Via John Hempton in his latest Bronte Capital client letter:
In these months some fund managers we admire have had solid double-digit returns. Also, some fund managers we think are gunslingers destined to drop 80 percent or more have had double digit returns (with triple-digit returns a possibility). This–despite what the averages say–is an aggressive melt-up market.
The real economy is awful at the moment (COVID), but the financial economy is setting bullish records.
There are 3633 words left in this subscriber-only article.
Start your free 14-day trial today!
The averages do not tell the story. Old-time value stocks are not nose-bleed expensive and, relative to bond yields, look outright cheap. We have been buying a few.
By contrast, many quality growth stocks are now very expensive, often requiring a decade of uninterrupted growth to “earn their way” into the current valuation. And garbage stocks and new issues are at levels that even a few years ago we would have considered vanishingly unlikely.
The rise in garbage stocks has been very difficult for us. We short garbage stocks. On the plus side we look at shorting opportunities now and see a “target-rich environment”.Alas, recent experience tells us that the targets can shoot back.
The rise of retail
Rampant speculation in growth-oriented and garbage stocks has had many drivers–but the one that matters most to us is the massive increase in the number, value and confidence of retail investors, particularly online retail investors, often young and with no investing experience or historical perspective.
It is not uncommon to have 20-year-old “investors” ask you about call options. The widespread retail interest in short-dated, highly levered positions is reflected in massive calloption volume in the most speculative retail stocks. Tesla has literally billions of dollars in one-week call options every week, even in the low-volume Christmas week.
This sort of levered speculation in controversial names sharply contrasts with dull markets in the sort of long-haul, established companies in which we like to invest.
How this has hurt us
Historically the biggest driver of our short book–and the driver that has worked best for us–is shorting stocks aggressively promoted to retail investors. We seek to find the most cynical and self-serving promoters who promote fads, frauds and failures to retail investors. But “sold to naïve investors” is a basic tell.
This tell has not worked in 2020. Indeed, it is a way to lose considerable money as a short seller. When you think the retail investors being promoted this new shiny fraud (that they cannot possibly know anything about) are hitting exhaustion, a new wave of newbies–with their Robinhood accounts–comes to bid your short up double or triple.
The biggest retail stock of them all–Tesla–is a stock we have no position in (anymore). But the eight-fold increase in stock price this year has convinced many newer investors that they can do no wrong. If your main schtick is finding the dumbest retail investors and shorting whatever has been sold to them then you have done poorly. This sort of bullish investor may have the intelligence of their bovine counterparts, but a herd of them can gore you.
A tidbit from a fellow traveler
We are not the only ones watching tip-sheets and other stock-promotion newsletters. A keen observer noted that 2020 is the first year in their decade-plus history that a majority of tipped stocks beat the market. Ordinarily, a handful of such stocks double, two-thirds trail the index, and a fair few lose almost all of their value. Promoted stocks with a good story are, in part, the raw material from which Bronte’s short returns are typically made.
…The growth end of the market is euphoric. Of particular note is the euphoria for stocks with so much as a whiff of “ESG,” a Wall-Street-ism for a desirable “environmental, social, and governance” story, with electric cars and their battery supply chain being the foremost example. Further enthusiasm is noted anything China-related with a gloss of technology, speculative gold mines (although that mania may be quieting as Bitcoin supplants gold as the speculative asset-du-jour), as well as certain areas of biotech. In extrema, someone rolling out electric car charging stations, a business that should ultimately be highly competitive and hence low margin, might trade at a hundred times sales.
With the exception of Tesla’s notable addition to the S&P500, these areas of great enthusiasm are not reflective of the broader market indices. Established technology stocks are expensive, but their valuations are less hard to justify. Traditional value stocks have performed relatively badly for years and particularly badly for most of2020, and they do notseem expensive at all. We have bought a few such value stocks and that has–if anything–exacerbated our underperformance.
Europe, outside those trendy sectors, has not produced glamourous returns at all. (Near-zero interest rates, a commonly-heard explanation for buoyant US equity valuations, havenot had the same salutary effect on European shares.) But there are still some fundamentally decent businesses there.
Quality growth has appreciated beyond what we think is rational. Fraudulent growth companies (of which there are many) have been even stronger. Companies with dodgy COVID-19 treatments abound. At the dodgier end of the market, old-fashioned disinfectants reborn as COVID treatments (yes, they kill the virus on contact, but then so does soap) were rewarded with big market caps. Further up the chain we find people with a history of dodgy stock promotion piggybacking on the new hot—but real—thing, namely RNA vaccines. Andthere is money for it: both from shareholders and fromgovernments that have beenspraying around money on anything COVID-related.
Our normal practice of shorting the low-quality end of the market has, lately, been a losing game. And the normal counterweight of being long quality stocks has–with the exception of a few growthy-positions in our portfolio–been a poor offset.
