Legendary short seller Jim Chanos says that despite the plunge in stocks, there are numerous swathes of the equity market with plenty of downside risk. On this episode, the Chanos & Co. fund manager, argues that the market overall has simply not internalized what sustained higher rates will mean to business models and valuations across a variety of sectors, including real estate, utilities and consumer packaged goods. He walks through the various excesses that we've seen over the last several years, and why investors are all paying the price for them now.
Points of interest in the pod:
Do tech companies have viable business models — 4:11
What’s going on with Chanos’s positions now? — 7:24
The weirdness of markets and differences to dot com — 12:30
Vulnerability of real estate to higher rates — 15:02
What does the market bottom look like? — 18:56
How higher rates will impact PE — 21:25
On leverage in the system — 24:59
Why fintech is so vulnerable — 27:55
macro environment versus company specifics — 30:21
On tech stocks’ use of share-based compensation — 33:32
Crypto (or NFTs) is like Beanie Babies — 34:08
Chanos says Tesla will survive — 41:11
What are regulators doing? — 44:59
The impact of higher rates on short-selling — 48:38
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Joe Weisenthal: (00:09)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway: (00:14)
And I'm Tracy Alloway.
Joe: (00:15)
So Tracy, obviously numerous assets across the market have been crushed, but you know, one of the things, you know, math says that something could go down 90% and it actually could go down another 90%. It could go down from there. So there is this question of like, well, is there real value at some point that's going to emerge out of this rubble? Or is it really just a lot of trash that's going to zero?
Tracy: (00:42)
Yeah, the thing that kind of worries me when it comes to valuations is, you know, people talk a lot about the ‘Ponzinomics’ of things like cryptocurrencies, or just the idea that the only value they get is by money continuously flowing into them. But then I worry that you could make that case for a lot of traditional assets as well, stocks and bonds, right? So we've just seen valuations go up and up and up seemingly without limit, which kind of means that on the downside, maybe they can go much further than you would normally think.
Joe: (01:17)
Well, and I guess the question too is, you know, cryptocurrencies aren't bolstered by like, oh, well, free cash flows or like some sort of cash in the bank that eventually makes it valuable. But in a company, you know, the question is do the unit economics work? Is there an actual business model? So you can have money losing companies that might still be worth something because there's like a business model there to be salvaged. But if you get a lot of companies that really in no economic conditions, whether it's boom times or bust, have something that is actually a business model that could be turned into something that can generate cash flow, then right. You can get into the situation, which the only reason they were going up is because of investor money. And when that's gone, perhaps the assets are worth zero.
Tracy: (01:59)
Yeah, exactly. And it just feels like there's so much uncertainty at the moment. And of course the big wild card is the backdrop of inflation, which we haven't really had to deal with before, right? Normally if things started going a little bit weaker in terms of the economy, we would expect the central bank to step in and do something, you know, provide some support and that would lift valuations up. Once again, that doesn't seem like it's going to happen this time around
Joe: (02:23)
That's a very new dynamic and it wasn't even in place, you know, obviously in 2008, 2009, when there was aggressive response to the downturn. Anyway, enough of our talking, because I'm really excited about our guests, someone who knows a lot about the state of the world, valuations, whether assets are cheap or whether it's just more Ponzinomics all the way down. We are going to be speaking with Jim Chanos. He is the co-founder of Chanos & Co., which used to be called Kynikos. He's probably one of the most famous hedge funders/short sellers in the world on Wall Street -- really needs no introduction.
Tracy (2:50):
So we just did one.
Joe (2:51):
I know. Jim, thank you so much for coming on Odd Lots. I don't think we've ever had you before. So this is a real thrill to have you on.
Jim: (03:09)
Hey, thanks for having me guys. But I would say that, you know, being a famous hedge funder or even short seller is a pretty low bar these days.
Joe: (03:16)
Well, so you said something that has really stuck with me for the last two years. And I want to start the conversation here. You know, summer 2020 and the stock market after plunging in March had started surging and people really going into a lot of these sort of internet companies and like Ubers and GrubHubs and all of these, you know, tech companies that recently IPOed and you said something interesting. You're like if they're not making money now, and I don't remember your exact words, but you said if they're not making any money now, when all of us, so many people are stuck home ordering online and so forth, if they're not making any money now, when are they ever going to make money? If not in the beautiful, perfect economic conditions of everyone in summer 2020 ordering, buying so much online. Is that still the case? Like have any of these companies made any progress to having a business model?
Jim: (04:11)
So the companies we were talking about were some of the gig economy darlings in 2020 and continued to be so in 2021. And, you know, we like to drill down not only in the financials of the business, but also the business models and to see if they make sense and what became pretty apparent to us in a number of them, particularly some of the well-known companies like Uber and Lyft and DoorDash, which came public later, is that the unit economics were terrible. And not only that, they were terrible at a time when they should have been Nirvana, right? As you point out, for example, food delivery, when everybody was getting checks from the government and stuck at home and restaurants were going out of their way to make delivery, you know, acceptable and easy.
