Back in June, we talked to the famous short seller Jim Chanos. He warned at the time that there was more pain ahead for some of the frothiest parts of the market. That's been proven correct, with the ongoing selloff in tech and crypto. So what now? In a special episode of the podcast, that was recorded live in San Francisco on November 9th, we got an update, while also talking about what he sees as the fraud of non-GAAP earnings reports. The transcript has been lightly edited for clarity.
Key insights from the pod:
The Chanos take on FTX and crypto — 3:43
The history of alternate currencies — 7:49
How regulators will respond to the FTX implosion — 10:49
Pervasive accounting fraud in the stock market — 13:11
The pro-cyclicality of stock-based compensation — 16:19
Why Chanos is still short Tesla — 25:00
Have we seen the bottom in the stock market? — 28:29
Tracy Alloway: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
So Joe, you know, one of the most famous maxims in markets has to be — I think it’s Warren Buffett — The quote about when the tide goes out, you get to see who's swimming naked. Yes. It's a cliche.
Joe: (00:30)
We are in a big time ‘tide goes out’ environment. I mean, the number of CEOs of various companies who have written some version of like, “I screwed up, this was all my fault, I misjudged.” Every day it feels like there's another one. And it is true. When there is a bear market, when there's a downturn, you discover both frauds and you discover insolvencies and you discover unsustainable structures, it all comes out, right?
Tracy: (00:55)
It is a popular saying for a reason, which is that it tends to be true. What is kind of amazing me about this particular cycle is, I guess is just the speed at which all of this seems to be happening. So, you know, it was only a few months ago that we had Jim Chanos the famed short seller on the podcast, talking about how he thought that there was gonna be more pain ahead for a lot of different froth spots in the market, and how interest rates going up basically meant that a bunch of frauds were gonna be exposed.
Joe: (01:29)
Yeah. And so basically the market, and particularly a lot of the tech stocks and a lot of the gig economy, sharing economy, the ARKK economy, all these things really have gotten hit pretty hard since we talked to Jim earlier in the summer, and it's still a mess. And so I guess part of the question is, “Well, what does it look like at the bottom?” What have we learned? What are we seeing with the tide going out? And are we any closer to, you know, something that could resemble like a bottom for this market?
Tracy: (01:56)
And then also, I guess my question is, do frauds pick up in this environment or do they get exposed and more difficult to perpetrate? So we are going to be talking about all those things with Jim Chanos. This is an episode that we recorded live at the Berkeley Forum for Corporate Governance in San Francisco. Jim is of course, the co-founder of Chanos and Co, which used to be called Kynikos. Here's our conversation.
Hi Jim...
Jim Chanos: (02:23)
Hi guys.
Tracy: (02:25)
Now Jim, the last time we spoke to you, I think was in June of this year. Fast forward a few months, you are completely correct. The froth was blown off the top of this market. I don't even have a question. I think I'm just gonna ask you, like, tell us what's gonna happen now.
Jim: (02:43)
Look, we're getting a situation where the various parts of speculation are getting wrung out of this market one by one. We talked a little about them back in June. I think we've waited right in the middle of kind of our second crypto over these past few days. On top of it, you've got the tech complex melting down. And a lot of this is just the byproduct, as we discussed, of perhaps the most speculative of market that I've seen in my lifetime — 40 years on the street — which was 2021. And one by one, whether it's crypto, whether it's NFTs, whether it's SPACs the poster children for that speculation are basically being taken out to the woodshed and disposed of. And the question will be, does it spread to something in the markets anyway, that's much broader than that? That remains to be seen.
Joe: (03:36)
Again, kind of like Tracy, I don't even have a question exactly, but: FTX -- give us the Jim Chanos take.
Jim: (03:43)
Well, I mean, I think, Joe, you basically are probably better prepared than me to talk about that because the quintessential moment for me in the whole crypto saga was the interview that you and Matt Levine had with SBF, I think back in April. As I pointed out, he kept saying the quiet parts out loud about how the business models were in effect Ponzi schemes.
