Bloomberg Oddlots: Jim Chanos on Crypto, Tech and the Golden Age of Fraud

Jim Chanos is back on Oddlots!

Here are my quick notes on the episode. Note that this episode was taped at The Seventh Annual Berkeley Fall Forum on Corporate Governance on 9th Nov 2022. The notes are written in my own words, emphasis are mine.

-Tracy Alloway mentions the famous Buffet quote, that when the tide goes out, you find out who has been swimming naked. Apt for the current instance when frauds and unsustainable structures are being exposed

-mentions the previous episode when Chanos' predictions came true

-Chanos says this is one of the worst bubbles he has seen and the poster children (SPACs, NFTs, Crypto etc) are taken to the woodshed. Question is will this spread further into the financial system.

On FTX and crypto

-obligatory mention of the episode with Sam Bankman-Fried (SBF) when he mentioned that quite a few cryptos are essentially Ponzis. This was an "ah-ha!" moment for many people.

-crypto's business model is predatory. It is a speculative asset with a huge cost structure built around it, to extract fees from investors.

-the problem with anti-Fiat structures like crypto is that you need fiat is when people are afraid. Governments can enforce contracts, adjudicate fraud and act as lenders of last resort

-Alternative currency schemes have existed in history. They come about during bull markets when people believe things that are too good to be true

-examples in history include various banking systems that thrived in early 19th century in the US, the various currencies brought forth by John Law in France

-these alternative currencies rely on a system of trust, whereas the system of fiat are built to engender trust. Proponents of these alternative system point to the drawback of fiat, which is risk of debasement and governments interference, but they are ignoring the good parts of fiat.

-he doesn't think this will result in contagion through the market, as it is a mark-to-market risk. So he thinks contagion effect on credit and payment systems is limited

On regulators

-he reminded listeners that regulators are more like archaeologists. The staunchest defense against prosecution is a high asset price. He points to the dot-com era bust when people were losing money for a year, before Enron hit and forced regulators to step in and look at wrong-doing. This resulted in Sarbanes-Oxley. He thinks that young investors who have lost money will now lead to political pressure for regulators to step in

-points out that many of these crypto entrepreneurs happen to live in Bahamas and Dubai instead of New York. It will be interesting to see the outcome of investigations from this. 

On fraud

-as it gets difficult to meet expectations, frauds get worse

-frauds follow business cycles with a lag

-as markets go down, frauds tend to get exposed. He refers to Tyco, Enron and Bernie Madoff

-a more subtle form of fraud is the abuse of accounting metrics by companies. Such as the abuse of "adjusted" metrics like adjusted  EBITDA. He expects these will be hard to prosecute

-accuses Silicon Valley of using metrics they like as opposed to those that reflect reality.

-remains to be seen if regulators will prosecute this.

On Share Based Compensation (SBC)

-it was a big issue post dot-com, when stock option accounting came under scrutiny. These had big pro-cyclical effects, when a rising stock price means less stock is issued but a falling price means more stock is issued. So now this number is becoming meaningful

-mentions a company which will increase share count by 10% a year because of this.

-points out that many companies are buying stock in the market to offset SBC. It is silly for SBC to be adjusted away from profit, resulting in positive operating cashflow, and cost of buy backs are recognized under financing cashflow. It is getting worse.

-investors are willing to tolerate SBC because it makes things look good on the way up (for price)

-points out that if there is a lavish equity issuance culture, and a compliant board that will agree to any equity issuance plan, they will be ok to rubber stamp equity repricing of the SBC in order to keep employees and management happy. Black-Scholes option pricing only pick up the cost of call options, not put. Also that is a frightening problem because they are essentially issuing put options to management. That is a risk that not many people appreciate

On shorting

-it is not difficult to identify shorts in this market but the problem is where they are going

-many companies have questionable business models.

-points out Doordash have higher losses per order now, versus a few years ago. They are not scaling, especially for companies using a digital platform and the internet.

-these companies are showing greater losses as they age, people should wonder when they will be able to turnaround

-so identifying these companies is not the issue, having other investors care about these problems is the issue

-Joe mentions that Jason Calacanis mentioned in a previous episode that many tech companies are simply incentivized to grow rather than be profitable. implying they can be profitable if they want to by cost cutting. Chanos says this yet to be seen, as they look at operating metrics, many of these companies are still inherently unprofitable high up on the income statement at the gross profit or operating income level. 

-what short sellers are looking for in these business models are companies that have stopped growing and are still losing money. This proves that they are structurally unprofitable as they are essentially unable to turn positive after investing for growth

On Musk, Tesla

-Tesla is the most profitable car company to his surprise

-with stock price down 60%, it is still the most expensive auto OEM in the world by a lot

-trading now at 30 times gross profit, which is a SAAS valuation but essentially sells luxury car. The 30 percent gross profit margin is not sustainable because the luxury car market is small and other competitors are catching up.

-it is a low ROIC business and although Musk has caught the sweet spot. This will be difficult to maintain, as his investors are still expecting 40 to 50% growth for the next decade but he doesn't think it is possible

-he is short Tesla

On the market bottom

-says market timing is not his forte but he points out the current market level is still very expensive.

-most bear market bottoms occur at 9 to 15 times the previous peak of earnings because earnings are depressed at bottoms

-maybe we are at peak earnings now, but at roughly 19.5 times peak earnings, the market is still far from bottom.

None of the above should be construed as investment advice. Do your own due diligence as I will not be responsible for any loss/risk.