Gregor . Mast
2/17/2023
Jim Chanos, the founder and president of Chanos & Company, asserts that the degree of absurdity and speculation observed in 2020 and 2021 was a critical turning point for valuations. He elaborates on what he considers to be the most significant fraud, which is readily apparent, and provides his reasons for believing that Tesla’s stock price still has a significant downward trajectory ahead.
Although the markets have started the new year off strongly, Jim Chanos is skeptical of the recovery. As the president and founder of Chanos & Company, a New York City-based investment adviser specializing in short selling, Chanos identifies numerous issues simultaneously. Stocks are currently factoring in decent earnings growth, a decline in inflation towards 2 to 3%, and interest rate reductions beginning 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 firmly believes that the era of zero interest rates has ended. In the previous decade, the great bull market was fueled by excessively accommodative monetary policies that propelled nearly all stocks higher. However, a return to more typical market conditions, with some stocks rising and others falling, would be advantageous for short-sellers like Chanos.
Chanos typically identifies short-selling opportunities in firms that are experiencing cash burn, have excessive debt, or are significantly overvalued. In a thorough discussion with The Market NZZ, Chanos clarifies which sectors currently expose him the most, how companies are once again engaging in dubious accounting practices, and why he is maintaining his bearish view of Tesla.
Mr Chanos, markets have notably recovered on hopes of a soft landing, China reopening and peak inflation. Is the worst over for stocks?
Strictly speaking we are not market strategists per se’ so we don’t know. But I can point out that there are three expectations currently priced into futures markets. The first is that the S&P 500 earnings will grow by 12% this year. The second is that inflation rates will decrease to 2-3% by the end of the year, as implied by inflation breakevens. The third is that there will be a rate cut in the second half of 2023, as indicated by the forward curve on short term rates. However, there is a possibility that none of these three things will happen, which could lead to disappointment.
As a short seller, do you worry about the market direction at all?
As a hedge fund manager, we aim to maintain market neutrality while generating alpha, which is how we are evaluated. However, there are times when it is more challenging to generate alpha, and when people are caught up in narratives, it can be difficult to do so on the short side. From my perspective, the market during late 2020 and 2021 was the most speculative I have witnessed in 40 years. For example, in February 2021, SPACs in the US were raising an average of $3 billion per night, which is equivalent to the country’s savings rate. We also saw rallies in meme stocks, cryptocurrencies, and NFTs, which resembled the events of early 2000 that I never thought I would see again.
In the meantime, valuations have come down and sentiment has cooled. Aren’t stocks attractive again?
The current sentiment in the market still appears to be overly optimistic to me. The fact that we are seeing stocks doubling again in the month of January, coupled with retail volume in the NYSE reaching a record high as a percentage of total volume just two weeks ago, and record volume in zero days to expiration options, which is essentially gambling, all suggest that the market remains highly speculative. In addition, it is worth noting that Tesla trades more options every day than the S&P 500 and Apple, further highlighting the continued prevalence of speculation.
What about valuations?
As an investor, I see that even with the S&P 500 near 4200, the market is still trading at a pricey 21 times trailing earnings. This valuation level is not cheap by any means, and it reminds me of the tech bubble in October 2000 when the Nasdaq eventually plummeted by 80%. Even after the initial drop, some people thought stocks were a bargain because valuations had fallen from 10 times revenue to 5 times revenue. However, in reality, valuations were still significantly inflated and continued to fall to a low of 2 times revenue. Therefore, relying solely on past market peaks as a guide for current market conditions can be risky, as nothing appears to be undervalued at present.
When would the market be cheap enough?
Based on historical trends, bear markets in the past 40 years have typically ended at valuations of 9 to 14 times past peak earnings. The question now revolves around the expected earnings per share for S&P 500 companies and whether the peak has been reached. If it does turn out to be the peak, and if Q4 earnings continue to decline compared to last year, then the downside risk could be significant, potentially falling to a range of 1800 to 2800. However, it’s important to keep in mind that rules are made to be broken and this is not a prediction of market direction, but rather an assessment of risk.
