Why So Many People Are Shorting Tesla

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Tesla (NASDAQ: TSLA) is an incredibly polarizing company, as is evidenced by its stock -- which continues to rise even despite its lofty valuation, both in short and long interest.

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In this clip from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu explain why so many people are shorting Tesla, especially recently. Find out the most pressing concerns facing Tesla as an investment, why so many people are still long the stock despite its unusually high and ever-growing multiple, some general risks that investors need to know about shorting any company, and more.

A full transcript follows the video.

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This video was recorded on June 16, 2017.

Evan Niu: Tesla is a very polarizing stock. You either love them or hate them, there's not really much in between. I think the main short thesis is primarily predicated on valuation, because if you compare Tesla's valuation to many other auto companies, it looks absurd and completely insane. The never-ending debate is: Do you consider Tesla a tech company or an auto company? They trade like a tech company, but is that warranted? It primarily revolves around the valuation argument, which is really hard when Tesla doesn't have any direct comparable peers, because they are very different from automakers. But, of course, their operations are dominated by making cars. There's never going to be an answer, because it's going to be a never-ending conversation. All the while, the shorts are betting against the basic valuation. But, if you remember, there's that old adage: "The market can stay irrational longer than you can stay solvent." So, even if you're right, the market can continue doing its thing, and you can get squeezed out. Even if you're right, but it takes a long time for your thesis to play out, are you willing to hold on that entire time?

Tesla has this incredible story, they have Elon Musk and everything he says makes headlines. I also have a theory that everyone wants to invest in Elon Musk, and Tesla is the only publicly traded company of his, out of his dozen companies that he runs and operates. So, I feel like some of the general interest in investing in Elon gets consolidated into Tesla, because you can't buy SpaceX, you can't buy his tunnel company. Tesla is the only one you can buy. If you want to invest in Elon somehow, that's how you do it. So, I think that contributes a little bit. But, it's really hard to bet purely on valuation. Of course, they do point to some of Tesla's mistakes and challenges, and there definitely are some. But are those fatal types of operational issues? Or is it something they can get over? So, I think that's the challenge with the short thesis for Tesla. And let me say really quick, I do think it's kind of insane that Tesla is almost $400 [a share] when two months ago it was a big deal when they hit $300. So, it is getting kind of crazy.

Dylan Lewis: And you're saying that as a long-term Tesla shareholder. I am also a Tesla shareholder, and I kind of agree with you. Every time I check my brokerage, it's up 1%-2%, gosh, pretty much every day. So, I understand why people are like, "This can't continue, we can't sustain this." At the same time, it is a company that has proven the shorts long for a very long time.

Niu: Right. Tesla trades almost entirely on sentiment, it's all based on sentiment. The current fundamentals don't have much bearing on it. Like most growth companies, it's all baking in the future possibilities, and that's going to create a lot of uncertainty and volatility in the short run. I'm long and I'm getting a little nervous at these prices. But, at The Motley Fool we're long-term-focused, so we're probably just going to sit on our hands. But, objectively, it's getting kind of crazy.

Lewis: It is. But, it is dangerous, those lofty valuations that Tesla and Amazon sport, they are a reflection of the fact that they're very dynamic, and the danger of betting against a super dynamic, very nimble company is that they roll out or decide to finally break out financials for a segment that they've been kind of cagey about, like AWS with Amazon, and all of the sudden you have this massive profit center that just skyrockets the stock and shows there's clearly something viable here beyond what they were doing an e-commerce, which is something that happened a couple years ago. So, I think in tech in particular, being on the short side of things is very risky. While looking at short interest can be helpful to understand how people feel about a stock and what the market sentiment is, I will revisit that episode that you and I did two months ago or so when we were talking about the risks associated with shorting a stock. If you haven't listened to that episode, I highly recommend it. And listeners, if you have any trouble finding it, write into the show, industryfocus@fool.com, we'll be sure to get it over to you. We touch on a lot of the basic ones there. We talk about how valuation and share price can go up, and you'll be kind of squeezed there. That is not the only risk when it comes to being short a stock, right, Evan?

Niu: Yeah, there are plenty of risks. But I think there's one in particular that most people are not aware of. That applies to all short-selling, and that's the fact that your broker, if you go short a stock, can buy you back in and close out your position at literally any time. And that's a huge risk, because if you go long a stock, that doesn't apply, because you choose when you want to sell. But if you go short a stock, your broker can choose to close you out. And the reason why that is is, if you think about it mechanically, when you short a stock, you're borrowing shares from someone, and when you close out you buy back the shares and return those shares. But, where does the broker get those shares? The broker gets those shares from other investors.

So if someone takes out a margin loan to invest, they're basically allowing the broker to use their long shares as collateral for that loan, through a process called hypothecation. So, if that investor, for whatever reason, pays off their margin loan, either by selling stock or putting money in their account or whatever, the broker can no longer use those shares as collateral, because there's no longer a loan there. So, you turn around, and whoever they had been previously lending those shares to, they no longer have access to those shares, so the broker just closes it out because they can't lend you those shares anymore. So, I think that is, in general, a risk. It doesn't happen a lot. But back when I was a broker, I used to get calls and people would be like, "Why did you buy me back in?" And that's the answer, because we no longer had access to those shares, so we had to close out their position. And when the broker does that, they don't care where you're at on the trade. You could be up or down, but they have to do what they have to do, and then your position is gone. So, I think that's a general risk. And certainly it's more pronounced for stocks that are hard to borrow, when there's really not a lot of supply of shares to lend. But, yeah, if you're going to go out and short a stock, there's tons of risks. That's one of them that most people are not as aware of that I think they should be.

Dylan Lewis owns shares of AMZN and Tesla. Evan Niu, CFA owns shares of Tesla. The Motley Fool owns shares of and recommends AMZN and Tesla. The Motley Fool has a disclosure policy.