Archive for October 2019

Unicorns and the Societal Benefits of Short Selling

I will refer you to my post last December on how much of society seems to hate short-sellers, and on some of the virtues of short selling.

For this post I just wanted to make a more narrow point -- one reason that unicorns (private startups with valuations north of $1 billion) like WeWork and Uber and Peloton had their valuations get so out of whack is because there is no way to short stocks in the private equity world.

Companies like Lyft and Uber and WeWork have seen private funding rounds at ever-increasing valuations.  These are done outside the accountability of the broader market and untethered to any sort of normal valuation metrics like earnings or even revenues.

Lots and lots of investors, perhaps the vast majority of them, believed that the last private round that valued WeWork at $45 billion was insane.  Many folks, including myself, would have gladly shorted the stock at this price had we been able.  Heck, many of us would have shorted back at $10 and $20 billion valuations for the company.  Because there is no short selling in this private equity world, unicorn valuations are +based on information from a very limited number of the most optimistic company supporters.  And because of this faulty price discovery, billions of capital that could be doing something more productive have been wasted in many of these companies, poured into business models that don't work or, worse, the tequila and drug fueled Gulfstream flights of the founders.

As I wrote over a decade ago, short selling broadens the group of people who can "vote" on a company's value

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

I am not advocating some goofy plan to bring short-selling to private equity.  What I am saying is that prices set in markets with a robust ability to sell short are going to be much more trustworthy than prices set where short-selling is not an option.

Sustainability Is Baked Right Into the Heart of Capitalism

A while back I was having a back and forth on Twitter with a Tesla supporter.  They had said that Tesla was the poster child of sustainability, I presume because since Teslas are electric that they are presumed to use less energy and produce fewer emissions.  I learned a long time ago not to try to have discussions with Tesla supporters on energy consumption -- even if the fan in question understands that electricity is not magic pixie dust summoned for free out of nowhere, they seldom understand issues with geographic variability of electrical generation sources or the difference between electrical sources for the average vs. marginal incremental load.

So I just said the company can't be very sustainable because it spends far more than it earns, ie it consumes more valuable resources than it produces (a ratio made even worse if one factors in all the taxpayer subsidies the company consumes as revenue).  The person I was tweeting with replied that this fact had nothing to do with environmental sustainability.

I would argue that financial stability has everything to do with environmental sustainability (though I will admit that this comparison is a bit hard since environmentalists seem to bend over backwards to NOT define "sustainability" very precisely).  In fact, I think that sustainability is baked right into the heart of capitalism.

The reason for this comes back to the magic of prices.  Of all the amazing, wondrous things we celebrate in the world, prices may be the most overlooked.  Just think of it: with no governing structure or top down ruling board, a single number encapsulates everything most everyone in the world knows about a particular product: both its utility and relative scarcity, both now and as anticipated in the future.  It is a consensus derived voluntarily between millions of people who never meet with each other and likely never communicate with each other.

It is amazing to me that people who talk so much about their concern for scarcity tend to be the same folks who ignore prices and even eschew markets and capitalism.  But in prices we have a number that gives us a single metric telling us the world's consensus on the current and future scarcity of any commodity.

We do know that prices can miss some things.  Perhaps most relevant today, they can fail to include the cost of emissions (ground, water, air) associated with that commodities extraction, refining and processing, and use.  But compared to the effort of trying to create some alternate structure for managing product scarcity, this is a relatively simple problem to fix (simple technically, but not necessarily politically).  Estimates of these pollution costs can be added as a tax (e.g. a carbon tax on fossil fuels to take into account climate effects of CO2 emissions) and prices will continue to work their magic but with these new factors added.

Along these lines, Andres McAffee writes about some research work by environmental scientist Jesse Ausubel.  He writes in Reason:

In 2015, Ausubel published an essay titled "The Return of Nature: How Technology Liberates the Environment." He had found substantial evidence not only that Americans were consuming fewer resources per capita but also that they were consuming less in total of some of the most important building blocks of an economy: things such as steel, copper, fertilizer, timber, and paper. Total annual U.S. consumption of all of these had been increasing rapidly prior to 1970. But since then, consumption had reached a peak and then declined.