The key question is whether there have been any changes in monetary or fiscal policy that could affect the market’s trajectory. While this remains to be seen, it’s important to note that zero percent interest rates are no longer in place. Additionally, with many stocks in 2020 and 2021 relying on terminal value as they were losing money, the discount rate used to calculate future cash flows could make a significant difference, ranging from 5% down to 1% or 2%.
Do you believe something has changed regarding interest rates?
It seems unlikely that the Fed will return to zero percent interest rates again, even if it may stop raising rates and potentially lower them slightly. Before the pandemic, inflation was not a significant concern, and central banks were attempting to encourage inflation. However, there is now considerable inflation in the system, and as a result, super accommodative monetary policy is unlikely to be pursued again for quite some time.
Does this mean inflation is here to stay?
It is uncertain whether an inflation rate of 5% or higher will persist, but it could be challenging to lower it to the target rate of 2%.
That doesn’t sound bullish, obviously.
It is natural for people to reminisce about the good times and want to go back to them, but I do not believe that we will see zero percent interest rates again anytime soon. The market conditions we experienced in 2021 were a clear indication of a high level of speculation and irrationality in valuations. In my opinion, this period marked an important moment for valuations, and we are unlikely to return to such levels of speculation in the future. If the market conditions become more normalized with some stocks rising and others falling, it will provide an interesting opportunity for fundamental short selling.
Why bother about shorting as markets go up most of the time?
It is true that over time, indices tend to go up, but it’s important to remember that most companies fail. Even if you had invested in the stocks comprising an index 20, 40, or 50 years ago and did not change your strategy except for reinvesting dividends, you would have underperformed the market because many companies did not survive. However, indices are constantly self-correcting by dropping underperforming companies and adding those that are still growing. Therefore, it would make more sense to buy the indices and short weak companies. This strategy becomes even more important now, with fraud on the rise again.
Do you spot companies where there could be fraud involved?
In our hedge fund, we saw that at the end of 2022, 60% of our portfolio by capital had some form of questionable accounting or outright fraud. One of the biggest sources of fraud is hiding in plain sight, which is the misuse of pro forma accounting. This is especially prevalent in Silicon Valley, where companies add back various expenses, including equity-based compensation, to the P&L statement. For instance, Uber’s CEO recently touted their adjusted profitability, but in reality, Uber is still losing money. Similarly, GE released an earnings report a couple of weeks ago that contained 16 pages of adjustments, making it difficult to determine the true earnings number. Pro forma accounting can be misleading, especially when it comes to share-based compensation because of its dilutive nature.
Share-based compensation was also an issue in 2000.
Until 2006, there was no stock option expensing, which has resulted in a significant increase in share count, particularly in recent times. The issue becomes worse when stocks drop because companies then issue even more shares from their underwater options, as they did in 2003. For instance, a company that had 100 million shares outstanding in 2000 had 1 billion shares outstanding by 2006. For the quarter that just ended, Coinbase will report $500 million in revenues, while their share-based compensation will be $400 million, which is 80% of Q4 revenues. I believe regulators should have intervened and put a stop to these questionable reporting practices. In the future, we may look back and regret not taking appropriate action sooner.
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?
One effective strategy to mitigate the unlimited upside risk associated with short selling is through the use of put spreads. As a short seller, we buy a put option with a higher strike price and simultaneously sell another put option with a lower strike price. This way, we can limit the potential losses from a short position. Nonetheless, there are still some costs associated with this approach.
It’s essential to diversify our short positions to minimize the impact of any single stock’s price movement on our portfolio. We currently have more than 50 different names in our portfolio, and we keep an average position size of 1.5%. We actively manage our portfolio and reduce our exposure to any stocks that become too risky. In my experience, more stocks go to zero than to infinity, so having a robust risk management strategy is critical for short selling.
Do you add back to your short positions when the share price is peaking?
As for the put strategy, there are two positive aspects and one negative aspect to consider. The downside is that you have to pay a premium for it. On the other hand, the first positive aspect is that it limits your potential losses, which is beneficial for managing risk. Additionally, with a put strategy, you become more exposed to the downside of the market and less exposed to the upside, whereas a regular short position works in the opposite way. When you have a regular short position, it becomes larger if the market moves against you, and smaller if the market moves in your favor. In contrast, the put strategy keeps you more static, which can be advantageous for maintaining stability in your portfolio.