Special Purpose Acquisition Companies (SPACs)
A feature of the late stage of most (maybe even all) stock market manias is a garbage new-issue market. There is a stage in the market cycle when masses of people trip over themselves to buy newly created shares at prices disconnected from reality. The market’s machinery will happily satisfy that demand.
New stocks are thus issued masse. A few are high quality businesses, but many are over-inflated mediocre businesses. And more than a few are outright frauds.
A “junk” market may even be a necessary phase of the end-game of any mania. After all, someone must mop up all of that speculative demand and teach new investors and thedeluded a lesson. If the market is being driven by fools then the sharp will separate the fools from their money.
This time round the mania is in SPACs or Special Purpose Acquisition Companies.
“Blank Check Companies,” so named because investors part with their cash before knowing what they have bought, have along and often dishonorable tradition on Wall Street dating back to the South Sea Bubble and the possibly apocryphal“ Company for carrying out an undertaking of great advantage, but nobody to Know What It Is”. At the late stage of bull markets new stocks are more attractive than old stocks and Wall Street happily provides them.
According to a recent academic paper, SPACs raised as much cash in their IPOs from January through late October 2020 as they had over the entire preceding decade—and the pace seems to have accelerated in November and December.
This time round there are a few extra protections. The typical SPAC is listed at $10 with“free” warrants granted at $12.50. The promoter receives as much as twenty percent of the issue for,well, being the promoter.
The $10 sits in a trust account (earning roughly zero) until a deal is done whereupon shareholders get to vote on the deal. If they vote “yes” the deal is consummated. If they vote “no” then their $10 is returned. Initial backers of the SPAC thus get a “free option”: they will vote “yes” if the SPAC is trading above $10and “no” otherwise. Reputable funds are regular buyers of the SPACaswhat hedge fund does not want a “free” option.
The promoter’s carry can be large. If a SPAC raises half a billion dollars (well within the range these days) the promoter’s carry can be worth a cool hundred million dollars. Often, theyget to cash a fair bit of it.
Unsurprisingly SPACs are being assembled by the full pantheon of Wall Street characters from the highest quality executives and fund managers to people we think are organised-crime adjacent. The latter of course will use the cash raised to buy rubbery assets from undisclosed related parties. In the old days of China stock fraud for instance, management had to convince gullible investors to buy their stock. Now they just“convince”the SPACtheyalready control to buy the rubbery business.
It may be even worse when highly reputable fund manager controls the SPAC. The payoffs are enormous–especially for a merger with a company in a hot sector. An “idea” on how the company might develop an electric car for instance commands billions of dollars in a SPAC merger, tends to drive the SPAC shares up and the promoter gets rich beyond avarice. Even the fund managers with the best records (and reputations for integrity) seem to like that. A few are cashing in their reputations.
This will end badly. Maybe not for every SPAC–but badly overall, and badly on average. We would like to think (and will return to this later) that the SPAC boom is the last stage of the long bull market since 2009. But there are no guarantees. And we debate it internally. The IPOs at the late stage of boom are normally all terrible. The companies that IPO’d in the year 2000 are as pustulant a list of failures as have ever been foisted on Wall Street. Per a a2002 copy of the organ Stanley Technology IPO Yearbook, of the 204 technology companies that went public in 2000, by 31 December 2001 only 30 had appreciated from their IPO price and many had collapsed by more than 80%. This time round there are plenty of festering pustules to be found–but interspersed are some quality companies (such as AirBnB) at prices that reflect their quality3. Whether that says there is more bubble to behad is yet to be seen.
An extreme example of where we are
We can’t let this pass without an extreme example–taken from a tweet–as to the state of the market. This is a direct quote from a famous venture capitalist, whose record is extremely good. He later turned SPAC promoter and has pocketed literally hundreds of millions of dollars. And it says everything about this market.
Eventually, stocks can trend back to 10-20x sales, but when you’re trading 30-80x, it’s incredible opportunity to aggressively expand/consolidate a market. These capital allocation decisions tend to be the hallmark characteristic that separates great CEOs from everyone else.
To an investor from another era–even someone who like Scott McNealy who was tartly realistic about the nature of bubbles–this quote is otherworldly.
There are plenty of precedents for this sort of market. But history only rhymes; it does not repeat.
We could write a book about the speculative morass of past cycles. But we do not need to.Our bookshelves are full of them.
Moreover, we suspect for the most relevant rhyming history, we must go back a few market cycles. We are not about to repeat the mortgage bubble and denouement of 2008. It is too recent in memory. We recall instead the great “blank check company” craze of the 1970s asvery few people remember that now. And so John found himself rereading the Go-Go Years, John Brooks’ excellent history of the 1960s on Wall Street.
