Watch the replay below. Also below are key excerpts transcribed from the interview.
Keith McCullough: Hi I'm Keith McCullough and welcome back to another Real Conversation. I've never had an opportunity to have Jim Chanos here in the studio, the founder of Kynikos Associates. Thank you for taking the time to be here.
You sent me the syllabus for the course you teach at Yale. Can you frame up why you thought it was important to create this curriculum?
Jim Chanos: Right. So I’ve been teaching the class now going on about 10 years at Yale and I teach it every other Fall, at the University of Wisconsin, which is my family's Alma mater. And it's evolved over time. But the idea was that the thread of fraud is somewhat consistent in the financial world and business world. Business school students are taught to emulate success and rightly so.
But as we know most likely at some point in your career, whether you're in finance or in business or a nonprofit, you’re going to be confronted with wrongdoing. And how do you recognize it? What do you do? You might not short an Enron, but it might hurt your career or your portfolio. What we've tried to do is set up a systematic set of models and then take a historical narrative starting with the first IPOs back in the 1680s where there was tons of fraud involved, and move through the centuries and see just how fraud manifested itself in the financial markets.
How could you have identified it? How could we use models today to look at current situations? Of course, history doesn't repeat, but it does rhyme. And it's amazingly consistent. Human behavior has a the dark side, if you will. The course has morphed and become pretty comprehensive over the last 10 years. It's also a fun class to teach.
McCullough: It's interesting that you start with the lens of history then you're applying your models basically like a fractal model, looking for similar sets.
So you take your course and tie it into what's happening in everyday life, like monitorable behaviors, things that you can measure and map so students might see the pattern recognition. How interesting is that?
Chanos: I usually pick a couple of topics that are somewhat timely and ask the students to stay abreast of developments in those topics. So recent topics would be Tesla, shockingly, Bitcoin and China. A few years ago, we were looking at the roll-ups in the drug industry. I want them to keep in mind that this is what the course is about, right? Taking these historical narratives and models and applying it to what we're seeing today in the financial world.
McCullough: I often think of this because I'm a macro guy. How procyclical is fraud?
Chanos: So that’s the macro model for analyzing fraud, which is the Kindleberger-Minsky model. What we've found down through the historical narrative is that the fraud cycle follows the financial cycle on a lag. The lag often is amplified by bull markets in which disruptive technologies are the main factor. For example, interestingly, during the Dot com era we saw much more idiosyncratic fraud after that bull market than previous or even the bull market immediately after.
Part of it is that, during bull markets, people begin to suspend their sense of disbelief. And as the bull market goes on and more people are sucked in, you begin to believe things that aren't true. And companies and or managements begin to proliferate that are happy to sell you stories that aren't true.
It's why most frauds are revealed after a market rolls over. Think about Madoff or others because at their core, a lot of frauds are Ponzi schemes. And when people close up their pocketbooks and demand their money back, most frauds can't deliver. And so, we've seen this down through the centuries, quite literally, the wrongdoing doesn't get exposed until well after the peak. In the Dot com era, we saw Enron and WorldCom revealed at the tail end of that. I think it'll be interesting to see in this bull market if that plays out similarly, but it's been a consistent macro observation over the last 300 years.
McCullough: Yeah. Again, it makes pro cyclical sense to me because you need a revenue slow down to reveal whether you have revenue fraud, expense fraud, balance sheet fraud.
Chanos: You also tend to be much more suspicious if you've started losing money. You pull up the file again, 'Wait a minute. Why are we in this?' And I've often said that stock prices are the very best defense counsels and prosecutors for fraud because when stock prices are going up, companies are bulletproof. It's not until they start going down that people begin looking closer. Law enforcement and government get involved because there's political pressure for them to get involved when people start to say, ‘I've lost a lot of money. It's not my fault. They defrauded me.’
McCullough: It's the beginning of the end of the bubble and what created the bubble in the first place. It's a story and a chart. And now we have the story, the chart and the machine, which perpetuates the upside of the chart because it becomes a momentum factor.
And then when it comes down, I mean these things have come unglued. They don't even have to be fraud. They just have to be what I call a rate of change slow down in a growth story that was sold as having unlimited TAM (Total Addressable Market). I'm sure you love that, or this idea of ‘secular growers.’ Of course these companies are ‘secular’ if they've never seen a cycle.
Does it surprise you that our business is loaded with people who are so gullible?
Chanos: I think that humans want to believe. We've had an amazing economy and amazing financial markets in the U.S. We've been blessed and it's paid to be an optimist. But this is why we're long the market and short our companies because on a micro basis lots of things fail. And that's good. That's capitalism. But even further on the scale there are lots of things that fail for reasons that should be obvious to people but aren't. That's the area we operate.
McCullough: I want to get into your revelations on China, which by the way were early and right.
Chanos: Well, it's funny because we get chided a lot, even today, because people say ‘Well you said China would be in smoking ruins by now and it's still going strong.’ Meanwhile it’s been probably the best short you could have had for the last 10 years because every other market has doubled and tripled. China's been flat to down, meaning the FXI, when we started looking at China.
What really intrigued us about China was what we'd seen in previous real estate bubbles. So one of our big calls in late eighties at Kynikos was the commercial real estate bubble in the U.S. The tax laws had changed and people hadn't figured out that the tax law had just put a torpedo into the ocean liner and we're still building and still doing tax shelter deals. And then everything collapsed.
