December 9, 2020

Jim Chanos: A Cynic’s Take on Markets & Investing | Hidden Forces Podcast

Checkout Hidden Forces episode page and show notes

Key Takeaways

• Investors short-sell to hedge and increase their long exposure, particularly in highly speculative markets
• In an ecosystem that promotes bullishness, shielding oneself from the psychological pressure of short-selling is crucial for success
  • This is more so in an intergalactic bull market, where the most questionable businesses tend to perform best
  • Even when correct, a short-seller must consider the current environment, the mass narrative, correct sizing till the position plays out, and the best stock to short
• “When you take the risk-free rate from 14% to 0%, good things happen to asset prices for the most part” – Jim Chanos
  • That said, it’s dangerous to think you can’t lose money make because “the Federal Reserve has my back”
  • Additionally, you can’t hedge against the political risk of benefiting asset owners at the expense of the majority of people
• The fraud cycle follows the financial cycle but with a lag, it starts long into a bull market and is revealed after a market crash
  • That is when people start losing money and demand regulators to get involved.
• In essence, most financial frauds are Ponzi schemes of unprofitable businesses using accounting techniques to justify raising more capital and paying off old investors
  • Moreover, because no one gets punished, corporations treat fines as a cost of doing business

Introduction

• Jim Chanos is the founder and president of Kynikos Associates and an investment manager focused on short-selling, he is most famous for shorting Enron before its collapse
• Host: Demetri Kofinas (@HiddenForcesPod)

What is Short-Selling?

• Broadly speaking, short selling is to take up cash upfront in exchange for goods and services to be delivered later
  • Examples include an airline selling an advance purchase seat or a farmer selling his crops in the futures market a year in the future
  • Insurance companies are the largest short sellers in the world, they collect premiums upfront with the promise to pay in the future under certain circumstances
• In the securities markets, short-sellers borrow a security and sell it. In theory, those lent shares are returned later at a lower price, thus locking in a profit
• Investors short-sell to hedge and increase their long exposure, particularly in highly speculative markets
  • This means finding companies that will structurally underperform the market. Whereas it’s better to conduct short-term bearish trades in the options or futures markets.

The Psychological Pressure of Short-Selling

• The securities market ecosystem is designed to make you purchase securities and it promotes bullishness
  • Thus, short-sellers are in an environment of negative reinforcement, “you are being told every day ‘you are wrong’”
    • Many successful analysts don’t perform well on the short side because they can’t shield themselves from the psychological pressure
• Most people will give in despite evidence, but every once in a while a company comes clean and a short seller makes all their profits in a day
  • Behavior finance barriers are why idiosyncratic alphas from the short side have historically been high, even if this hasn’t been the case recently

Shorting When Stocks Always Go Up

• Shorting becomes increasingly difficult in an intergalactic bull market, especially because the most questionable businesses tend to perform best
  • No matter how good you are, you begin to question your financial sanity
  • “In really epic bull markets people do really silly things with their capital” – Jim Chanos
• It’s essential to do the work to ascertain reality from your thoughts
  • Even when correct, a short-seller should consider the current environment, the mass narrative, correct sizing till the position plays out, and the best stock to short
    • Keep in mind, “There is nothing you can do if the entire world, for a certain period of time, wants to believe that a duck is a cow” – Jim Chanos
• While most businesses fail, winners recycle losers and capture the biggest chunk of stock market returns
  • For this reason, passive indices tend to outperform active management over time, because failures are discarded from the index
• Jim compensates short accounts on an inverse benchmark

Investor Complacency

• With all the government support, prices are often determined by policymakers, this pushes investors to think they can’t lose money in questionable companies
  • However, “counting on policymakers to have your back is a very dangerous place to be, policymakers are often wrong” – Jim Chanos
• “The Federal Reserve has my back” was a popular thought process back in the dot-com bubble
  • However, even with the Fed cutting rates after the 1998 default of Russia and LTCM, S&P and NASDAQ went down 40% and 80% respectively
• The last round of easing by the Fed was due to the market beginning to wobble in the fourth quarter of 2018, not because of the pandemic
  • Again, people thought they can’t lose money and started leveraging up
• “If indeed, the central banks have solved the problem of risk in markets, it will be a first” – Jim Chanos

