Tesla is a Hidden Risk to S&P 500 Index Fund Investors

We believe index funds have immensely contributed to investors by permitting them to capture beta inexpensively. Yet, even ardent index fund supporters concede that the rapid growth of index funds raises some concerns.

As we demonstrate below, investing in US Large Caps using only an S&P 500 index fund mandates ownership of stocks that are so expensive, the historical evidence indicates they may cost investors money. Empirical evidence suggests prudent long-term investors will be well served to own portfolios that exclude expensive stocks like these.

The Price to Sales ratio

The Price to Sales ratio (P/S ratio) is defined as a formula “that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.”

The formula used to calculate the P/S ratio is:

While the P/S ratio has limitations, when it gets beyond 10x price to sales, the empirical evidence for avoiding these stocks becomes secondary to simple common sense.

An important observation

In April 2002, Scott McNealy, the founder and CEO of Sun Microsystems, addressed a group of investors. His talk took place almost one year after the burst of the dot.com bubble, costing investors trillions of dollars.

Investors who bought Sun Microsystems when the P/S ratio of the company was at 10x lost 95% of their investment. McNealy wasn’t surprised by this outcome:

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero costs of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

We bring up the dangers of owning stocks at 10x P/S because owners of S&P 500 Index Funds have record levels of exposure to these stocks.