And I think we're gonna look back at that as a watershed moment because the crises in liquidity and the revelations of the stablecoins all immediately followed that interview. And it was one of those moments, and kudos to you all, it was one of those moments in the markets that not only went viral on social media, but but went viral amongst professionals and others. Like, have you seen this interview? Did you see what was said here?
And it's very rare you get that “aha moment” like that crystallized. But that was one of them. And the whole idea, and I've called it a predatory junkyard, as you know, the whole crypto structure in my view, was designed to extract fees from really unsuspecting investors and investors that were kind of sold a bill of goods where the bill of goods kept changing.
You know, we remember all the use cases for crypto as they kept changing over the past handful of years. It was going to be an alternative currency. It was gonna be a store of value. It was gonna be an inflation hedge. And at the end of the day, it was really just a speculative asset and speculative asset class and with an immense cost structure built around it. So the idea really was for the crypto, you know, community was how can we extract the most amount of fees from unsuspecting investors? And that's my view. I still hold to it.
Tracy: (05:33)
What happens now for crypto? Is there a recovery here or is this so bad? I mean, FTX, Sam Bankman-Fried, and you know, I was there at that Odd Lots interview as well, and we were all sat in the room quite shocked by what SBF had just said. For those who haven't listened to it, we asked him to describe how yield farming works. And he basically says, well, you put money in a box and more money comes out of the box and you worry about the use case later. All right, so fast forward to today, it's all falling apart. Can crypto emerge from this and potentially find a new narrative to sell? A new potential use case?
Jim: (06:12)
Yeah, I'll just add the ultimate irony. In the last couple of days is the crypto community talking and sort of begging and asking where are the regulators. It’s really truly the ultimate irony since the crypto ethos was about really being outside of the regulatory environment and being a separate and independent system.
And now it's begging for the same sorts of things. And you know, as I pointed out for a few years, the real problem with anti-fiat structures is exactly when you need fiat is the time when people are most afraid and when fear stocks the markets, because governments through their various different means can not only enforce contracts and adjudicate fraud, but in effect can act as lenders of last resort and or established deposit insurance, which is exactly what everyone looks for when, when people are worried about getting their money back.
And it's why alternative currency schemes — and by the way, crypto isn’t the first I mean, there have been all kinds of alternative currency schemes to fiat for centuries now — and they always flourish in bull markets. When people's sense of disbelief is suspended and people begin to believe things that are too good to be true and crypto and all the other ancillary aspects of crypto, whether it's NFTs or what have you. But really were the latest iteration of that.
Joe: (07:40)
The last time we talked, you said that as well, what's an example of an alternative currency that thrived in a bull market? What's a historical parallel to?
Jim: (07:49)
So I mean you had the various different banking systems that thrived in the early 19th century in the US. That's certainly probably one that that economic historians would point to. And we can go back further. I mean, the various different currencies that, that the father of fiat John Law, who I teach in my fraud course, brought forth in the early 1700s in France. But there have been a number of them.
And the problem again is, is they rely on a system of trust whereby the systems that fiat has developed in the past 300 years have really been designed to engender trust. It's the offset, of course, to the downside of fiat, which is the debasement. And so the crypto community pointed out the risks of debasement and uh, and all the other risks of sovereign governments getting involved in your currency. But they forgot the good parts. And that's I think, the lesson that we have to learn.
Tracy: (08:49)
Do you worry about crypto drama? What's going on in that industry having a contagion effect on either the rest of Silicon Valley or the wider market, given that there do seem to be these interlinkages between, for instance, crypto players and venture capital firms?
Jim: (09:07)
To me this looks a lot more, as we discussed, this looks a lot more to me like the dotcom era on steroids rather than sort of the prelude to the global financial crisis because of the nature of the banking system and payments. I don't think this is a contagion effect. I do think it's a pretty bad mark-to-market effect for equity type investors, much like the dotcom era, but I don't think it is contagion through the credit markets.
