Podcast Summary
Understanding the uncertainty of global valuations: Investors should consider the underlying economics of their assets and prepare for a potentially volatile market, as the current economic climate presents significant uncertainty regarding the value of various assets.
The current economic climate presents significant uncertainty regarding the value of various assets, both traditional and non-traditional. While some assets may appear to have no inherent value beyond the continuous flow of investor money, others may have underlying business models that could generate cash flow in the future. However, the absence of a central bank response to economic downturns and the potential for inflation make it difficult to predict which assets will retain value. Jim Chanos, a renowned hedge funder and short seller, will be discussing his insights on the current state of global valuations on the Odd Lots podcast. It's important for investors to carefully consider the underlying economics of the assets they hold and be prepared for a potentially volatile market. Principal Asset Management, with its 360-degree perspective and expertise in public and private equity and debt, can help investors navigate this uncertainty. But remember, investing always comes with risk, including the possible loss of principal.
IPOs of tech companies during summer 2020 struggled to make a profit despite ideal economic conditions: Despite ideal economic conditions, many recently IPO'd tech companies struggled to make a profit, leading to inflated market valuations based on future potential rather than current profitability, reminiscent of the dotcom era.
During the summer of 2020, many tech companies that recently IPO'd, such as Uber, Lyft, and DoorDash, were unable to make a profit despite the ideal economic conditions of people being stuck at home and ordering online. The unit economics were terrible, and the market valuations were inflated based on future potential rather than current profitability. This phenomenon was reminiscent of the dotcom era but on a larger scale. As a short seller, it was an emotional experience to watch these companies attract vast amounts of money despite their unproven business models. The market's sentiment was driven by narratives of future market size and profitability, leading to exorbitant valuations. The trend was kick-started by the Federal Reserve's reversal of course in late 2018, followed by unprecedented monetary and fiscal support during the pandemic and the widespread reduction of retail commissions.
Retail investors favored individual stocks and options over index funds and ETFs: During the 2019-2021 market period, retail investors shifted from passive investments to active trading in high-flying tech stocks and meme companies, with SPACs raising massive amounts of cash. However, many of these companies had unsustainable business models, leading to market volatility and a subsequent recession.
The market behavior from late 2019 to early 2021 was markedly different from the previous bull market, with retail investors moving away from index funds and ETFs to individual stocks and options. This trend was particularly evident in high-flying tech stocks and meme companies, which saw meteoric rises and subsequent crashes. SPACs also entered the scene, raising unprecedented amounts of cash, equivalent to the US savings rate for a brief period. The market's peak in the first half of 2021 saw the faltering of various companies, including those in the gig economy, whose unit economics didn't add up. The speaker suggests that these money-losing companies, such as Robinhood and Coinbase, will likely trade below book value. The unique aspect of this market period is the widespread insanity across various sectors, unlike the tech bubble where value stocks held up relatively well. The recession that followed was also more severe and affected consumers, adding to the market's volatility.
Impact of Rising Interest Rates on Overvalued Sectors: Investors should prepare for potential declines in equity valuations for sectors like REITs, electric utilities, and consumer packaged goods, which have thrived during low-rate era but have low return on invested capital. Tech stocks and defensive sectors may also be vulnerable.
Investors may be underprepared for a significant increase in interest rates, which could negatively impact various sectors and business models that have thrived during the era of ultra-low rates. These sectors include real estate investment trusts (REITs), electric utilities, and consumer packaged goods companies, which are currently trading at high valuations. Many of these businesses have low return on invested capital due to the abundance of cheap capital over the past decade. A return to more normal interest rates could lead to a significant decline in equity valuations. The speaker also mentioned the vulnerability of tech stocks and defensive sectors, which have been seen as less risky but may have similar risk profiles as tech stocks. The speaker is long the S&P 500 in his hedge fund but short a "radioactive" group of companies. He does not have a specific target for the S&P 500 but notes that corporate profits, which have been at record levels, may not be sustainable in the long term.
Sectors with low to mid single-digit returns on capital could face challenges with rising interest rates: Retail investors' speculation and private equity industry's potential reality check could prolong market volatility as interest rates rise
Some sectors and companies with low to mid single-digit returns on capital, particularly in real estate, consumer industries, and ESG space, could face significant challenges if interest rates continue to rise. Retail investors' willingness to speculate despite market downturns has been surprising and may prolong market volatility. The private equity industry, which has seen significant growth over the last decade, could face a reality check similar to hedge funds after the 2008 financial crisis, especially if interest rates continue to rise and leverage becomes more expensive.
Private equity returns underperforming expectations: Despite impressive past returns, private equity has not outperformed the S&P 500 or Russell net of fees and leverage. With potential higher interest rates, challenging exits, and a closed IPO market, managers should reconsider allocations.
While private equity has had impressive returns over the last 40 years due to declining interest rates and rising equity values, the returns have not been as superior as expected, especially in the last few years. Net of fees and adjusted for leverage, private equity has not outperformed the S&P 500 or Russell. With the possibility of structurally higher interest rates, private equity may face challenges with difficult exits and a closed IPO market. Despite being the asset of choice for institutional investors, private equity managers should consider re-evaluating their allocations. The financial crisis of 2008 serves as a reminder of the risks involved in leveraged investments, but the risks in today's market might not be as systemic or related to the banking system. Instead, the risks could be related to rate risk and corporate leverage. While there are concerns about hidden leverage in new asset classes like crypto and Fintech, the risks are not the same as those during the 2008 financial crisis. Every bull market has its unique characteristics, and this one was less debt-driven compared to past deflationary credit shocks. However, there is still significant leverage in the market, and investors should remain cautious.