John read it the first time in his twenties (fully a quarter of a century ago) and had alas forgotten some of the lessons.
Some of it was quaint. You had to add zeros to all the numbers. Numbers were between 1.5and 3 orders of magnitude too small, with large changes in relative values. It was a true scandal with national significance for instance when someone was bankrupt to 15 million dollars. (A good Monet was repossessed with a value of $75,000. You could easily add three zeros now. Telling us about relative values though Fragonard’s“Portrait of a young woman”was repossessed for considerably more than the Monet.)
Some of the hot stocks of the era actually earned their way to respectability. Motorola has gone now but was hot then and remained so well into the new millennium.
But most of the hottest names disappeared.
We should make a few further observations. The averages (usually in those days the DowJones) went down but they never collapsed. The mania was not in Dow stocks. It was in the hot sectors of the times: electronics companies, tech companies such as Polaroid, and financially engineered conglomerates. The mania stocks dropped well over 90 percent with the rubbery ones dropping 100 percent. They were held by retail either directly or through gun-slinger aggressive mutual funds sold to retail.
If you shorted those stocks on the way up, you were gored. But if the positions could be maintained, our strategy would have enjoyed a golden era as the market dropped maybe 30percent while the hot sectors fell 90 percent or more.
There were several quotes that read utterly true.This from Chapter One for instance leaves us speechless:
Before the crash in 1929 the financial sages had insisted repeatedly that there couldn’t be another panic like that of 1907 because of the protective role of theFederal Reserve System; before the crash of 1969-70 a later generation observed repeatedly that there couldn’t be another panic like that of 1929 because of the protective role of the Federal Reserve System and the Securities ExchangeCommission. In each case, a severe market break had taken place about eight years earlier (in 1921 and 1962, respectively), followed by a period of progressively more unfettered speculation.
This sounds familiar, and yet we cannot see what breaks the market’s faith in the protective role of the Federal reserve system—despite that belief having obviously failed to protect investors in prior bear markets.
While the explanations seem quaint, the book also (repeatedly) described the sort of scenario that is anathema for our strategy. For example:
By the end of May (in this case May 1962 but to be repeated in 1969) the blue chip averages were beginning to lose ground–evidently because people were digging up their old certificates out of bank boxes, selling them and putting the proceeds into the new issues market”.
This situation where stable companies are being sold to finance junk is a repeated late-stage market phenomenon–and one we have seen this year. There is also a description of a company which sounds like a traditional Bronte short–but where the stock goes up:
Goaded by stock underwriters eager for commissions or a piece of the action, owners of family businesses from coast to coast–laundry chains, soap-dish manufacturers, anything–would sell stock in their enterprises to the public on the strength of littlebut bad news and big promises. In conformity with the law, the bad news would bespelled out in the prospectus: the company had never made any money and had no real prospects of making any; the President had a record of three business failures insuccession; the competition had the market for the company’s product all sewn up;and so on. But the effectiveness of warnings is limited by the preconceptions of thosebeing warned, and the stock would be snapped up, leaving the underwriter with his easy commission and the owner of the company with more cash than he had everseen before in his entire life. To top it all off, the heedless buyers of the stock would come out ahead to; they would ride it up…
To this we would add two further laments:
1.the firm’s President not only had a record of three business failures in succession, atleast one of them we would think on good reason had been a fraud.
2.not only would the heedless buyers of the stock come out ahead, riding it up, but thedopey short-sellers of the stock (us) would lose because we bothered to read aprospectus. (One of famed value investor Sam Zell’s favorite aphorisms, he has said,is “We suffer from knowing the numbers.”)
It would work out all right for the shorts in the end provided they could hold on.
The final denouement of the book also has a quote for the ages, from Bernard J (Bunny)Lasker, the then-Chairman of the New York Stock Exchange. He describes the scene after avast proportion of the exchange’s member firms have gone bust, and in which he and FelixRohatyn had managed to organize shotgun weddings for many of the failures.
As Lasker said in 1972.“I can feel it coming, S.E.C. or not, a whole new round ofdisastrous speculation, with all the familiar stages in order–blue-chip boom, then afad for secondary issues, then an over-the-counter play, then another garbagemarket in new issues and finally the inevitable crash. I don’t know when it will come,and I can feel it coming, and, damn it, I don’t know whatto do about it.”
This really does feel familiar except that the over-the-counter play doesn’t really applyanymore. And despite vigorous internal discussions, we are not really sure whether we areon the first or the second garbage market of this cycle.
But there is one further warning for us ofThe Go-Go Years: it is entitled Go-Go Years and not the Go-Go Six Months. These cycles alas are longer than our monthly cycle at which we report to you. And we might need to manage the mania for quite a long time yet without succumbing.