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«I’m not Sure Speculation Is Gone»

Jim Chanos, president and founder of Chanos & Company, believes the level of silliness and speculation seen in 2020 and 2021 marked an important moment for valuations. He talks about the biggest fraud which is hiding in plain sight and why he believes Tesla has a long way to go down.

Gregor Mast
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The markets have made a brilliant start to the new year. But Jim Chanos does not trust the recovery. The president and founder of Chanos & Company, a New York City-registered investment adviser specialising in short selling, identifies several problems at once: Stocks are pricing in decent earnings growth, a drop in inflation towards 2 to 3%, and interest rate cuts starting in the second half of the year.

«I believe there is a chance none of those three things will happen, so you could get disappointment», says the renowned investor who predicted the bankruptcy of Enron. Despite the correction in 2022, he says, the S&P 500 is not cheap with a trailing price-earnings ratio of 21, and speculative appetite remains high.

Chanos is convinced that the era of zero interest rates is over. After the great bull market of the last decade, driven by extremely accommodative monetary policy, which lifted almost all boats, a return to more normal market conditions with some stocks rising and falling would be a boon for short-sellers like him.

He mainly finds short candidates in companies that are burning money, have too much debt or are heavily overvalued. In an in-depth conversation with The Market NZZ, Chanos explains which sectors he is currently most exposed to, how companies are once again applying questionable accounting practices and why he is sticking to his bearish assessment of Tesla.

«The Fed might stop raising rates, maybe it lowers them a little bit, but I don’t think they will go to zero percent anymore»: Jim Chanos.

«The Fed might stop raising rates, maybe it lowers them a little bit, but I don’t think they will go to zero percent anymore»: Jim Chanos.

Photo: Bloomberg

Mr. Chanos, markets have notably recovered on hopes of a soft landing, China reopening and peak inflation. Is the worst over for stocks?

The simple answer is: I don’t know. We’re not market strategists per se. But there are three expectations priced into futures markets I would like to point to. First, the market expects S&P 500 earnings to grow by 12% this year. Second, inflation breakevens imply that inflation rates are headed down to 2-3% by the end of the year. And third, the forward curve on short term rates is still predicting a cut in rates in the second half of 2023. I believe there is a chance none of those three things will happen, so you could get disappointment.

As a short seller, do you worry about the market direction at all?

In our hedge fund, we’re roughly market neutral, but we worry about our alpha, that’s how we are judged. There are times when generating alpha is easier and times when it is harder. When people are chasing narratives like they did in late 2020 and 2021, it's difficult to generate alpha on the short side. I firmly believe that this period was the most speculative market I have seen in 40 years. In February 2021, SPACs in the US were raising on average $3 billion in cash every night which is equal to the US savings rate. You had rallies in meme stocks, in crypto currencies and in NFTs. I thought I would never see anything similar to early 2000 again, but that’s what happened in 2021.

In the meantime, valuations have come down and sentiment has cooled. Aren't stocks attractive again?

Sentiment still seems pretty frothy to me. We have stocks doubling again in the month of January, retail volume in the NYSE as a percentage of total volume hit a record two weeks ago, and you have record volume in zero days to expiration options which is basically gambling. Tesla trades more options every day now than the S&P 500 and Apple. I’m not sure speculation is gone.

What about valuations?

At close to 4200, the S&P 500 still trades at 21x trailing earnings. That’s not cheap. It reminds me of October 2000 when the Nasdaq was on its way to go down 80%. After the first drop, people thought stocks got really cheap as valuations dropped from 10x revenues to 5x revenues. Well, valuation was on its way to 2x revenues. It should never have been at 10x. Judging from past mania peaks can be dangerous because nothing got cheap in 2022.

When would the market be cheap enough?

No bear market in the past 40 years has ended at more than 9 to 14 times past peak earnings. The question is obviously if the $200 the S&P 500 companies are expected to earn in 2022 is the peak. If it turns out to be the peak – and it looks like Q4 earnings are down from a year ago –, then the downside could be to 1800 to 2800. Obviously, rules are set to be broken. But still, this tells us about the level of risk, although not about the market direction. The question is if something has changed in terms of monetary or fiscal policy. That remains to be seen, but I do know we won’t have zero percent interest rates anymore. With so many stocks in 2020 and 2021 depending on terminal value as they were losing money, it makes a big difference whether you’re discounting future cash flows at 5% rather than 1% or 2%.