Fintech's vulnerability during economic downturns: Identify companies with low ROIC, especially below 10%, as they're vulnerable during economic downturns
The financial technology industry, or Fintech, has seen egregious valuations due to its ability to use algorithms and big data to predict consumer loan repayment, but these companies are vulnerable to economic downturns and may not have a better mousetrap than traditional financial institutions. When making investments, especially short positions, it's crucial to consider both the macroeconomic environment and company-specific insights. The business model should look problematic even when economic conditions are favorable. Companies with low return on invested capital, especially those earning less than 10%, are particularly vulnerable during economic downturns. The speaker emphasizes the importance of identifying such companies and avoiding them.
Identifying struggling companies during economic downturns: During economic downturns, scrutinize companies' financial statements carefully to identify those with unprofitable or barely profitable business models and be cautious of those heavily relying on 'pro forma' metrics, which can mask underlying losses.
During economic downturns, it's crucial to identify companies with unprofitable or barely profitable business models, as they may struggle significantly when times get tough. Additionally, be cautious of companies that heavily rely on "pro forma" metrics, which can be misleading and mask underlying financial losses. The aggressive use of such metrics, particularly in adding back share-based compensation, can lead to a vicious cycle of dilution and increased share issuance when the assumption of constant stock price growth no longer holds. Ultimately, it's essential to scrutinize financial statements carefully and not solely rely on headline numbers.
Economic stress leads to reliance on government-backed systems and questioning the value of cryptocurrencies: During economic uncertainty, people look for secure systems. Crypto market's rise saw potential as currency replacement, but high fees and predatory practices targeting retail investors have raised doubts about its true value
During times of economic stress, people turn to government-backed systems for security and fraud protection. This was observed in the early days of banking, and it's still relevant today. Cryptocurrencies, such as Bitcoin, were initially seen as potential replacements for traditional currencies, but many of the early assumptions about their value and use cases have not held up. Instead, the crypto market has seen a proliferation of rent-seeking activities and predatory practices, particularly in the form of high fees charged to retail investors. For instance, Coinbase earned almost a billion dollars in commission revenues from retail traders in Q1 2022, compared to less than 50 million from institutional investors, highlighting the disproportionate burden on retail investors. This predatory behavior undermines the potential benefits of cryptocurrencies and raises philosophical questions about their true value and worth.
Tesla's High Valuation and Competition Risks: Despite surviving financial struggles, Tesla's high valuation and intense competition pose risks. Regulatory inaction on potential fraudulent activities adds uncertainty.
Tesla, despite surviving past its financial struggles in 2018, still faces significant risks due to its high valuation and intense competition in the EV market. The company's dramatic over-earning and reliance on profits from its China plant raise concerns about its ability to maintain its current multiple. Regulators, who are often criticized for being backward-looking, have yet to take significant action against companies like Tesla and Elon Musk, despite potential fraudulent activities and the creation of alternative financial systems like crypto. This may be due to the fact that regulators focus on financial archaeology, providing clarity on past events, while journalists and short sellers act as real-time financial detectives. Tesla's status as a bellwether stock in the EV industry and its large earnings from China make it a significant risk for investors.
Politics and Investor Sentiment Shape Financial Landscape: Politics and investor sentiment influence financial regulations and markets, with missed opportunities for securities regulation and changing dynamics for short selling based on interest rates and market transparency
The political nature of financial regulations and the role of investor sentiment play significant roles in shaping the financial landscape. The failure of securities regulators to regulate crypto coins as securities offerings is an example of a missed opportunity to prevent potential harm. The business of short selling, which involves selling borrowed securities with the expectation of buying them back at a lower price, is influenced by interest rates. In a low-interest-rate environment like Zirp, the business of short selling becomes less attractive due to the lack of yield on the cash received from short selling. Conversely, in a higher-interest-rate environment, short sellers can earn yield on the cash, making the business more appealing. However, with the advent of more transparent markets and algorithmic trading, negative rebates on hard-to-borrow stocks have become more common, further impacting short selling returns. Ultimately, the political climate and investor sentiment can significantly impact financial regulations and markets, highlighting the importance of effective communication and education.
Determining Inflation's Duration: High Stakes for Investors: Renowned short seller Jim Chanos emphasizes the importance of inflation's duration, with implications for sectors like utilities and REITs, and warns of potential parallels to past market bubbles.
The ongoing debate about inflation and its potential impact on various sectors of the market carries significant implications for investors. Jim Chanos, a renowned short seller, emphasized the high stakes involved in determining whether inflation will be transitory or sustained. He highlighted how sectors like utilities and REITs, which are typically less glamorous compared to tech or crypto stocks, could be disproportionately affected by interest rate movements. Chanos also shared insights on the parallels between the peer-to-peer lending bubble and current market trends. Ultimately, the outcome of the inflation debate could significantly influence investors' reputations and the entire investment landscape.