And yet the food delivery companies still couldn't make money because there were just too many people with outstretched hands earning fees. And so, you know, it got to the point where narratives by 2021, the first quarter of 2021, which was sort of the peak of the craziness narratives, trumped everything. And if you had a story and you could spin it about, you know, future size of market and profitability by 2030, you could go public. You know, do a SPAC, and unlike the dot-com era, where those kinds of pie in the sky stories had, you know, 2, 3, 4, sometimes $5 billion valuations, in this case they had 20, 30, 40, sometimes even $80 billion valuations. And that's why we sort of called it the dot-com era on steroids, because we're setting aside the profitable companies, you know, the sort of legitimate Silicon Valley companies, I'm talking about the stuff at the end of the whip. And, you know, that's what was sort of shocking to us was just how big people were paying for the, you know, in effect the option value that the business would be worth something, you know, possibly someday, even though the business model was certainly unproven in 2020 and 2021. And that that's to us, probably the most striking part of what happened in the markets in Silicon Valley versus say, 20 years ago.
Tracy: (06:40)
So one of the things about being a short seller is that it can also, it can often be a fraught emotional experience for many, many months and even years until you’re sort of proven right, or the market turns your way. So I'm curious what have the past few years been like for you? You know, watching some of these companies that aren't generating earning -- some of them aren't even cash flow positive -- and seeing them attract loads and loads of money? And then how are you feeling right now? Because it does seem like some of the air is getting kicked out of the valuation tires of these companies that you have long been criticizing or targeting.
Jim: (07:24)
Yeah. So really, what happened, the sort of ride of the Valkyries of the short side was sort of kicked off when Powell reversed course at Christmas of 2018, you remember the markets had gone down almost 20% and high yield was ticking up and they were tightening gradually and completely reversed course. And by the way, real GDP was roughly 2% in the fourth quarter of ‘18 and 2% in the first quarter of ‘19, there was nothing going wrong with the economy, but he blinked. And that turbocharged the markets in 2019. And then with the pandemic, you saw just the unprecedented both monetary and fiscal support. And also, I would point out in the fall of 2019 when we saw widespread reduction in retail commissions, if you remember, everybody went to zero commissions and you had the advent of Robinhood and Ameritrade and Schwab all advertising.
And that's when we saw retail begin to pour into the market. Prior to that, for the 10 years of the bull market from 2009 to ‘19, retail was basically buying, you know, index funds and ETFs and basically, you know, sort of investing reasonably. But starting in the fall of 2019, everybody decided to pick stocks and buy options, and you can see it in the price chart of say Tesla or whatever. The high flyers really began to go in October of ‘19. And, you know, they took a speed bump in March of 2020 with the pandemic, but as soon as the Fed opened the spigots, it was back to the races. And it really went on until sort of the first quarter of 2021, which was a period unlike anything, you know, I've seen in my 40 years of being on the short side. It was the meme stocks.
But what was really striking to me was the fact by February of 2021 for a couple week period, SPACs were raising, new SPACs were raising on average 3 billion in cash every night. And that was equal to the US savings rate. So for a brief period of time SPACs were taking the entire US savings rate, which just struck me as the height of absurdity. And so, you know, most stocks peaked out in that first quarter, first half of 2021. And you know, our performance hit its bottom there and really began kind of climbing in the summer of 2021, even though the market made a new high in the fall. A lot of stocks began to falter. And then we saw in our portfolio and I think overall, we began to see disasters. Things like Peloton and Robinhood and DraftKings and, you know, stocks that were suddenly darlings were suddenly down 50, 60, 70%, on perceived, you know, bad news. And that was before, that was, you know, as the market was peaking in October, November.
Joe: (10:35)
So some of these gig economy companies that you mentioned in the beginning, their unit economics, they just didn't work. Too many fees, even under the best conditions. Some of those names you just mentioned like a Robinhood, Peloton, etc., how do you think about any value for them now? Because it doesn't seem like in theory that it should be impossible for Robinhood, and I guess they don't charge fees so maybe that is maybe that is tough, it doesn't seem like it should be impossible for those to be viable businesses. Like at what point, I guess, how do you think about how far this could go?
Jim: (11:13)
Well, I mean, like anything we, we look at, you know, we look at what is our upside and downside and try to structure our trades accordingly. But, you know, for a money-losing, a money-losing financial, generally trades slightly below tangible book value. I mean, that's where the Chinese banks trade. That's where the European banks trade, who are profitable. But people don't trust the numbers and trust the model long term. So I would say that, you know, some of the money-losing brokers like Coinbase or Robinhood, or some of the fintech companies, which was another absurdity foisted on the market in 2020 and 2021, you know, those stocks are going to probably trade below book value, slightly below book value. And for some of these companies, that's a long way down.