Do you believe something has changed regarding interest rates?

The Fed might stop raising rates, maybe it lowers them a little bit, but I don’t think they will go to zero percent anymore. Prior to the pandemic, there was no inflation, and central banks tried to encourage inflation. Now, there is a lot of inflation in the system. Super accommodative monetary policy is not going to happen again for a long time.

Does this mean inflation is here to stay?

I don’t know if an inflation rate of 5% or above is here to stay, but I think that getting it down to 2% might be difficult.

That does not sound bullish, obviously.

Everybody would love to go back to zero percent interest rates. It was a fun party, but I think that party is over. 2021 was an important moment, and we do believe the level of speculation and silliness we saw back then marked an important moment for valuations. If we revert to more normal market conditions with some stocks going up and some stocks going down, it’s going to be an interesting time again to be a fundamental short seller.

Why bother about shorting as markets go up most of the time?

That’s why we own the indices. They go up over time, but don’t forget that most companies fail. If you invested in the stocks making up an index 20, 40 or 50 years ago and you didn’t change anything apart from reinvesting the dividends in these companies, you underperformed the market because most companies didn’t survive. The indices are constantly self-reinforcing, they drop the losers and bring in the companies that are still growing. I would ask people why are you not just buying the indices and short bad companies? To me, that would seem to be a much more logical thing to do, especially now with fraud on the rise again.

Do you spot companies where there could be fraud involved?

At year end 2022, 60% of our portfolio by capital showed some sort of questionable accounting or outright fraud. The biggest fraud is hiding in plain sight which is the misuse of pro forma accounting, in particular in Silicon Valley where companies are adding back all kinds of expenses – especially equity-based compensation – to the P&L statement. Uber's CEO was recently crowing about their adjusted profitability, but Uber is actually losing money. Or take GE. They put out a press release on their earnings two weeks ago that had 16 pages of adjustments. So what is the real earnings number? Pro forma accounting is really misleading, particularly when it comes to share-based compensation because of its dilutive nature.

Share-based compensation was also an issue in 2000.

Right, and there was no stock option expensing until 2006. The share count has gone up dramatically recently, and it gets worse when stocks drop because companies then issue even more shares from their underwater options, as they did by 2003. A company having 100 mio. shares outstanding in 2000 had 1 bn. shares outstanding by 2006. Coinbase will show $500 mio. in revenues for the quarter just ended, while their share-based compensation will be $400 mio. That’s 80% of Q4 revenues. I think we’re going to look back on that and say the regulators should have stepped in and stopped these questionable reporting practices.

When it comes to shorting, another challenge is that risk and reward are asymmetric as stocks can go up indefinitely while losing a 100% only. How do you deal with that?

First of all, it is how you structure trades. We use a lot of put spreads where you buy a put with a higher strike and sell short another one with a lower strike. This takes away a lot of the unlimited upside. We pay a price of course, but this is a way to mitigate that risk. However, you can’t eliminate the risk completely. That’s why we diversify our shorts in over 50 names. Right now, our average position size is 1,5%. When Tesla was going tenfold in 2020 and 2021, we just cut it back. We don’t sit there and watch stocks going up, we actively risk manage our portfolio. On top of that, I would humorously say that I saw a lot more stocks during my career go to zero than to infinity.

Do you add back to your short positions when the share price is peaking?

There are two good pieces of news about the put strategy, and one bad one. The bad one is you pay a premium. The good news is it limits your losses and it keeps you more exposed when the stock goes down and less exposed when it goes up whereas a normal short position is the opposite. A normal short position gets bigger when the market goes against you and smaller when it goes your way. A put strategy keeps you much more static.

What are the typical characteristics of a short candidate?

At year end, we had 50 names in our portfolio. Companies which we think are worth zero – they are not going to go to zero, but we can make the case they are worth zero – were 32% of the portfolio. Stocks which we think could go down 70 to 80% just on valuation alone were another 50% of the portfolio. Companies that lose money on a GAAP basis stand at 47%. Companies which were showing declining estimates, either for their 2023 revenues or earnings, made up 84% of the portfolio. Companies showing questionable accounting or fraud stood at 61%. 26% of the companies had debt greater than 10x Ebitda. Of the 50 names, 5 are on the most shorted stocks basket, meaning 10% of the names where high short interest stocks you would recognize, like Coinbase.

