In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and Spencer Jakab discuss:
- GameStop Mania: What Went Wrong
- Investment Insights from Mimicry in the Natural World
- Proxy Statements: The Key to Honest Investment Signals
- Navigating the ‘Q’ Designation and ‘Greater Fool’ Theory in Investing
- Cash is King: How Stable Capital Structures Define Reliable Businesses
- Melvin Capital’s Losses: Poor Risk Management or Illegal Activity?
- The Evolution of Mischief: How Small Investments Can Cause Wall Street Chaos
- AMC’s Surprising Survival: How Meme Stock Traders Rescued the Chain
- AMC’s Unorthodox Stock Tactics: The APE Preferred Stock Saga
- Understanding Naked Shorting and its Impact on Stock Markets
- Short Interest Reporting Changes Amid GameStop’s Market Turbulence
- Costco’s Modest Approach: A Lesson in Effective Business Management
- The Power of Buyback History and Unemotional Rebalancing
- Maintaining Integrity in Financial Reporting: Spencer’s Take on Sourcing and Ethics
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: We are live. This is Value: After Hours. I’m Tobias Carlisle, joined, as always, by my esteemed cohost, Jake Taylor. Our special guest today is Spencer Jakab. He’s the editor of the Wall Street Journals, heard on the street, and he’s got a book out. He’s talking to us about GameStop, Roaring Kitty. How are you, Spencer? Good to see you.
Spencer: I’m good. Thanks for having me. It’s great to be with you, guys.
Jake: Welcome.
Tobias: So, the book is called The Revolution That Wasn’t. Why is it called the revolution?
Jake: Spoiler alert. Hold on.
[laughter]Tobias: You told us how it ended.
Jake: Yeah.
Spencer: Yeah. I think I failed Book Marketing 101 with that one, or the editors at Penguin Random House did. If it wasn’t, then why am I reading this? But that describes how this event was perceived and what it wasn’t, which it wasn’t a revolution. Journalists are accused of getting carried away with things. They also said that we write the first draft of history. The first draft was not really correct in this case. The 80% to 90% of the of breathless coverage of that initial meme stock squeeze was that they had turned the tables on Wall Street, that things would always be different, that social media had changed the way things work, and that Wall Street had been given a black eye. That just is not the case at all.
I think every mania tends to extract wealth from the masses and transfer at least some of that wealth to Wall Street. Wall street writ large, and this one did too. That’s something that people continue to not understand or don’t want to understand about this episode. It’s a fascinating story. It’s interesting for many, many reasons. I hesitate to say that some financial episode was different than all the ones that came before it. But so many things had to happen for this meme stock squeeze to occur. And so, it was a real moment financially and just generally in history, but it wasn’t the revolution. In that sense, the title is correct. It’s just not [chuckles] maybe not marketing pixie dust.
Tobias: [crosstalk] seem very high-profile scalps though.
Jake: Yeah.
Tobias: Melvin Capital seemed to have been taken down by GameStop at least.
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GameStop Mania: What Went Wrong
Spencer: For sure. Yes. Investing to some extent is a zero-sum game. They got zeroed out almost. They lost close to $7 billion, this previously very successful hedge fund. There were other people who got blown up on Wall Street. So, I’m not saying that there weren’t some very substantial losses as a result of the meme stock squeeze and GameStop mania. What I’m saying is that Wall Street is comprised of lots of different people. Most of the money on Wall Street is earned through fee income, through processing transactions, and just holding other people’s money, and writ large. Wall street made a ton of money in the run up to this event, during the event, and following it, because you had all these young people–
It was mainly young people rush into the market with their money and lose lots of it. Even if they individually didn’t all lose money, because many people did make money or on paper are still sitting on gains. It was a very profitable event for wall street and for corporate insiders also, which is something people forget. People who just were really in the right place at the right time had some stock options, were sitting on the board of or in the C suite of these companies that were slowly going down the tubes, and all of a sudden, lightning struck, and they walked away with a lot of money when they didn’t expect to.
