Tesla (NASDAQ: TSLA) returned more than 720% to investors in 2020. It is a great year by any standard, and holders must be very excited about this performance. However, for many, this creates an allocation problem that requires rebalancing.
In my view, the worst mistake that Tesla investors can make is ignoring the need to diversify. This suggestion may fall on deaf ears for speculators or Tesla’s disciples, but it is a great time to sell a portion of its shares while retaining some for future growth.
The automaker grew aggressively in 2020
Tesla was one of the most popular stocks among investors in 2020 and many people held it as part of their portfolios. These stocks are almost certain to have grown to occupy a much larger part of their portfolios since the beginning of last year. A hypothetical portfolio that was 5% Tesla in early 2020, with the rest spread across the S&P 500 and NASDAQ, it would now be about 25% Tesla due to the excellent performance of that position.
There is some disagreement between Fool’s contributors and the investor community on this issue, but I am a staunch supporter of diversification and rebalancing. This is especially important if stock performance is being driven by valuation inflation, not fundamental growth. In the example above, investors have established a volatile and high growth position with 5% of the portfolio. Having exploded in value, Tesla now has less upside potential and more risk of falling. To replicate this year’s performance, the company would have to grow to $ 5.6 trillion in value. Tesla is likely to continue to perform well, and this huge assessment may indeed be achieved eventually. However, it will take a while and I hope that we will go through some market corrections before that day arrives.
Tesla holders must be thrilled – the stock generated its earnings ahead of schedule, without a corresponding increase in sales, and there is a good chance that you will be able to buy more again later with a less aggressive valuation.
Rebalancing, earning and allocating
Even if you fundamentally agree that rebalancing is important, the actual moves required for rebalancing can be difficult to accept. Tesla is forecasting a 30% growth in sales in 2020 and made quarterly profits for the first time last year. Analysts are forecasting rapid growth again in 2021.
It may seem strange to sell a stock that generated great returns, reporting solid fundamentals and looking forward to another great year. However, this is exactly what you must do to effectively rebalance yourself.
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The bull’s narrative for Tesla was not interrupted. In fact, the automaker’s sustained growth and recent profits validate the optimism about the shares. Why would you need to sell some, if that is the case? Because the risk is still present here.
Tesla trades at a forward price / earnings (P / E) ratio of 175, a price / sales ratio of 24.5 and a price / book value ratio of 41.7. Investors should expect promising growth stocks to attract high valuation rates like these, but Tesla holders need to recognize that significant amounts of future success are already assumed at this price. Strong continuous results are needed to justify the current price. Any indication that Tesla may fall short of optimistic market forecasts could cause stocks to plummet, even as the company continues to grow.
This may not be a problem for optimistic long-term holders who just want exposure to the eventual market leader they expect Tesla to become, but others recognize the opportunity to redistribute that capital into other stocks that can offer solid returns without much concentration risk. Growth investors can sell some Tesla shares and use the profits to buy several other high-growth shares. Recent IPOs of big names and important stocks in sectors such as e-commerce, cybersecurity or telehealth can offer a great advantage along with the opportunity to dilute the risk that any individual stock will perform poorly.
Do not exaggerate
Rebalancing also does not mean giving up a good position completely. It makes sense to lock in some gains and retain a smaller position at Tesla to take advantage of future growth potential. Investors may be nervous about Tesla’s aggressive valuation, but Tesla may well become a leader in several key sectors in the coming decades. Most investors who allocated a certain proportion of their portfolios to Tesla last year should feel comfortable allocating a similar percentage of their holdings to shares this year.
Tesla may have attracted a large number of speculative growth investors and they may not like to hear that, but this is a great time to make some gains and reinvest them elsewhere. The stock outperformed the rest of the market so dramatically in the past 12 months that it left portfolios overexposed to their performance. This is especially risky with Tesla’s high rating ratings. Optimistic investors should keep some of these stocks in their portfolios to benefit from future growth, but there are more than enough high-potential companies to justify diversification.