So, going to zero basically means having too much debt?

Or losing so much money every quarter that the business model doesn’t work. An example is Affirm Holdings, a buy now pay later company. They lost $360 mio. last quarter. They have a sub $6 tangible book value while losing $1.10 per quarter. At this rate, they will be insolvent by mid 2024. I think they will raise equity before then, but you just can’t keep losing so much money and survive.

What are you doing on the long side?

We do some pair trades, but they have to be pure arbitrage. Our longs should primarily take out the systematic risk of the short portfolio. We do this in two ways: for the bulk of our portfolio, we would use ETFs on the S&P 500 weighted, the S&P 500 unweighted, the Nasdaq, the Russell or some combination thereof. To hedge certain industry exposures like our short REIT position which represents about 15% of the portfolio, we use two REIT ETF’s, the IYR and the VNQ. If we had China exposure like we had 10 years ago, we would use the FXI, and/or an A shares ETF. Right now, our China exposure is less than 5%. The beta of the short portfolio moves around, it can be anywhere from 1,1 to 1,4. We want to aim for very low net exposure. There are too many variables to be perfectly hedged, but we are close.

What segments of the real estate sector do you short?

We are negative on offices in New York where we think the risks are still not priced in on a certain number of companies. The big short are data centres that the «FT» outed us on in the summer of last year. These stocks traded at 100x earnings despite very low earnings quality. Same store revenues and operating income of Digital Realty, the biggest company, have been going straight down for the last quarters, but still, these stocks trade at a premium to competitors like Amazon, Google and Microsoft, the hyper scalers. This makes no sense to us. Data centers are technology service companies which should trade at 20x earnings, not at 100x, meaning they should trade 80% lower.

What other stocks are you shorting?

Another concentration is money losing Fintech. Most of these companies at some point trade at tangible book value when it becomes apparent to investors that they are just not going to make any money. Robin Hood and Sofi stock prices both touched tangible book value last year. People know we’re short Coinbase. In December, Coinbase had a tangible book value of somewhere around $17 . It is losing $2-3 per quarter. It should drop off to $1.50-2.00 per quarter, but that would still put its tangible book value at year end 2023 at $10. Coinbase traded at $80 last week. And Coinbase is still charging its retail customers almost 3% roundtrip commissions and fees which is outrageous. I think there will be pressure on their revenues. Another big sub-sector is Consumer Discretionary, but that’s anywhere from fitness companies to Tesla. Apart from commercial real estate and Fintech, we have a pretty idiosyncratic portfolio, meaning you wouldn’t recognise any themes.

In a recent interview, you mentioned Bed Bath & Beyond’s bonds trading at 4 cents on the dollar while retail investors are enthusiastic about the stock. Do you touch this name?

No, the borrowing costs are too high. It’s a fascinating academic exercise on what retail investors are doing because it doesn’t make any sense. But for professionals, it’s not really actionable.

The short position that attracts most attention is Tesla. What’s the problem there?

Tesla lost money up to 2019, making very expensive cars in California. They opened up their Shanghai factory in 2019, and profits took off. If you look at their 10-K tax disclosure, it looks like all of their profits in 2020 and 2021, and 65% of their earnings in 2022 came from Shanghai. I sort of joked, but seriously, Tesla is a Chinese car company. Therefore, what’s happened in China in the last 4 months is significant because Tesla out of nowhere has been overtaken by BYD. BYD is now selling 5x the number of cars in China Tesla is, and they didn’t even have any models a couple of years ago. This should be a warning sign to Tesla bulls as it just shows that even the market leader can be overtaken. We were wrong about how fast competition will come, but that doesn’t mean it’s not happening.

Doesn’t China’s reopening help Tesla?