What are the typical characteristics of a short candidate?
At the end of last year, our portfolio consisted of 50 companies, with 32% of the portfolio consisting of firms that we believed were worth zero, although we did not expect them to go to zero. Additionally, we had allocated 50% of the portfolio to stocks that we thought could fall 70 to 80% on valuation alone. Around 47% of the companies were losing money on a GAAP basis, and 84% were reporting declining estimates for their 2023 revenues or earnings. Moreover, 61% of the firms in our portfolio showed questionable accounting practices or fraud. Out of the 50 companies, 5 were included in the most shorted stocks basket, consisting of high short-interest stocks like Coinbase.
So, going to zero basically means having too much debt?
Another example of a risky business model is when a company is consistently losing money every quarter to the point where their financials become unsustainable. One such company is Affirm Holdings, which operates in the buy now pay later space. Last quarter, they lost a staggering $360 million, which is not sustainable in the long run. Moreover, their tangible book value is less than $6, while they continue to lose $1.10 per quarter. At this rate, they will be insolvent by mid-2024. Even if they raise equity before then, they cannot continue to hemorrhage money indefinitely and remain viable.
What are you doing on the long side?
We occasionally engage in pair trades, but only if they present a clear arbitrage opportunity. Our primary focus for our long positions is to mitigate the systematic risk of our short portfolio. To achieve this, we typically use ETFs such as the S&P 500 weighted, S&P 500 unweighted, Nasdaq, Russell, or a combination of these. Additionally, we use two REIT ETFs, IYR and VNQ, to hedge our short REIT position, which represents about 15% of our portfolio. If we had China exposure, as we did 10 years ago, we would use the FXI and/or an A shares ETF. Currently, our China exposure is less than 5%. The beta of our short portfolio varies between 1.1 to 1.4, and we strive to maintain very low net exposure. While it’s impossible to be perfectly hedged given the many variables at play, we come close to achieving our target.
What segments of the real estate sector do you short?
Our negative view on New York offices is based on our assessment that the risks associated with these companies are not fully reflected in their prices. As for data centers, we have taken a “big short” position due to our belief that these stocks are overvalued. We were previously exposed by the “FT” for this position, which we had held since the summer of last year. Our analysis shows that these companies trade at a price-to-earnings ratio of 100x, despite having low earnings quality and declining same store revenues and operating income. We believe that this valuation is not justified and that data centers, as technology service companies, should trade at a more reasonable P/E ratio of 20x earnings. As a result, we think that these stocks are overpriced by as much as 80%.
What other stocks are you shorting?
The fund also has a concentration in money-losing fintech companies. These companies often trade at or below tangible book value once investors realize they are unlikely to generate profits. Two examples of such companies are Robinhood and SoFi, both of which saw their stock prices drop to tangible book value last year. The fund is also short on Coinbase, which had a tangible book value of around $17 in December and is expected to continue losing money. Despite this, Coinbase’s stock traded at $80 last week, which the speaker considers unreasonable. The Consumer Discretionary sector is another area of focus for the fund, covering companies ranging from fitness to Tesla.
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?
The borrowing costs are prohibitively high, so while it is interesting to observe the behavior of retail investors, it is not a practical strategy for professionals to pursue.
The short position that attracts most attention is Tesla. What’s the problem there?
Tesla’s financials have significantly improved after the opening of its factory in Shanghai in 2019. The move resulted in a surge in the company’s profits. According to Tesla’s 10-K tax disclosure, all of its profits in 2020 and 2021, and 65% of its earnings in 2022, came from Shanghai. However, despite Tesla’s strong presence in China, the company has been outperformed by BYD, which is now selling five times the number of cars Tesla is, despite not having any models a few years ago. This serves as a warning to Tesla bulls that the market leader can be overtaken, and competition is intensifying at a rapid pace.
Doesn’t China’s reopening help Tesla?