Tracy: (12:04)
Do you think something changed in terms of fundamental investor behavior that allowed us to get to the 2020, 2021 point? Or is this just what we've seen before? I mean, most notably with the tech bubble. Like we can have instances where valuations go absolutely crazy, or did something actually happen that makes this period unique in some way?
Jim: (12:30)
I think there's a confluence of events in, if you remember, that in the tech bubble, it was primarily tech, right? There were a lot of value stocks that actually held up pretty well in the ensuing bear market. It's where a lot of hedge funds made their reputation. For example, being short the garbage and long value in 1999 to ‘03. And so you had this one pocket of insanity based on a narrative, the internet and everything else was kind of, you know, reasonably priced, given where rates were and the economy. And remember the recession that we had in ’01, ‘02 was pretty mild. It was a business-driven recession, didn't really affect the consumer at all. And so this go around, it's almost everything and that's what's so interesting.
You know, it was not only technology, but think about things like cap rates in real estate, you know, down at 3% and 4% and crypto and NFTs and just a wide variety. I mean, I still have lots of shorts in my portfolio where the companies are barely profitable and they're trading at, you know, 30 times cash flow and 40 times cash flow is still -- even after the decline. And I think that’s the one thing that people are not prepared for still, is interest rates resetting meaningfully higher because it hasn't happened in most investors' lifetimes. I came on the Street in 1980, just as rates were peaking. And so the idea that actually interest rates are not going to be 2% or 3% for the foreseeable future is going to be hard for a lot of investors to deal with. If we go back to, you know, what I would think would be more reasonable rates based on what we're seeing in the economy and inflation, whatever, this market will not be able to handle 5% or 6% 10-year. I mean, it just won't. And so many business models that we look at are just extremely low return on invested capital, because capital's been so plentiful for the last, you know, 12 years.
Joe: (14:49)
You mentioned the fintechs, you mentioned the gig economies. When you look at just terrible business models or business models that can only possibly survive under the cheapest, most abundant capital, what else is out there that looks egregious?
Jim: (15:02)
Yeah, I mean, just take almost the whole cross section of Reits, just seems absurd to us. That you're going to be buying, you know, apartment buildings at a 3% cap rate -- that's before capital spending. That's pre-tax, you know, with the 10-year at 330 today, I mean, this just makes no sense and office buildings and warehouse, I mean, just go across the board. Data centers. I mean, it's just, it is, we've gotten so used to feasting on these ultra-low interest rates that I don't think people realize, you know, where equities will trade in a resetting market where risk-free rates are 4% or 5%. So, and I think that’s a big area, but even things like electric utilities and consumer package good companies. I mean, these things are all still trading at 25, 30 times earnings. And I think that they've seen been seen as defensive because they're not technology, but at this point they may have as much risk as the tech stocks.
Tracy: (16:09)
So, you know, I hesitate to ask you for a price target on the S&P 500, but could you give an indication of how low you think things could go? And also what do you think is the most overvalued at the moment and the most vulnerable to higher rates?
Jim: (16:26)
I mean, I'm long the S&P 500, my hedge fund, just FYI. So we're long the broad market and short our radioactive sort of group of companies. So just get that out there for full disclosure. So I don't really, I don't have a target for the S&P, I do think that the S&P is, you know, corporate profits, which for years have been mean reverting, have not been. And, you know, this has been a golden age for the corporation in terms of profitability and valuations. And, you know, that remains to be seen, whether those profit margins will hold up longer term. They're at record levels. So I, you know, I don't know where the S&P can trade, that's my cop-out answer. I know that some of the stuff we're in just trades at such extreme premiums to that, that, you know, if the market goes nowhere, I think we're going to do just fine on our short portfolio.
Tracy: (17:28)
What's most overvalued to you right now?
Jim: (17:30)
Right now, I think that if you can find any companies -- and there are a lot of them -- that are earning, you know, low- to mid-single digits return on capital -- things like the real estate industry, for example, or a number of consumer companies, a number of companies in the ESG space like solar, or just the unit economics are just crappy. But there's a narrative. And where there's leverage, and there are lots and lots of these names out there. Those are going to, I think, you know, be problematic going forward if rates drift higher, because again, people just are used to financing things at 2% and 3%, and those days may be over.
Joe: (18:18)
You know, man, I have a million questions, you know, obviously we're not going to get the Jim Chanos S&P end of 2022 forecast, but I am curious more broadly, because everyone's like, is this the bottom? Is this the bottom? You've seen these cycles, obviously there was the dot-com era. You've seen lots of other crashes. How should people think about what it looks like? Not from a numerical perspective per se, but what it looks like when the pain ends or what other things people might look for and say, okay, this is what bottoms kind of look like.