Jake: Yeah. So, how did the little investors end up losing money? They just kept overpaying for shares of GameStop, let’s say. Or, was it options that ended up going expiring at zero?
Spencer: Well, the whole episode really, if you want to get back to its origins, begins with the pandemic, which emerged about a year earlier. Not quite a year earlier. Every brokerage in late 2019 went to zero commissions in the United States. Then in early 2020, you had the pandemic and you just had a rush of young people. More than 10 million accounts opened. Mainly, places like Robinhood, but also E-Trade, Fidelity, Schwab, eToro, what have you. A bunch of people who previously had not been interested in finance suddenly were very interested in it.
There were many reasons for that. Part of that was just boredom. Part of that was that they had stimulus checks or other enforced savings with which they could invest. They were stuck on their phones for many hours, especially in the early part of the pandemic. Sports gambling had taken off. Suddenly, all sports were off the air, and they were looking for some other outlet. We’re talking really males between the ages of 18 years and 35 years were the kind of the Vanguard of the group that sent GameStop to the moon. They began doing all kinds of what you and I might consider dumb things with their money, with their investment accounts. And those dumb things turned out to be pretty profitable for a brief while.
If you look at, for example, ending in the month of the GameStop squeeze and beginning that March of 2020, or rather April of 2020, an index of unprofitable companies maintained by Goldman Sachs, it was up almost 300%. So, the worst stuff did the best. You had Warren Buffett, who obviously has a fantastic long-term track record, being spooked out of airlines. He dumped airlines close to the bottom. In terms of managing risk, probably it was the right move. In hindsight, it wasn’t the right move. You had an index of airline stocks jumping almost 100% in the following three months. So, all the things that people who their parents and grandparents may have respected the talking heads on wise gray hairs saying you should and shouldn’t do.
Doing the opposite was very, very profitable. And you had a bunch of new influencers emerging on the scene and telling people to buy Hertz, because even though it was bankrupt. Basically, everyone agreed and it wound up actually making money, but everyone agreed it was worthless. And people plowed into Hertz, doubled or quadrupled their money in a matter of days. All these reckless things made a lot of money. The peak of that was GameStop mania. So, I guess, I’m not talking specifically about GameStop. GameStop went from a $4 stock prior to the pandemic to as low as being a $2 stock. To being a $4 stock, call it the summer of 2020, when things started to percolate to a $483 stock.
There are some people who made money, and it’s still adjusting for splits and things like that. It’s still above where it was for various complicated reasons. Some of them just purely psychological, not financial, because it’s continued to lose money. It’s been through, I guess, now seven CEOs since our story begins has not– [crosstalk]
Jake: Wow. [laughs]
Spencer: -penny of profit, but the stock price is higher. So, I guess, if you bought early in the mania and then held on and that was part of the ethos was just holding on and never selling, you’re still up. Certainly, people who got in and were very cynical and then sold at or even slightly after the peak made a ton of money. I’m talking about the bulk of people who got involved in this. I have three sons, all in the age cohort that would have been doing this, ranging now from 17 years to 24 years, who got excited about the 17-year-old is too young to have their own brokerage account. But there were people who did it. Certainly, 24-year-olds were in the sweet spot. I know that their friends were in it. Some of them made money. A lot of them lost money.
The people who heard about it on social media, the week that this thing became a national sensation, the week that GameStop became the most traded security on planet Earth. [Tobias laughs] Most of those people lost money, especially the people who saw it as a cause, who said, “I’m going to put my little bit of money into this thing and I’m going to hang on and never sell, because this is the way to hurt- [crosstalk]
Jake: Sticking to the man.
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Melvin Capital’s Losses: Poor Risk Management or Illegal Activity?