Tesla recently slashed prices by 25%, but their growth in China is being threatened by increasing competition. Although they remain popular, the success of rival company BYD, which now sells five times as many cars as Tesla, serves as a warning to investors that even market leaders can be surpassed. This underscores the risk of Tesla’s future prospects. It’s possible that Daimler, Ford, or BMW could catch up with Tesla’s technology in the future, causing a shift in market dominance. Elon Musk, the charismatic CEO of Tesla, often speaks of the company as an AI or robotics firm, claiming that they will soon introduce robotaxis, batteries, and solar energy products. Because of this, Tesla’s valuation has been the subject of much debate among investors, some believing it to be deserving of a higher valuation due to its potential as a robotics company rather than just a car manufacturer.
Isn’t that the case, at least to a certain degree?
The fact is that 96% of Tesla’s revenue over the last year came from selling cars and that’s up from 95% the year before, similar to other car companies such as Daimler, VW, and BMW. Tesla is forecasting gross margins of 20-21% this year, which is in line with these other car companies. However, while Tesla was previously growing at a faster rate of 40%, that growth has slowed down. The disagreement between Tesla bulls and bears now lies in how much they believe the market should be willing to pay for Tesla’s current level of growth and profitability.
What’s your take?
Tesla’s market capitalization is currently at $700 billion, but its gross profit for this year is expected to be $20 billion, which is the same as last year. This means that the market is paying 35 times this year’s earnings for Tesla, while paying only 3-5 times gross profits for other car companies such as Daimler, VW or BMW. The market is thus paying 10 times more for Tesla than its competitors. While Tesla will likely continue to trade at a premium, this premium is unlikely to remain at 10 times the amount of its competitors.
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. Currently, analysts are reducing their estimates for Tesla. Previously, Tesla was projected to earn $4 per share in 2022 and $6 per share in 2021, which would represent a growth rate of 50%. However, the revised estimates have lowered those numbers to $4 per share for both years. Despite this change, Tesla supporters are highlighting the company’s recent price reductions, arguing that they will have a more negative impact on competitors rather than Tesla itself. The issue with this argument is that it suggests that Tesla should now be compared to traditional car companies, implying that Tesla now has a cyclical profit stream. But, that’s not how Tesla was initially viewed as it was considered a growth company.
Yet, the market applauded Tesla’s recent earnings report.
Recently, we have seen some dramatic movements in certain stocks, such as Bed Bath & Beyond and Affirm. These movements may not necessarily reflect changes in the underlying fundamentals of these companies, but rather are driven by short interest and market positioning. Bed Bath & Beyond stock price went up by 3x and Affirm’s by 100% and then over just 3 weeks the stock price collapsed again. It’s important to keep this in mind and not be swayed by short-term market volatility when making investment decisions.
The bulls’ argument has always been that Tesla has competitive advantages in batteries and software. Do these advantages fade out?
I’m not entirely convinced of the idea that Tesla has an advantage in software. They still purchase almost all their batteries from Panasonic and CATL. When it comes to software, they are still at level 2, which is assisted driving. Full self-driving is level 5, and Daimler is the only company at level 3. Tesla has been selling full self-driving software packages for $12,000 for the past seven years, but it simply doesn’t exist. Frankly, I’m surprised the FTC allows them to do this. I don’t know what people are seeing when they say Tesla has an edge in software. It’s not true; they are at the same level as Audi, GM, or Ford. It’s yet another example of Elon’s self-promotion, all about the narrative. There is also another issue to consider: once you get to level 4 or 5, the liability shifts from the driver to the product. Is Tesla prepared to assume unlimited liability? I don’t think so.
Jim Chanos
Jim Chanos, aged 65, is the president and founder of Chanos & Company (previously known as Kynikos Associates), a registered investment advisor in New York City, specializing in short selling. Chanos gained notoriety for his accurate prediction of Enron’s collapse. He stumbled into the field of short selling almost by chance. The very first company he analyzed as an analyst for boutique brokerage firm Gilford Securities in Chicago turned out to be a massive fraud, with Baldwin-United ultimately filing for bankruptcy just one year after Chanos’ discovery. Chanos obtained a degree in Economics and Political Science from Yale University, where he currently teaches a course on the history of financial fraud. He is also an avid art collector and appeared in the BBC Four documentary, “The Banker’s Guide to Art.”