Jim: (18:56)
What I've been kind of surprised at and this sort of again, to use the, it's never exactly the same, but to use the 2000 analog, I've been kind of surprised since November, just how much retail investors continue to want to speculate. And that to me has been one of the things that's kept me, you know, as exposed on the short side, you know, in our hedge fund and short fund as I have been. I mean, you know, Cathie Wood was getting inflows for most of the first quarter, in some cases record inflows. And we see it in the meme stocks that people were still speculating every time the market, you know, sort of stopped going down, the meme stocks would jump. And every time the market stops going down, my shorts typically go up 3%0 to 40%, 50% in two weeks.
And that's exactly what they did in 2000 and 2001 and 2002. And people just still want to believe that this is the bottom, that, you know, I'm going to make my stand here. And I don't know, but I do know that the willingness, particularly of the people who came late to the party, the retail investor buying individual stocks or options to still speculate, is still there. And it's somewhat shocking to me. Now this latest swoon and the crypto selloff we're seeing, may dampen some of that. We'll have to see, but that's been one of the surprises to me is just how much people are willing to keep coming in. And when the market sort of stops going down buy the most speculative stocks for a bounce.
Joe: (20:41)
So we've been talking obviously a lot about the sort of the retail angle, because that really does sort of dominate the story maybe since the end of 2018 or middle of 2019, when the free trades started. But the other big, one of the big stories of the last 12 years, or maybe much longer, and I know that you've been critical of it is the opposite, the PE industry. Institutional. And like the degree to which that has been the sort of one-way train up. I'm pretty sure you're skeptical of some of the marks they've had over the years. Is this the going to be the end for some of these highly, especially if interest rates go to where you're talking about them, is this going to be the end for some of these more leveraged models?
Jim: (21:25)
So a couple things about the private equity industry. I suspect they're about to have the same reality check that hedge funds had after the global financial crisis. So, as we talked about a little earlier, you know, hedge funds made their chops in the first seven or eight years of this century, right? They were short the dot-com garbage, they were long value. And both of those trades paid off from 2000 to ‘07 in a big way. And hedge funds began to attract large amounts of assets, and it completely fell apart in the GFC. Most equity hedge funds. We're talking about equity hedge funds here. Most equity hedge funds were net long and buying, you know, value all the way down and got killed. And hedge funds have had a rough go of it ever since really, quite frankly.
Think about private equity. Private equity, it has had two major developments at their wind at their back for the last, you know, 40 years, but particularly for the last certainly 12 years. And that is massively declining interest rates and rising equity values. And so if you are a leveraged buyer of equities, that has been a massive tailwind and what is shocking to me, and I allocate capital, I sit on some investment committees so I see the private equity numbers and I hear the pitches, what is shocking to me is that if you were buying a portfolio of stocks leveraged two or three to one, that you would expect to be doing a hell of a lot better than the S&P 500 over the past 12 years or the Russell, right? You know, even net of fees. And the fact of the matter is that's not really been the case.
And I think that's going to be one of the biggest problems for private equity is the fact that, you know, the returns net of fees and adjusted for leverage have gotten a lot more pedestrian, in the last handful of years. And if we're going to revalue interest rates structurally higher, where you're not going to get easy exits, and the IPO market, you know, closes down, then private equity's going to have some heavy weather of it. And it has been the asset of choice for institutional investors. There's no doubt about that. And I think, you know, that alone tells me that if you're big in private equity, you ought be taking a look at your allocations and understanding you own leveraged equity. And just because they don't mark it promptly, doesn't mean you're not taking the risks. And that's my concern about private equity.
Tracy: (24:16)
So just to broaden that point out a little bit, you know, we are at the point now where some people are drawing parallels to 2008 and the financial crisis, or, you know, they say, ‘oh, we're going to get there.’ But the difference that you often hear stated between 2008 and now is the reduction in leverage in the financial system. And I'm curious what you think about the degree of leverage that may or may not be out there because, you know, especially with something like crypto, it feels like it's such a new asset class, and it's quite hard to track. It feels like there could be linkages there that we just don't really have a good sense of at the moment.
Jim: (24:59)
Yeah. I mean, we clearly, you know, the warning signs were everywhere back in ’06 and ’07 because you could see it on the balance sheets of the banks and the brokers, they were just getting more and more levered and they were getting more and more levered to so-called Level II and Level III assets, which were harder and harder to value. And in this go around, you know, I think that that the generals basically always fight the last war. Right. And we regulated the banking system pretty tightly after the GFC. And so I don't think there's systemic banking risk out there in terms of the need for government intervention and what we saw in ‘08 and ‘09.