I think I I saw something this morning that and it might even be lower now as we speak, but I think the crypto mark to market for the all the coins out there is something now below $1 trillion, somewhere on $800 billion. And, you know, $800 billion is a lot of money, but I'll remind you that until about a week ago, you know, Tesla's market cap was 800 billion. That's just one stock. So I think the contagion effects are probably going to be de minimus to the payments and credit system.
Joe: (10:22)
I definitely want to get to like tech stocks and Tesla and all that in one second. But one last question. You know as you pointed out, the crash happens, people say, where are the regulators? This is again, I think a classic part of the cycle that the regulators seem to come in late. What does history say about how far they go? Would you expect to see, for example, criminal charges people in jail as a result of this.com trading on steroids in crypto?
Jim: (10:49)
Yeah, so one of the things I teach is that not only are are the regulators, archeologists, not detectives, but that, that asset prices are, are both the staunchest defense attorney and the harshest prosecutor for financial fraud that nobody's out looking to bring the bad guys in when everybody's making money. It's only when people start losing money that, uh, you, you begin to get a public outcry of, of, you know, throw the rascals in jail. You know, if we go back again to the.com era, people were losing money in.com for a better part of a year. But it wasn't until the Enron and WorldCom scandals hit that the federal government really geared up its efforts to, uh, to look at corporate wrongdoing and, and bring on Sarbanes-Oxley. So this is gonna be the same thing. I mean, people have lost a lot of money in crypto, a lot of new investors, a lot of young investors.
So you're gonna get a political outcry now to regulate this system and bring bad guys to justice. Now I've also pointed out that it seems to me that there might be a reason why a lot of these crypto entrepreneurs live in places like The Bahamas in Dubai and not New York City. So it might be and I think there are one or two actually that are technically fugitives from justice already. So it's gonna be interesting to see what we see from a prosecutorial as opposed to a regulatory initiative against this and what kind of wrongdoing that gets exposed if it turns out that there were actual misrepresentations or assets that were claimed to be there, were not there. On the other hand, it just seems, I mean, people have been warning about this for now a few years. It's not like the warning signs weren't there for people to notice.
Tracy: (12:37)
Yeah, there's at least one crypto entrepreneur that has effectively purchased diplomatic immunity as well, preemptively. Nothing's happened to him yet, but he has it. Let's talk about frauds more generally. And you mentioned Enron, and you've obviously been a player throughout different boom and bust cycles. What generally happens to frauds in a downturn? I'm assuming many of them get exposed, but there must also be incentive there to maybe start new ones and try to bury some of your problems as they get worse.
Jim: (13:11)
Well, the problem is that as it becomes more and more difficult to meet expectations, often the frauds get exponentially worse as they go on. But what I would point out is that the fraud cycle follows the financial cycle with a lag. So typically fraud thrives in a bull market. And the longer the bull market and the longer the business expansion, typically the worse the waves of fraud that are subsequently discovered.
And then when markets turn down and, and people become a little bit more leery since most frauds require new capital to keep going, they tend to get exposed after the markets turned down. And Madoff in December of 2008 is a good example. And of course we mentioned Enron and WorldCom and Tyco and that class in this cycle, I think crypto is probably gonna be right up there.
And that has started clearly, but I think the fraud that's occurring is much more subtle and I think is gonna be even harder to prosecute. And that's the abuse of metrics self-described and self-generated metrics that now investors have just gotten so used to, which have really, in my opinion, you know masked over business plans that probably will never be profitable and, and the amount of adjusted profitability and adjusted EBITDA.
There was one of our shorts reported last night, and they said that they expected to be profitable by the end of of 2023 on an adjusted basis, adjusted for other operating costs. I have no idea what that means, but you know, analysts dutifully this morning said they expect to be profitable at the end of 2023. And so the investors have gotten so used to particularly Silicon Valley describing profitability as they would like it and not as it really exists. You kind of wonder, will the sec crack down on that? Will, will congress crack down on that and, and get us back to kind of generally accepted accounting principles as opposed to accounting principles or whatever I want them to be?