Not really, they recently cut prices by 25%. China is becoming a drag on their business because of all the competition. People are still buying cars, but to us, China underscores the risk of Tesla. If they can be overtaken that fast by BYD, then what’s going to happen when Daimler, Ford or BMW get their act together. Every bull market has a hopes and dreams stock, it was Cisco in the dotcom area, it has been Tesla in this bull market. Elon Musk is wonderful, he’s a lightning rod for bulls and bears. He will tell you Tesla is an AI or a robotics company, they are going to do robotaxis, batteries or solar, so everybody can pin whatever they want on Tesla. That’s why people say it’s not a car company, it’s a robotics company, deserving a higher valuation.

Isn’t that the case, at least to a certain degree?

Fact of the matter is that last year, 96% of their revenues came from selling cars, up from 95% the year before. The numbers are exactly like other car companies. Daimler, VW and BMW all have gross margins of 20 to 21% which is what Tesla is forecasting for this year. Obviously, Tesla was growing at 40%, but that’s not the case anymore. Now the question is what do you want to pay for that. That’s the discrepancy in the view point between Tesla bulls and bears right now.

What’s your take?

Tesla has a $700 bn. market cap, they will earn a gross profit of $20 bn. this year, flat from last year. That means the market is paying 35x this year’s earnings while paying 3-5x gross profits for Daimler, VW or BMW. That’s 10x as much for Tesla. Tesla will most probably always trade at a premium, but this premium will not be 10x.

Meaning Tesla’s fair value is around 30 to 40 $.

Yes, somewhere around that. That’s where it came from in 2019.

Would you close your short if it drops there?

Very likely.

What else would make you change your mind?

If earnings reaccelerate. Right now, estimates are being cut. In October, Tesla was supposed to make $4 in 2022 and $6 this year, a growth rate of 50%. Now it’s $4 and $4. So the story has changed, but the bulls now point to Tesla’s price cuts which are going to hurt its competitors more than they hurt Tesla. The problem is that they are now comparing Tesla to car companies, implying Tesla has a cyclical profit stream from now on. That’s not what it was, Tesla was a growth company.

Yet, the market applauded Tesla's recent earnings report.

The market also took up Bed Bath & Beyond by 3x, it took up Affirm by a 100% in three weeks and collapsed it again. What the market has done recently might not tell us much about the fundamentals because it has been more about short interest and positioning than it has been about fundamentals.

The bulls‘ argument has always been that Tesla has competitive advantages in batteries and software. Do these advantages fade out?

I don’t think this is factual. Tesla still buys virtually all its batteries from Panasonic and CATL. In software, they are still at level 2 which is assisted driving. Full self driving is level 5. Daimler is now the only company at level 3, and they will remain at level 3 for a long time. Tesla has been selling full self driving software packages for $12’000 for seven years, but it doesn’t exist. I’m actually shocked the FTC allows this. I don’t know what people are seeing when they are saying Tesla has an advantage in software. It doesn’t, it is at the same level Audi, GM or Ford is at. It’s another example of Elon’s self promotion. It’s all about the narrative. And there’s another problem: If you get to level 4 or 5, the liability shifts from the driver to the product. Is Tesla ready to assume unlimited liability? I don’t think they are.

Jim Chanos

James «Jim» Chanos is the president and founder of Chanos & Company (f.k.a. Kynikos Associates), a New York City registered investment advisor focused on short selling. The 65-year old investor who got famous for his call on Enron’s collapse came into the business of shorting almost by accident as Baldwin-United, the very first company he had ever looked at as an analyst for Gilford Securities, a boutique brokerage firm in Chicago, turned out to be a giant fraud, going bankrupt a year after Chanos brought it up. Chanos received a B.A. in Economics and Political Science from Yale University where he currently teaches a class on the history of financial fraud. A noted art collector, Chanos appeared on the BBC Four documentary «The Banker’s Guide to Art».
James «Jim» Chanos is the president and founder of Chanos & Company (f.k.a. Kynikos Associates), a New York City registered investment advisor focused on short selling. The 65-year old investor who got famous for his call on Enron’s collapse came into the business of shorting almost by accident as Baldwin-United, the very first company he had ever looked at as an analyst for Gilford Securities, a boutique brokerage firm in Chicago, turned out to be a giant fraud, going bankrupt a year after Chanos brought it up. Chanos received a B.A. in Economics and Political Science from Yale University where he currently teaches a class on the history of financial fraud. A noted art collector, Chanos appeared on the BBC Four documentary «The Banker’s Guide to Art».