This was unexpected, to put it mildly. "The reversal in use of some of the materials so surprised me that [a few colleagues] and I undertook a detailed study of the use of 100 commodities in the United States from 1900 to 2010," Ausubel wrote. "We found that 36 have peaked in absolute use…Another 53 commodities have peaked relative to the size of the economy, though not yet absolutely. Most of them now seem poised to fall."

The charts are great and I encourage you to read the whole thing:

Postscript:  Going back briefly to Tesla, if the company consistently spends more money that it takes in, then it means the resources it employs could be used elsewhere more productively.  Talented people who design cars could be using those talents more productively at another car company.  Or defined differently, talented people who are passionate about saving the environment could have more impact working on something else that helps the environment.  Scarce (and environmentally suspect) cobalt and other Lithium ion battery resources could be used to more impact in other applications (many of which also may be to transition the world's energy economy from fossil fuels but do it better or faster).

I Think I Would Prefer to Pay Commissions

Several years ago, a new brokerage called Robinhood successfully began penetrating the millennial market for stock trading with a zero brokerage fee model.  In recent weeks, Fidelity, TD Ameritrade and Interactive Brokers have all followed suit (I have accounts with the latter two).  This sounds cool until one sits back and wonders how these companies expect to make money instead.

We know one way Robinhood does it -- they route consumer stock orders to large companies who pay for this order flow.

Payment for order flow is a decades-old practice that can be traced to the early years of electronic trading. It was pioneered by Bernie Madoff at his regulated securities firm. (He later became infamous for a multibillion-dollar Ponzi scheme he ran on the side.)

Read more: How high-speed traders are transforming the stock market 

Here's how it works: Retail brokers like Robinhood focus on recruiting customers and building the trading interface, but don't actually execute their clients' orders. They outsource that to firmsincluding Citadel, Two Sigma and Wolverine Securitiesthat pay for the right to handle those trades. While orders from large, sophisticated investors can burn the market maker who executes the trade, retail trades are considered relatively safe.

These firms earn a tiny bit of money off each transaction, often 1 cent or less per share. Some see payment for order flow as a critical piece of market infrastructure—facilitating the fast and cheap buying and selling of stocks. But critics of high-frequency trading have long argued that the practice actually hurts the little guy, to the advantage of large firms.

Federal rules dictate that brokers must seek the best execution for clients’ trades, but finding the best price possible is not necessarily a requirement. Consumer advocates say the system creates an incentive for brokers to route orders to the market maker that pays the most.

During last year’s fourth quarter, regulatory disclosures indicated that Robinhood shipped virtually all of its orders for stock trades to four high-speed market makers. The bulk was bought by Citadel, which paid Robinhood an average of “less than $0.0024 per share" on the trades it was routed in that quarter. Those small numbers add up—Robinhood’s users have executed more than $150 billion in transactions.

While companies like TD Ameritrade also accept money for order flow, these payments are far less than the ones helping to keep Robinhood afloat, though that may change now.

I am sure if I bothered to Google search, I could find articles and studies that go both ways as to whether this directed order flow costs a retail investor (in the form of a slightly worse transaction price) more or less than a $5 or $12 commission.  Here is my default on this, and it goes back to the saying that if you don't see the sucker at the poker table, then you are it.  If something is opaque in the financial world, it is not very likely it is breaking in favor of the retail investor.  As such, I would MUCH rather a cost a I see that is well defined than one I do not.

Why You Are Seeing All Those Videos of Teslas Wandering Dangerously Through Parking Lots

As I promised readers of this blog, I have mostly taken my Tesla obsession offline from this blog and, when I need to, scratch that itch on Twitter.  But there is an interesting story developing in the Tesla world that I think gets at the heart of the unseriousness, perhaps even amorality, of its management.  For those of you who follow all things $TSLAQ on Twitter, there is likely to be little new for you here.

When last I blogged about Tesla, it was struggling to still be the growth company that its equity valuation implied.  Last year I wrote a fairly comprehensive take on why I thought Tesla was done as a growth company (I argued, among other things, that Q32018 might be their high water mark -- remember that in a second).  That was intended to be my last post as my kids were worried about my obsessive behavior, but I just couldn't resist posting in May when Musk announced that Tesla was no longer really a car company and would be a robotaxi company by 2020 with a million automated rideshare vehicles on the road.