Joe: (15:30)
Well, as you say, the fraud cycle follows the financial cycle. And of course one way that Silicon Valley companies in particular flatter their financials, makes profitability look better, is you know, substantial share based compensation. And it's not really a cash expense, but of course still investors are paying it. What happens to this place, Silicon Valley, what happens to share based compensation in an era in which shares go down? I imagine for employees, they're not as excited about getting stock as they might have been a year ago or two years ago as part of their comp. So talk to us about like how that unfolds and like what the down cycle of an industry that's so driven by equity issuance to employees, what happens in a down cycle?
Jim: (16:19)
Well, it was a big issue, Joe. The post dotcom era, and back then it was stock option accounting that went under the microscope and ultimately had to be accounted for. And now of course, in effect it's taken out through the use of proforma adjustments, but what people found out was that it had just a tremendous procyclical effect on things. That is when your stock price was going up, you didn't have to issue as many shares for a given dollar level of compensation. And now that the stock is down, if your stock is down 80 or 90%, you have to just issue massive amounts of stock. So you're issuing more stock as it goes down, you're diluting people. So it becomes procyclical to the downside as well. And the numbers are now becoming meaningful. Uh, the company I mentioned just a few minutes ago that reported last night is got run rate share based comp of almost a half a billion dollars.
And based on their current share count, that means that, that the shares outstanding are gonna be going up something like seven to 10% a year just on the back of share base comp. The other problem is we've seen a number of companies beginning in the second quarter companies like DoorDash and salesforce.com and Zoom announced large share buyback programs to offset the dilution of the share base comp.
So you have the silliness of the share-based comp being excluded from the adjusted profit figures and actually being a positive for operating cash flow in the cash-flow statement. But yet now the substantial share buyback cost is below the line in the cash flow statement under financing. So it's skewed incentives in so many different ways, but it's getting worse. The amount of share base comp for some of these companies is actually going up faster than revenues. So they're on the treadmill, if you will and I don't know how they're gonna get off it.
Tracy: (18:21)
Why do you think investors have been willing to accept these types of proforma adjustments in the past? Cuz I mean, this has been a known issue. I think we had someone from the SEC recently, I think it was an article in the Wall Street Journal, they were talking about this. We used to make fun of, you know, community adjusted EBITDA and stuff like that. People knew that this was happening, and yet it didn't seem to have that much impact on either the company share price or its ability to raise funding
Jim: (18:50)
Yeah. Until it did. Right. And again, that's my view on the procyclical of all these kinds of developments. They make things look much better than they are on the way up and they really hit you pretty hard on the way down. And so it just increases the amount of volatility in given corporate assets.
There's one other aspect I will mention that your audience might not appreciate and, and we saw it in the dotcom bust, and that is if you have a lavish equity issuance culture and you have a compliant board that basically will agree to almost any management equity issuance plan, then when you issue stock options and various different equity instruments to your management and your employees, if the board's rubber stamp things well, they will rubber stamp repricing those equity awards if the stock goes lower or granting more if the stock goes lower to keep employees happy.
And what that means is, is that boards are acquiescing to not only call options, but they're granting put options to the employees and and management. And that's a frightening alternative because number one, the Black-Scholes model is only picking up the cost of the call options. And B, you don't really want a management team that has a bunch of puts in their stock as well as calls. And it's something that I don't think a lot of people pay enough attention to on the governance side that I think your audience might appreciate.
Joe: (20:45)
I have a really short question, question. Are you gonna make us look a which company's reported earnings on November 8th and have a half a billion dollar share based compensation run rate? Are you gonna just tell us the name of the company?