We looked at things like Japan in 1989. We looked at Ireland and Spain in 2007, and what stunned us was the size of the Chinese residential real estate market. To this day it still stuns us in China. It is the biggest real estate bubble in history.
They're still building a 1.8 billion square meters a year of residential, which is 20 million apartments because the average Chinese apartment is 90 square meters. We've long gone past ‘We’ll build it and they will come.’ The rural people won’t move into it because these apartments aren't affordable for people who are moving from rural to urban. They are only being built at this point for speculation. Depending on how you want to figure out the ancillary real estate stuff, it's anywhere from 20% to 25% of their GDP.
McCullough: The October numbers in China, fully loaded, even with the shadow financing loans that they're reporting are horrible. We know they’re making up the numbers. If you're making up the numbers, make up less bad numbers.
Like you've said many times, no bubble or fraud is the same, but the patterns of behavior repeat. Do you think there are similarities to the 90s and Japan versus China today?
Chanos: So I give a talk a few times a year to Chinese bankers. I'm usually up at Yale. At the end of the lecture I put up, ‘Who am I.' I put up “a state driven economic model, heavily reliant on investment in real estate, a protected currency, exporting capital to developing market countries as a way of diplomacy, a managed exchange rate, capital controls, blah, blah, blah, blah, blah.'
And the Chinese bankers always laugh. They think I'm talking about China and then I put up the last side, which is the rising sun. ‘I'm Japan of 1989.’ There are quite a bit of similarities other than democratically elected government. The parallels are interesting if you look at the two side by side.
McCullough: I know there’s one guy who likes to do business in China. Maybe he's going to just move his auto operations there. He's already done part of that. I'll just give you an opening volley on Tesla. What's up with that?
Chanos: Well, the stock price. So I will say that Tesla is and remains one of our biggest and our best short positions. I think there was some speculation on social media about that yesterday. So for anybody watching, we're still bears. This stock has been in a trading range for about five years now. And it's funny, I always try to tell people that at below 200 everybody thinks the company is about to go bankrupt, including Elon. Let's point out that earlier in 2019, he talked about the company being in financial trouble. And then very famously in the spring of 2018, he said they were weeks away from insolvency.
But I try to just point out to people that the company has had enough liquidity even when the stock price was nosediving that they probably weren't imminently going bankrupt.
There's a lot of bears on social media who were prematurely spiking the ball. On the other hand, at 350 bucks, 360 bucks and being taken out at 420, this company is an auto OEM and it is trading at six to seven times all the other auto OEMs.
I posted something just a little while ago showing just how much Tesla looks like the other auto OEMs in terms of margins except for valuation. The rest of the auto OEMs globally are trading in an amazingly tight band of 0.5 times total enterprise value to revenues. And it's been like that forever. It's why auto stocks really don't perform a lot because it's a capital intensive industry and you get a valuation of 50 cents on the dollar of every dollar of capital you raise. Right? It's a problem.
And also, uniquely both on a mean and median basis, global auto OEMs have traded a little bit under five times enterprise value to EBITDA. If you use both of those metrics, either/or, with Tesla's numbers, they have about $25 billion in revenues. They have about $15 billion in net debt, negative working capital, long-term liabilities and preferred minority interest. They have on a best quarter basis, meaning the best quarter times four, EBITDA of $3 billion, give or take. It’s less than that on the latest 12 months.
All of those metrics, you run them through the global valuation model for an auto company and you get a stock price that is interestingly worthless. It's zero. And so what you have with the stock at 350 is simply the market's view on all of the future brilliant products that are going come out of here at amazing margins.
They're just not doing it. I think trailing 12 months operating income, including the sale of tax credits is under $200 million at Tesla.
McCullough: It's terrible.
Chanos: The company has raised equity and net debt of $20 billion in its life. So it has taken $20 billion from investors to get you here and there's no return on the business. Now, will there be a million robo taxis next year? Well, there better be, right? I mean, we can talk about all these future products because on just the core business of making automobiles this company is not worth anywhere close to the total enterprise value of $70-plus billion or whatever it is. And it should be trading of course, much, much lower.
So the problem I think with Tesla is that Tesla was correctly early on this. They made an amazing car with the Model S. I've always said that. The problem is the rest of the world was slow but is catching up.
And you’ve now got Porsche with the Taycon, which is an amazing car, right? And increasingly now you're going to have very good manufacturers in that mid-price sector, which are going to be right at the Model 3.
One of the most interesting things that I think people ignore on the third quarter conference call, well, two interesting things that I want to highlight that are important for the future valuation of the company. The company acknowledged that their Model 3 demand in North America is plateauing at 45,000 units a quarter. That's really important because you've run that through their model of how many cars they sell globally, across the S, X and 3 in the U.S. versus the rest of the globe. You can start to get your arms around what the product profile looks like at best case.
Number two, interestingly, they said that gross margins for the cars they're going to manufacturer/assemble in Shanghai are going to be no better than they are in Fremont. So why the hell are you doing it? What's the point really, given the massive capacity and production capability in China.
So there are a lot of head scratchers here, but I think the reality about Tesla is that it's about the stock, not the profitability of the company. And this CEO is, we know, very promotional and sometimes it works for him and sometimes it works against him. And that's what we've seen for the past four or five years.