That was not the end of Tesla news this year.  Since that time it has become increasingly clear what I have said form the very day the acquisition of SolarCity was announced, that that transaction was a thinly-veiled bailout of Musk and his family to the detriment of Tesla shareholders.  And for added bonus points, Tesla was recently sued by Walmart when its SolarCity installations on the roofs of various Walmart stores started catching on fire and threatening to burn the stores down.  And I don't even think I have mentioned on this blog the Musk fake $420 buyout announcement or the Musk "pedo" lawsuit by the Thai cave diver hero.

So obviously I continue to be tempted out of my vow of silence.  And it is happening again.  Several days ago, in fact just before the end of Tesla's 3rd quarter, Tesla released by OTA update a "Smart Summon" feature in its cars, part of a package of autonomous driving features Tesla has promised for years and for which many Tesla owners paid in advance with their purchase (many years ago).

Smart Summon is a sort of automated car valet.  When one comes out of, say, the mall she can pull out the Tesla app, hit a button, and have their Tesla start up and drive itself to them.   Unfortunately, this feature sometimes works and sometimes is a real fail (here and here, for example).  Already people are reporting damage claims to their car when in summon mode, though Musk and his enablers in the hipster media claim its all operator error. This by the way is right out of the Musk playbook:  go on social media and hype Tesla autonomous driving uses that go beyond the terms and conditions, and then defend themselves in court that users violated the terms and conditions (Musk taking his hands off steering wheel in a 60 Minutes show demonstration and Musk retweeting people having sex in a Tesla while in autonomous driving mode are just two examples).

So why would Tesla release what appears to be at-best beta software that could easily lead to people getting hurt?  One reason is that Musk is totally steeped in the Silicon Valley "fake it before you make it" culture, all the way back to Paypal.   Given its paint and reliability issues, the Tesla Model 3 should arguably have been tested for much longer than it was before release, just as one example.  And certainly there was a lot of pressure on Musk as he has been promising this release as imminent for months, and some folks have been waiting literally years since they first paid for the feature to actually get it.

The problem with this is that there is a difference between the consequences of screwing up at Paypal and screwing up with a motor car.  A half-baked Paypal feature might have led to someone not being able to pay for their beanie baby they bought on eBay.  A half-baked summon product can lead to children getting run over (just as a half-baked Theranos product led to thousands of people with potentially life-threatening diseases getting false and misleading blood tests).  At some point there is going to have to be a reckoning of where to draw the line against this culture -- perhaps Tesla will give us that opportunity.

But I (and many others) think there is another reason this was rushed to market.  To understand this reason, we need to put together four pieces of data

  • Tesla has collected over a billion dollars in pre-payments for autonomous technologies like Smart Summon.  Because customers have not gotten an actual product, these sit on its balance sheet and have not been recognized as revenue in Tesla's financial reports.  Releasing Smart Summon could allow Tesla to recognize some of this billion dollars as revenue in the quarter it was released, which happens to have been, just barely, the third quarter.
  • In the third quarter of 2018, Tesla really starting selling the Model 3 in mass.  It had a big quarter as it worked through years of pent up orders, and a profitable quarter in part because it focused all its production on fulfilling only the highest margin variants in the order queue.  Remember what I said above -- because it was blowing through all its pent up orders and selling an unusually profitable mix, I predicted Q32018 might be its high water mark.  Even with record unit deliveries in Q32019, Tesla's revenue and profit is likely to be down year over year.
  • Tesla's stock, while down substantially over where it was a year ago, still trades at sky-high valuations for a company that is a) in the auto industry, which typically trades for very low multiples; and b) loses billions of dollars with little prospect of making any money.  The reason it has such high valuations is expectations of growth that Tesla fans have for the stock.  Obvious evidence of stalled growth could knock a huge percentage of the value off the stock, perhaps even driving it below Musk's margin call price.
  • In the SolarCity story linked above, we found out just how far Musk is willing to go and how many ethical corners he will cut to defend his investment in a failing growth company.

My hypothesis is that Musk demanded that Tesla rush release of Smart Summon, whatever condition it was in, to market before the end of the third quarter so he can book hundreds of millions of dollars of customer pre-payments as revenue in the quarter and perhaps prevent a year over year revenue decline.  Yes, that would be super cynical, but this is the man that essentially faked the solar shingle product in order to get Tesla shareholders to bail him out of his soon-to-be bankrupt SolarCity position.

Trade carefully.  As disclosure I am current short Tesla via long-dated put options.