Jim: (20:57)
It's a FinTech company that's based out where you guys are right now. And let's say it's involved in a sector of FinTech that a lot of people have questioned: Buy Now Pay Later.
Joe: (21:12)
I think that’ll narrow it down.
Tracy: (21:16)
Well, okay, this kind of leads into a process question, but in an environment like this, do you find identifying potential shorts easier than during the bull market?
Jim: (21:28)
Identifying them wasn't the problem Tracy. It was where the stocks went, that was the issue.
You know, some of these business models, I mean to us and others have been questionable from the get go. You know, take a look at at ride hailing or food delivery, something we're all familiar with. These companies been around for 10 and 15 years. They haven't found a way to make make profit. DoorDash, to single out one company, actually has higher losses per order now than a few years ago. And so they're not scaling. And, and that is for companies that are based on digitization and having a platform and using the internet, you'd better scale.
That's the whole concept. And you know, so many business models are, are showing increasing losses as they they age. And I just sort of wonder at what point do, do people just say, okay enough. And I've been shocked that it, it went on as long as it did for a lot of these business models. So identifying them was not the issue. Having other investors care about that is really the issue.
Joe: (22:42)
So I've always found this point that you make to be very compelling. If these ride hailing, sharing economy, whatever companies couldn't make money during the boom, during the good times, then when were they ever gonna make money? The counter that we've heard, and we did an interview not long after the last time we talked to you with the VC Jason Calacanis.
He's like, “Yes, that's a good point. But on the flip side, investors were encouraging all these companies to grow at any cost and they were not being rewarded for profitability. They were rewarding for growth. And so it's not fair to say they can't make money because they just weren't incentivized to, there was no reason why they would have, when the gains were all to growth.”
When you look at these models, why can't, in your view, they turned the dial? Because that is the big question, right? Can they cut costs now? Can they right size and make money? We've seen these big stock price declines in many case, 90% we see management going into cost cutting, layoff, profitability mode. Why don't you think that they can now turn the dials and get to positive cash flow?
Jim: (23:45)
We'll see. And and so far they haven't. And maybe they're not losing as much money, but if you look at the operating metrics, a lot of them are still inherently unprofitable at reasonably high up in the income statement, whether it's operating income or gross profits. But what we're really looking for as short sellers in looking at these business models is for the companies that have stopped growing and are still losing money because if they've stopped growing and the losses are still considerable, then the whole idea, well we were investing for growth or investing for future capacity investors, you know, didn't care as long as our top line was growing.
But if you're structurally unprofitable as you slow down or stop growing, then you have a problem. And that's why the things like the DoorDash metric I mentioned to you, you know, the losses per order become important to judge whether or not what your guest said is true or not.
Tracy: (24:45)
We've made it 25 minutes without actually mentioning Elon Musk, although we did mention Tesla. So again this is one of those things, I don't even have a question. But Tesla, Elon Musk, Twitter, Jim, go
Jim: (25:00)
Look, I, you know, the Twitter saga is, is one for the ages and I'm an interested observer like everybody else.
We're focused on on Tesla, the car company, and I would just keep pointing out to people that Tesla, the car company is not only the most profitable car company, which certainly we didn't never thought it would be, but is also — even with the stock down almost 60% — is still the most expensive automobile OEM in the world by a lot.
And I think we're looking at a company that that's trading now, right around 30 times gross profits. 30 times gross profits is, you know, there's software as a service stocks that would kill for that and basically sells luxury cars, right? He sells 50 and 60 and $70,000 cars that uh have immense gross profit margins. 30% where the rest of the industry has is lucky to get 15 or 20%. We don't think that's sustainable.
We think that the number one, the luxury car market is a much smaller than people think. And number two, even though the other OEMs have been slow on the uptake, they are coming and competition will increase and most cars will be EVs by the next five to 10 years. And it's a tough business.