It’s much more diffuse and it's much more localized in things like crypto. And as you say, is there hidden leverage in that system? My guess is there is, but, but we'll find out probably shortly. And then other mechanisms, we haven't talked about fintech, but you know, sort of the shadow banking world of fintech, which, you know, I've been joking now for a while is just simply subprime lending , you know, done on an app and, you know, we'll find bodies floating to the surface probably there, before all is said and done as well. I don't think the systemic issues though are the same and every bull market has its own flavor. And this one was not as debt-driven, you know, as it would relate to I think, risk to the banking system.
Now there's plenty of leverage out there and corporate leverage and again, I think the risk might not be credit risk. It might be rate risk. And that's, you know, a whole different, that was the seventies, and that's a whole different kettle of fish than sort of these deflationary credit shocks we had in the past 20 years. So again, we'll have to see. Now if you want to talk about systemic problems and, you know, there's lots of them elsewhere around the globe. And then on top of it, I think you've got geopolitical issues that are probably, you know, really, really different from the last 10 to 20 years. You know, the rise of China and, you know, for God's sakes, we have a land war going on in Europe right now.
Joe: (27:27)
You mentioned fintech for a second, and you also mentioned it earlier in the chat. Can you tell what is it about this particular industry and the way it's structured? I don't even know what fintech is, to be honest sometimes, like, I don't know, it's lending or trading, whatever, but what is it about fintech that caused you to focus some, or that you see such egregious valuations in business models?
Tracy: (27:47)
Fintech is a label used to get higher valuations.
Joe: (27:51)
I know Tracy has strong opinions on fintech. I need to interview her sometime all about it
Jim: (27:55)
And it, furthermore, since the advent of the internet, it really has boiled down to, we have a way of figuring out what people who generally don't pay back their loans, will pay back their loans. So we have algorithms and we have big data, and we have all these things that these stodgy bank and credit rating agencies and consumer credit companies haven't figured out. And we're going to get people to pay us back who are paying us, we're lending lots of money to at big rates and fees. And every down cycle, you know, since ‘98 has seen those companies blow up, because it turns out they didn't have a better mousetrap. They just had the credit cycle at their back and the algorithms didn't didn't work, you know, when things got tough. And I think this is going to be no different.
I mean, I just, you know, I just see the narratives by companies that claim they've figured this out again. And the reality is that after 12 years of easy credit and consumers getting flushed with government payments and all kinds of things, you know, everybody looks like a great credit and it's not going to be until times get tough that you're going to see, you know, where the risks in your portfolio are. And this was just another way for Silicon Valley to kind of tell another narrative, but this one's been around for a while. The first fintech companies came out in ’98, ‘99.
Tracy: (29:26)
I have a process question based on that answer, but you talked about the idea of the credit cycle at a company's back when you are making your investments. And in particular, when you're assuming short positions, how do you balance the macro environment and your expectations for the broader economy versus company specific insights that you might have? Because again, we kind of hinted at this at the beginning and the intro, but it's, I don't want to say it's easy, but you can find a company and say like, wow, that this company has problems. There's a flaw in the business model, but if everything's moving in its favor, if there aren't very many defaults at that particular moment in time, it can kind of go along just fine for quite a while. So how do you balance those two things?
Jim: (30:21)
Yeah. So it can and does. Look, what we're trying to find, what we're trying to find particularly apropos of Joe's comments at the beginning of our conversation is does the business look problematic when everything should be going its way? That stacks the odds in the skeptics’ favor, right? So if you're, you know, a food delivery company and you're not making money, when people are throwing money at you, when everybody's at home, you know, maybe you have an issue and maybe the model just doesn't work. And so, again, we're looking for businesses that with really low return on invested capital, it's a big, big thing. We focus on, you know, what, for every dollar you give them to invest in the business, what do they return?
And you know, for most of corporate America, that number is in double digits. It's somewhere, you know, in the mid-teens to low-teens. And yet there's just lots of companies out there that the people have thrown money out that are earning four, five, 6% on their capital. And if you're only earning four or five or 6% of capital at the top of the business cycle, with rates at two or 3%, you know, you're going to be in trouble. And so, so we try to look at the macro and understand that, that there will be cycles and to try to find companies that are either unprofitable or barely profitable. You know, when things are good, because certainly things, when things aren't good, it's going to, they're going to make heavy weather of it.
I should make one other point, Tracy. And that's the other thing that has really struck us in this cycle, which is sort of addresses this question of yours, is the amazing use of proforma metrics by corporate America. And, you know, it's amazing how many companies will report numbers and the media will dutifully say, you know, Salesforce.com, you know, beat expectations and made so much money. And then you look at the actual financial statements, you see they lost money and, you know, this is getting worse and worse. And I think, you know, as it relates to the course I teach on fraud. You know, I've been telling my students for the last couple years, that a lot of, you know, the, the disingenuousness in corporate America is happening right in front of you, through the aggressive use of self-defined metrics. And the most egregious of which of course is adding back share-based compensation, which Silicon Valley is just, you know, lavish in using. And as long as we just pay our people in stock, that doesn't count. And I think that virtuous circle is going to turn into a vicious cycle on the way back down, it already has for some companies.