Interest Rates and Risks

• The decline of interest rates is unprecedented and is behind the financialization of our economy
  • “When you take the risk-free rate from 14% to 0%, good things happen to asset prices for the most part” – Jim Chanos
    • It’s unlikely this will be replicated in a move to -14%
• The market is completely overlooking political risk. Namely, policies that increasingly help asset owners at the expense of the majority of people
  • “You can’t hedge against torches and pitchforks” – Jim Chanos
• A different government could heavily tax profits from the Fed supporting the market

Democrats Taking the Senate

• “Just because the democrats might hold the senate doesn’t necessarily mean everything can get past” – Jim Chanos
  • While most legislation needs 60 votes to pass the senate, budget and tax issues are likely to go through reconciliation, which requires a simple majority vote (51)
    • Other broader issues might be more difficult (Green new deal possibilities)
  • Additionally, Biden is likely to reverse many of Trump’s actions by executive order
    • This will be most visible in how they address areas where regulation can make an immediate difference, such as education and the environment

Fraud and Financial Regulation

• “I dubbed this the golden age of fraud” – Jim Chanos
  • Corporations treat fines as a cost of doing business, especially with the lack of criminal action
    • The public can sense there are 2 sets of laws about lying and stealing, and one doesn’t apply to corporations or executives
• The laws against fraud come with a lot of discretion in how to apply them
  • Policymakers are trying to protect markets to the detriment of basic concepts like justice
    • This is a worsening global phenomenon (E.g. Wirecard scandal in Germany)

Fraud and Stock Price

• The fraud cycle follows the financial cycle but with a lag, it starts long into a bull market and is revealed after a market crash
  • That is when people start losing money and demand regulators involvement, and portfolio managers start to re-examine their positions
    • For instance, Enron stock was down 60-70% before the fraud was exposed
  • In a way, a company’s stock price is both its best defense lawyer and harshest prosecutor
• Most financial frauds boil down to being a Ponzi scheme, an unprofitable business using clever accounting techniques to keep raising capital and payoff old investors or debt
  • A lot of the fraud is hidden in plain sight by the aggressive use of pro-forma metrics to hide the actual losses on financial statements (e.g. Valeant fraud)

On Tesla

• Tesla narratives took over its fundamentals in 2019
  • Most automakers trade at .6-.7 their revenues, which would value Tesla at $30 per share
    • A share price of $400 reflected how people perceive future business and technological breakthroughs
• Getting into the midsize vehicle class (Model 3) was the only way to justify Tesla’s valuation
  • That said, its first-mover advantage won’t last forever with major manufacturers entering the market
  • Tesla sales have flattened out or declining in the US and Europe but is growing in China
• Despite all the narratives, “It’s [Tesla] still, as we enter 2021, shockingly, a car company” – Jim Chanos
  • Tesla Battery Day event didn’t showcase new batteries
  • Tesla still at level 2.5 on the autonomous driver scale out of 5.0 (full autonomy)
• Similarly, people highly value Uber and Lyft under the narrative that autonomous cars will eliminate the need for drivers, 80% of the cost
  • However, if cars don’t need drivers, then we don’t need Uber
  • Keep in mind, “Uber is still losing spectacular amounts of money” – Jim Chanos
• Companies now use the total addressable market to justify valuations, rather than metrics or actual execution
  • In that sense, space exploration companies should be valued at infinite

Additional Notes

•  “People have lost far more money looking for the next Amazon than they’ve made in Amazon” – Jim Chanos
  • It’s often better to invest in the company itself rather than chase the next big thing

Hidden Forces : 2020 election, fraud, investing, short selling, show notes, tesla
Notes By Mostafa Khaled