It's a low return on capital business. It always has been. He caught the sweet spot to his and his shareholders benefit and to the short seller's detriment, but now he's gotta maintain it. And I think that's increasingly difficult because his investors are still looking for 40 to 50% growth for the next, you know, decade. And that means that pretty much he's gonna be the entire car industry, you know by the early 2030s and we just don't think that's gonna happen.
Joe: (26:55)
Are you short Tesla right now?
Jim: (26:57)
We are.
Joe: (26:58)
Because I wasn't sure cuz I where you, you're, so obviously the stock has come down a lot, it's gotten hammered over the for a while now, but you even at the current levels, unsustainable.
Jim: (27:10)
We are and I would be remiss if I didn't point out that people have now lost more money in Tesla than they've made
Joe: (27:17)
Just like crypto, I believe.
Jim: (27:17)
Think about that. Yeah, exactly.
Tracy: (27:20)
And when do you think about Twitter? Does that distract from, um, Musk's role at Tesla?
Jim: (27:27)
Well, remember he's also the CEO of a couple of other companies, not just Twitter and Tesla. So, you know I don't understand the valuation, I don't understand the price he paid. And you know, but it's his to do with what he wants and I believe in private property and free enterprise and, you know, I'm kind of scratching my head at some of the initiatives, but we'll see how it plays out. I don't think it was worth $44 billion. I I think he thinks it probably wasn't worth $44 billion. And it'll be interesting to see how that plays out, but I think it's probably gonna take a disproportionate amount of his attention over the near term.
Joe: (28:12)
So we just have about a minute and a half. So just like really simple, you’ve seen the backside of many bubbles in your career. does it look like we're close to the bottom here? What would be the signs that we are close to something that you would call a
Jim: (28:29)
Again, I market timing is not my forte if it was a bottom, it would be the most expensive bottom probably in modern financial history. I mean, most bear market bottoms have basically bottomed out somewhere between 9and 15 times the previous peaks of earnings. And because normally the earnings are depressed at the bottom of a bear market. But if we think that roughly, you know, earnings are peaking right now, and they may or may not be, but my guess is they're pretty close.
9 to 15 times would be 1800 to 3000, 3,100 on the S&P and we're a long way away from that. I saw that for the first time Factset was saying that S&P earning estimates are coming down for the fourth quarter are gonna be down year over year. So we might be at peak earnings right now of 205 or $210. You know, we were, where were we the other day? 3,900. So we were at 19 and a half times that number. That's a pretty rich number to be a stock market bottom.
Tracy: (29:43)
All right. Well, Jim Chanos, it was lovely seeing you again. We look forward to maybe catching up with you in like another four months and we'll just ask you, we'll just say you were right again.
Jim: (29:52)
Thanks guys. I appreciate it.
Joe: (30:06)
Well, that was our conversation with Jim Chanos at the Berkeley Forum on Corporate Governance. Tracy, it's always a pleasure to talk to Jim. Of course. You know, I thought it was actually interesting, obviously we're in the sort of like fraud exposure cycle, but the other sort of procyclical element besides discovering all this bad activity is just what we see about financing and what he talked about with share based compensation and the sort of compensation structure coming home to roost.
Tracy: (30:33)
Right? And also the idea that those sorts of share-based compensation schemes can be an amplifying force for stock prices on the way up, but also on the way down, right?
Joe: (30:43)
Because you know, when, when it comes to Silicon Valley, you know, and we think about leverage, we sometimes don't think of tech companies in that because they don't have any debt per se. But when you think about like how crucial share based compensation was, and if you think about it in terms of almost borrowing from your own investors in order to pay employees and so forth so that they'll keep working at the salaries and expects, it really is like a form of financial leverage. It's just not a credit leverage.
Tracy: (31:11)
Share-based capital is the lower tier two capital of Silicon Valley.
Joe: (31:16)
I like this. That's good stuff.
Tracy: (31:20)
Right. Shall we leave it there?
Joe: (31:23)
Let's leave it there.
Follow Jim Chanos on Twitter at @wallstcynic