Joe: (33:23)
Right, because presumably, if the assumption no longer exists that stocks only go up, then people might actually want more cash.
Jim: (33:32)
Exactly. And then you have to run it through your P&L, right? Or the equity. You're just going to have just a lot more dilution. You're going to have to just issue more and more shares, right? For a given dollar value. And so, you know, in any case, I think that that metric and, for example, the gig economy companies, they were just masters at this, Uber, Lyft, DoorDash. They’ll tell you adjusted, it would all be adjusted Ebitdapositive at some point in the future. And then you look at the numbers and they're losing hundreds of millions of dollars every quarter.
Joe: (34:08)
What's the best historical analogy for crypto?
Jim: (34:13)
Beanie babies?
Joe: (34:14)
Is it just that, is it just Beanie Babies?
Jim: (34:20)
No, that that's NFTs. Sorry. But look, you know, the thing about the thing about alternative monetary systems is there's a long history of them. And they tend to be, you know, adopted, or embraced or recommended in good times, not bad times. And I think that's a really interesting, you know, aside that, that I tell my friends who are kind of heavily invested in the concept of crypto and it, you know, the first guy to think about this, I teach in my fraud course, was John Law, maybe the greatest financial criminal of all time. You know, he wrote about this in 1705, on this, this seminal work he did on the nature of fiat currencies. And he pointed out that the state should embrace fiat.
And he knew the risks. He knew the risks of debasement and inflation and all of these things that the reason why people wanted gold and silver and not paper, but he also made a couple of really interesting observations. And one of which was that in times of stress, and I'm forgetting his actual, you know, term from 1705. But people actually will embrace government-based fiat because the government can adjudicate fraud and contracts. And then he talked about the fact that a banking system based on that could also offer protection. He didn't say in deposit insurance. He wasn't that far thinking yet, but it was the first sort of forerunners of that. And the whole idea that when, you know, you are in a situation where nobody trusts anything, you actually want the state to back things.
And you want the ability of the Federal Reserve to be a lender of last resort. And you want to have the fact that, you know, that if you have $250,000 in the bank, no matter what happens, you still have $250,000 in the bank. And I think that's a really important concept that we kind of forget every time everything's going to the moon and we're all making lots of money, you know, speculating in things. And that's the really interesting thing about crypto to me, is that a lot of the concepts behind its adoption early on have proven to basically be, you know, not there or wanting. You know, it was going to be a replacement currency. Well, no, it's not. Well, it's going to be a diversifying asset. Well, no, it hasn't been, and, you know, we can check down the list and you know it better than I do, but I do think there was a seminal moment – [it] was the interview that you had with Sam Bankman-Fried And I said so at the time, I mean that to me was a bell loud and clear that one of the crypto, you know, giants is telling you, you know, flat out…
Joe (37:16):
We were pretty shocked.
Tracy: (37:18)
Yeah.
Jim: (37:18)
It's Ponzinomics. And, you know, he said the real, real, quiet part out loud. And that's when you boil down a lot of these structures, that's what they are. And I’ve called it a predatory junkyard and I stand by that.
Tracy: (37:35)
So I have a philosophical question based on that, but, you know, there are a lot of hardcore crypto believers out there, especially of Bitcoin, the Bitcoin maximalist and those types. And they look at something like Bitcoin and say, oh, this is the future of the monetary system. And everything is going to change because of this. And then someone like you looks at Bitcoin and presumably says, this is a Ponzi. And, you know, it's just money following money. And that's all there is to it. This is -- I almost feel like it's an unfair question, but like, how is it that two, or it's basically asking you to explain how markets work -- but how is it that two different people can look at the same asset, like a Bitcoin and come to wildly different conclusions about its worth and its value?
Jim: (38:23)
So I'm not, I should say that, you know, Bitcoin is the leading currency sort of like the dollar of the crypto space. And because of its limited, you know, issuance, whatever, I have no idea where it's going to trade, but where my problem was, was all the ecosystem built around crypto that is clearly just rent-seeking and that's been my criticism of the whole space is just all the various staking, you know, staking things, the ‘yields,’ the ridiculous, the high fees they charged, you know, I've been publicly short Coinbase, not because I thought, you know, Bitcoin was going down, but because they're over-earning. And so that to me was really this vast ecosystem that sprung up overnight around it to basically extract fees from unsuspecting primarily retail investors.
And I'll give you a great example. So if you look at Coinbase’s first quarter in 2022, retail trading volume was huge compared to institutional. They earned almost a billion in commission revenues from retail traders during the quarter. And they earned only less than $50 million from institutional investors. And it turns out that on a dollar value of trading value, retail is paying almost 60 times the rate of institutions. And it gets to my point that this is borderline predatory behavior in the industry and where the fees and everything else is just outrageous. Not to mention some of the claims about, you know, how you're yielding and what the economic engine is behind these yields. And that's my complaint with what's going on in crypto is all of the circus around it.