Spencer: -these short sellers.” They lost, for sure. They’re down quite a bit. So, yeah, it’s not a monolith. As a group, perhaps, they made money. Melvin Capital’s loss was more than GameStop because anything that was a bad stock– He was not a pure short seller. Of course, he ran a long-short fund. He was net long and he traded consumer and retail stocks. The rest of his portfolio also did very poorly because the things that he was long were pummeled, and the things that other stocks that he was short went through the roof.
Nowhere in his risk management did this show up. What’s the worst thing that can happen? You’re short a stock– Let’s say, I think he entered into the short position at $20, right? He was one of the first shorts that he opened. The stock went down as far as $2. He saw it going to $0, so he never closed out, and he increased his short position as it rose. What’s the worst-case scenario is that, someone shows up and buys this for $8, for $10? That’d be a very bad day for you if you had a big-short position in a stock, but you don’t see something going to $400. There’s no way that that happens.
I think that it is his fault, because this was being talked about openly on social media. And so, what really struck me initially about this, and I sent an email to the acquisitions editor at portfolio, which is the imprint of Penguin Random House that published my book. I said, “This is a stock corner or an attempted stock corner that has not happened for almost 100 years since securities laws were written.” I think this is completely legal because I’m reading about this on social media, and they’re discussing it openly. They’re discussing the most efficient way to do it, which is a gamma squeeze. They’re talking about all the strategies openly and who they’re going to screw over. Because it was a few hundred thousand people doing it out in the open, all documented. I don’t think it was illegal at all, whereas if you two got together and discussed it over the phone and did it, you would getting– [crosstalk]
Jake: We’d be the Hunt Brothers.
Spencer: Yeah.
Jake: [laughs]
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Tobias: Spencer, just let me do some shoutouts. I always like to shoutout where our listeners have come in from. Santo Domingo, Dominican Republic. Dubai. What’s up, Samson? Brandon, Mississippi. Porto de Mós, Portugal. Congratulations. Petah Tikva, Israel, Israel. Hope you’re staying safe. Mérida, Mexico. Surrey, Canada. What’s up? Savonlinna, Finland. Good to see you. Copenhagen, Scotland. London. Wildwood Crest, New Jersey. Kennesaw, Georgia. Leeds, UK.
Jake: Yeah, worldwide.
Tobias: We’ve got a few more here. It’s quite a few.
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Jake: We’ll get a quick little veggie segment. Just short out of the way here. Supposedly, anteaters, obviously it’s in their name, they eat ants. That’s how they get sustenance. But apparently, a swarm of ants can organize and swarm the anteater so much that they actually suffocate the anteater by crawling into its nose and breath passageway. So, do you think that’s a reasonable analog of these little smaller day traders who are trying to be the little ants that are swarming the Melvin Capital anteater?
Spencer: Yeah. I think that’s a horrifying image in my mind right now, but I think that’s actually a great analogy. I wish I had thought of– I didn’t know that that could happen to anteaters, but I guess why not. You’re right, because it’s a great analogy in the sense that you get your sustenance from this stuff. And then in a freak occurrence, you can be destroyed and die, which is what happened to Melbourne Capital. After my book came out, Melbourne Capital finally shut its doors and went out of business. You think about what you do as–
Well, whether you’re just a long only investor, but certainly if you’re a long-short investor, you’re trying to find securities that are mispriced. If you’re long-short, you’re looking for securities that are mispriced on the other side where people just have too much hope and something’s a fraud or just going to go bankrupt. GameStop wasn’t a fraud at any point. It just was a doomed business model. GameStop, at the time that these events occur, for those not familiar with it and don’t have teenage boys or sons in their young 20s, it’s a place I visited a lot with them. I drove them to GameStop a lot. It’s something that it takes on a special resonance for the group that led this, because they had this kind of cartoon villainish view of hedge fund managers as being evil. This is the Occupy Wall Street generation.
