Key Points

• The “big market delusion” is when all firms in an evolving industry rise together, although as competitors ultimately some will win and some will lose.

• The electric vehicle industry, with its astronomical growth in market-cap over the 12 months ending January 31, 2021, is a prime example of a big market delusion.

• In the highly competitive and capital-intensive auto industry, the January 2021 valuations of electric vehicle manufacturers are simply not sustainable over the long term.

If a capitalist had been present at Kitty Hawk back in the early 1900s, he should’ve shot down Orville Wright; he would have saved his progeny money.  — Warren Buffett

Our objective is always to build big companies—if you don’t attack a big market, you’re highly unlikely to build a big company.  —Don Valentine, Founder of Sequoia

Big markets have a special allure for investors. They offer the promise of another Apple, Google, or Microsoft. But big markets also bring with them the threat of what Cornell and Damodaran (2020) call “the big market delusion.” Big market delusions generally begin with innovation or disruption that opens a new market, such as cannabis, or reinvents an old one, such as advertising. The hallmark of a big market delusion is when all the firms in the evolving industry rise together even though they are often direct competitors. Investors become so enthusiastic that each firm is priced as if it will be a major winner in the evolving big market despite the fact this is a fallacy of composition: the sum of the parts cannot be greater than the whole.

The Lesson of the Airline Industry

An example of the big market delusion is the invention and development of aircraft. The development of the airplane was one of the great technological innovations of the early 20th century. In the years that followed, affordable air travel and transport revolutionized the way people lived and interacted as well as altered global commerce and trade. Air transport became a huge business, but airlines did not necessarily provide a wealth bonanza for investors.

From the beginning, the air travel business has been capital intensive and highly competitive. During good times, new airlines emerged and drove down profits. During bad times, many less well-capitalized companies folded. Over the course of the last century, virtually every company in the business either failed or merged into a larger airline, most of which also collapsed.

The simple fact, as Warren Buffett so cleverly stated, is that technology does not translate into great fortunes for investors unless it is associated with barriers to entry that allow a company to earn returns significantly in excess of the cost of capital for an extended period. Of course, Apple, Google, and Facebook are well-known examples of such technological success, but they are the exception rather than the rule. For a host of complicated reasons, these companies have been able to build moats, or barriers to entry, around their businesses. They also benefit from the fact their products can be produced with limited capital investment.

EV Industry: A Lesson in the Making?

Like airlines, the auto industry has historically been a competitive, capital-intensive business. For this reason, despite the global demand for their products, the traditional major auto manufacturers have tended on average to trade at book-to-market ratios near or below 1.0. From an industry perspective, we have little reason to believe that a change in the propulsion system from internal combustion engines to electric motors should have a pronounced impact on market competition or on the total industry valuation of the companies.

We examine the recent growth in market value for the global auto industry, focusing on the largest public auto companies by market capitalization. Over the three-year period ending January 31, 2021, the global auto industry gained 70% in market value, growing to $2.16 trillion.  Interestingly, auto industry total value declined for the first two years, 2018 and 2019, of the three-year period. Traditional automakers absorbed almost all of the decline in value, while the market value of electric vehicle (EV) specialists remained flat.

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