Joe: (40:37)
I want to ask you, or you mentioned Coinbase, but I’ve got to ask you about another specific company that you've had opinions on over the years. Of course, that's Tesla. I know you were short it for a long time, I think you paired back your shorts as it went to the moon. And, you know, still obviously it's come back, but it's in a way, you know, it's like the bellwether of the Cathie Wood portfolio. It's also probably like the ultimate meme stock. Is it a sustainable company at this point? Like A) do you have a position on it, but B) what does it look when you look at Tesla right now? What do you see?
Jim: (41:11)
Well, I see a company… Yes, they will survive. They've made it past – 2018, that was in question. As Musk, you know, admitted later. But no, they certainly, at this point, you know, got past the tipping point. However -- it's a big however -- they are dramatically over-earning right now. And I think the risk to the stock is the fact that, and I do think by the way, I think it is the bellwether stock in the stock market. I think it's sort of like Cisco was in 1999, where people were just kind of put putting their hopes and dreams on, you know, any, any hardware having to do with the internet, Cisco was going to dominate it. And it's the same sort of thing now. So whether it's EVs or solar, or what have you, you know, Tesla is seen as the one stop shop for that.
And I think that, accordingly, you know, Tesla still trades at almost 10 times revenues and 30 times gross profits. So it's trading, you know, like a SAAS company, but it is an auto company. It has gross margins of 30%. Now the risk they have is that almost every other auto company in the world has gross margins of 20%. And so Tesla, which is earning, you know, trading at just a monster multiple, is also trading on a monster multiple of a profit stream that is going to get competed. And that is the risk of Tesla that becomes, you know, just an established EV company amongst a whole bunch of established EV companies.
And I think that one of the things that people thought was that, you know, the other OEMs would never get their act together. And certainly for a while, they didn't. But now with the advent of Ford and, you know, the F-150 Lightning and lots of other products that are both out and coming, you know, it's going to be the auto industry and make no mistake about it, Tesla is, is a car company. You know, they're building car plants. They're capital intensive. One of the risks to Tesla that I think is underappreciated by the market, and that is this company turned the profitability corner when it opened the China plant. And we and others have a large suspicion that a disproportionate amount of the profits are coming out of Shanghai. And that, of course, you know, raises all kinds of other risks to the multiple, and whether or not they can actually, you know, pay, you know, get their hands on that money. And I think that's not appreciated by the market as much as it should be. If you look at the company's gross profit margins, it took off as soon as Shanghai, you know, started volume production.
Tracy: (43:58)
Do you have a position on Tesla now?
Jim: (44:01)
Yeah. We're short. We have put position, yeah.
Tracy: (44:07)
So, actually this is kind of riffing off of Tesla, but also something that you mentioned earlier, and I know you've been critical of regulators. And you mentioned earlier that regulators are sort of backward looking and always fighting the last war. And I guess my question is why is that? Because, you know, you look at something like Tesla and Elon Musk and the circus around Twitter, you could easily make the case that the SEC should be doing something here. Certainly if you look at crypto, you could certainly make the case, they should do something here. And there's very little incentive for governments to actually let crypto, you know, just run wild. I mean, especially since a lot of crypto proponents, basically say ‘we're trying to create an alternative monetary system to a government-dominated one’, but what's going on? Whyy don't the regulators get more involved?
Jim: (44:59)
So I've said a couple of things. I've said, obviously that journalists and short sellers, we're being very self serving here, you know, are real-time financial detectives because they're incentivized to look for things. Whereas regulators and law enforcement and legislators are financial archeologists. They'll tell you, you know, with much clarity five or 10 years after the fact why you lost money and why this was fraudulent. And a lot of that has to do with the fact that much of that is political by its very nature. And I've also said that basically, the strongest defense attorney and the harshest prosecutor for any company, is its stock price and that when everything's going up, it's kind of hard to throw stones, particularly politically, to say, okay, well maybe we should be taking a look at this.
What do you want to do? Stifle innovation? I mean, that was what, you know, the securities regulators heard about crypto. And in fact, I mean, to me, the failure of global securities regulators to in concert, you know, basically declare most crypto coins and schemes securities, is a major failing, because they clearly are. And I think that that would've stopped a lot of the nonsense that that has subsequently happened. If these coins and whoever had to register as securities offerings, I think that's one easy thing to point at, to say, you know, gee you guys dropped the ball on this one, but as for everything else, it's not until investors start losing money that they begin to get upset, with people, look at the meme stocks in January of 2021.
