. As far as the bulls are concerned, their faith has been generously rewarded, and it is thus hard to shake. To the bears, they say “Doubt all you want, but Tesla is making me rich.”

Risky Behavior

This faith was amply demonstrated in a story told by one of the message board posters. The person claimed to be an unemployed MBA caring for his ailing mother. Nevertheless, he had placed his entire savings into Tesla stock. 

The poster claimed that he had already grown a four-figure investment into a five-figure investment, and fully expected that to grow into a six-figure investment in Tesla as the company realized the wildest fantasies of the bulls.

I thought “How sad and stupid that this person is probably going to lose his life savings.” He seems not to have considered at all the cost of being wrong, only the possibility that the unlikely success of the past five years is repeated over the next five years. He displayed the mentality of someone counting on a winning streak in Las Vegas as his retirement plan.

On the flip side, for fundamental investors, the cost of being wrong about the direction of Tesla’s share price over the past five years was the loss of enormous potential returns. Still, we could make that same argument about picking winning lottery numbers. Tesla is highly unusual in that the share price soared on the basis of hopes for the future, but despite consistently deteriorating financials.  

The important thing for a long-term investor to consider is whether Tesla’s performance in the face of weak fundamentals — but a hopeful future — is an anomaly, or something likely to be repeated in the future. 

My answer to that is that markets can remain irrational for a long period of time, but the fundamentals always win out in the end. 

A Fundamental Measure Signals Trouble

There are many financial measures that warn of Tesla’s troubles, but one I like to utilize is called the Altman Z-score, or simply the Z-score. This Z-score is a formula for predicting the probability of bankruptcy within two years, factoring in assets, liabilities, sales, earnings, and equity. 

While there are caveats to using it, in general when the Z-score is 1.8 to 2.7, the company is considered likely to be bankrupt within 2 years. When the score is less than 1.8, the company is highly likely to be bankrupt within two years.

From 2013 to 2016, Tesla’s Z-score fell steadily from 4.69 to 1.13, before bouncing back slightly to 1.29 in 2017. Nevertheless, the score in 2016 indicated a high likelihood of bankruptcy within two years. 

That’s probably not going to happen, even though it would happen with most companies. But Elon Musk has an uncanny ability to raise money, and as long as he is able to continue doing that Tesla will stave off bankruptcy. 

PayPal co-founder Peter Thiel once famously said “I would never bet against Elon Musk in anything.” But eventually, even the most enthusiastic investors will lose patience. 

Confession

It’s true that bears have lost a fortune shorting Tesla shares. But I have a little confession to make. I bet against Tesla five times in the past year and won four of those bets. In next week’s column, I will describe a limited-risk method for capitalizing on an overvalued company. I will explain in detail the actual bets I made against Tesla, including the one I lost. 

To be continued…