You know, when Robinhood, because of capital issues, you know, froze people from adding to their accounts, people were upset because they couldn't buy more . And there were hearings about that. You know, these stocks are now down dramatically, and they were blaming short sellers for example, and hedge funds who got run over. It was like bizarro world. And yet, you know, I talked to a lot of congressional staff at that time and, you know, they were just hearing from their constituents, how outrageous this was. And so, you know, these things are politically motivated with a lag.
Joe: (47:40)
Yeah, it's crazy, in retrospect, all these different politicians about the outrage of not being able to add to your GameStop position in February, 2021. You know, I want to go back to something. You were talking about rates re-resetting, or moving significantly higher. And I don't listen to many podcasts because I don't really have time, but one that I did listen to is one that you did years ago with Matt Klein when he was at the FT. And you talked a bit about the business of short-selling and in particular, how short sellers think about rates and the fact that in a Zirp environment, it's kind of no fun or not great because you sell a share, you get cash and you park it somewhere, but you don't get any yield on that cash, which I had never heard. And no one really talks about that. So like does the business of short selling get better in this higher rate environment because you can earn yield on the cash that you.. Talk a little bit about the business of short selling in a different rate environment.
Jim: (48:38)
Yeah. So the golden age of short-selling alpha was basically, you know, the eighties and the late nineties. And part of that was due to basically the fact that in addition to the fact that that stocks, you know, basically fluctuated a lot, was that on your short sale proceeds, you got 80%, you split with the prime broker, typically 80/20, the cash received interest on that segregated cash. So when rates were six and five and six and 7%, you were earning five or 6% on the cash. And that was a big cushion. Now obviously you're obligated to pay any dividends from your short position, but a lot of shorts, you know, have very low yields or don't pay dividends. And that was a nice, you know, cushion to the short side. That all went away with Zirp.
And there was another factor that prior to really the GFC, that there was kind of a floor on negative rebates at 0% that in effect, unless it was a really crazy risk arb situation or something, that it was very rare that you actually had to pay to short something, you might earn a lower interest rate. You might earn 2% instead of 6% on the cash, but you didn't have to pay negative 10 or 20. And with the advent of much more transparent markets and algorithmic trading where you have these monster books that are long and short or whatever, rebate rates, you know, often go negative in hard to borrow stocks. And that became a new reality. So those two factors definitely impacted your returns on the short side, both relatively and absolutely.
Joe: (50:37)
Jim, I think that's a great place to leave it. I mean, we could talk for hours and hours longer, but this was a real treat. It's kind of crazy it took us so long to have you on, but it seems like perfect timing. So appreciate you coming on Odd Lots.
Jim: (50:51)
I'm so happy we finally, finally got to do it. Thank you.
Joe: (50:54)
We gotta do it again. No more waiting six years next time.
Tracy: (50:59)
Thanks, Jim. That was fun.
Joe: (51:11)
Well, obviously that was great. It was a real treat to talk to Jim, hearing him talk about some of these other areas that aren't tech and how much he sees like this sort of what he views is like this egregious valuation is pretty eye-opening.
Tracy: (51:27)
Yeah. And it sort of gets to that Ponzinomics point, like obviously a stock isn't necessarily a Ponzi. You know, a company can have real cash flows and real potential profits, but it does feel like we have had this, I guess, this overall dynamic of just money flowing into things almost indiscriminately, it feels like.
Joe: (51:49)
Well, you know, one thing too, listening to this and it's sort of obvious, but I think it's worth driving home. The stakes are extremely high for whether this question of will inflation essentially be transitory or are we in a new sustained higher inflation, higher rate environment? Because if we really are, then that's where you get into, you know, you're talking about utilities or you’re talking about like Reits. You know, these are sort of like industries and sectors that aren't particularly sexy by any stretch, but they are very rate sensitive. And there's a lot of room for multiples potentially to come down. So you hear him talk about rates, or you hear him talk about data centers or hear him talk about utilities in the sort of same breadth as fintechs and cryptos and gig economies stocks. You could see like how high the stakes are for, well, where do rates end up? What is terminal? What does the terminal look like?
Tracy: (52:44)
Right. Like your entire reputation as an investor is going to come down to whether you get the inflation call right, because that's going to change everything in markets.
Joe: (52:53)
Right. I mean, arguably it already has, but I mean still, yeah. There's huge swabs of the market that could be highly affected by what goes on from here.
Tracy: (53:01)
Anyway, tons to digest there.
Joe: (53:13)
Can we do an episode where I interview you about fintech?
Tracy: (53:17)
I mean, I do have thoughts and it did come up recently in our stablecoin episode, the parallels with P2P, but I do feel like to some extent, the peer-to-peer bubble or direct lending bubble was like a very nice microcosm of a lot of the trends that we're seeing now. But anyway, let's leave it there.
Joe: (53:20)
Let's leave it there.
You can follow Jim Chanos on Twitter at @WallStCynic.