This is a generation whose formative financial experiences before they ever had any money to invest was their parents, or their parents’ friends losing money, perhaps losing their homes during the global financial crisis and the housing crisis, the housing crash. They also grew up going to GameStop. If there were men in this country, GameStop was a place where you took your old games and traded them in for new ones. That’s how they made most of their money. Actually, they don’t make it very much money selling you a PlayStation 5, because anybody can do that, and you know what the price is, and you can buy it from Best Buy or buy it online. They made a lot of their money from analog games that were on cassettes or discs. People bought them, bought used ones, brought in the old ones they were no longer needed, and they got completely fleeced, as my sons did on a regular basis, [Tobias laughs] and they made 40% margins on that.
When a business becomes digitized, as video games did, and I know this from my sons, they would just say, “I’m not going to go and buy this. I’m going to buy it online right now. It comes out at midnight, comes out at 12:01. I’m buying it at 12:01,” and they’d stay up until 06:00 in the morning playing a game. They didn’t need to go to any GameStop physical store to buy it. It was great for the video game publishers because there’s no middleman, there’s no margin to give up. There’s no physical media to ship. You can’t then go and trade it in and then have someone else forego paying for that physical media. It’s not completely, but very heavily digitized form of entertainment.
So, if you’re blockbuster when streaming is rising, that’s very bad news for you. And if you’re GameStop when digitized video games are on the rise, that’s very bad news for you. And so, I think Gabe Plotkin was correct in his analysis of this company circling the drain. He had not made money in years, but he made a huge miscalculation. Right in the book, I happened to know that people at his fund were aware that it was being written about on social media. They just didn’t take it seriously. They didn’t think that there was anything to worry about with these people. So, this is a very long answer to your anteater analogy, but he thought instead of being a $4 stock, it was a $2 or a $0 stock at best. And so, there was more juice to squeeze out of it, and he failed to recognize the risk. One part of the risk should have been very obvious to him, which is that the net short interest as a percentage of the float rose as high as 140%.
Jake: Huge.
Spencer: So, that should have given him pause, not what he read on social media, it’d be like, “Okay, this is getting a little rich, and I could lose a lot of money.” But it was such a small position in such a large fund that I guess he thought that he could ride it out. And obviously, that’s not what happened.
Tobias: What is funny is, it was small–
Jake: Oh, Toby went into the matrix. I have a question while Toby’s getting back in. I’m reading still about zero-day expiry that are still happening even now. Is the story completely finished yet, or we still have some other things to go here? [laughs]
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The Evolution of Mischief: How Small Investments Can Cause Wall Street Chaos
Spencer: No, it’s not. So, whenever you have something– Let’s say, you read about– I’m trying not to be condescending, but this is going to sound a little bit that way. You read about some teenagers doing some dumb prank online, you see 5 or 6 or 10 copycats of it all over the country. Let’s say, it was some epic stunt. The next five don’t quite work out that way and often [Jake laughs] blow up in people’s faces. And so, there have been many, many echoes of this. People using some of the same tools to recreate it. And so, there have been a lot of– Bed Bath & Beyond is the perfect example. Unless you got out, you are at zero in Bed Bath & Beyond.
Certainly, if you bought call options, you probably lost money, because you usually do lose money buying call options. But people tried to replicate to use the techniques learned in this, which were discussed openly in the message boards to create a gamma squeeze. Not necessarily zero-day options, which are more recent development. They existed then, but the equivalent of zero-day options, right? You had options that were expiring in a few days or in a week. You get the most bang for your buck if you want to make a stock go up. If it’s a $5 stock and you buy a $10 strike call maturing in a week, any options dealer will gladly sell you that, but does not even need to hedge at the time that they sold it to you. The chances of it being in the money are infinitesimal. You’re just wasting your money. But the price of purchasing those calls is also tiny. So, it’s just pennies that you’re losing. That’s of course part of the whole strategy.
Then the more volatile stock is and the more that you have meme stock traders in it, the more expensive it gets. That’s why it actually got more expensive to execute these gamma squeezes later on. But as you get closer and closer to the option being in the money, even if there’s a very small amount of time left, the options dealers need to use their own money. They’re not losing money, but they need to use their own money to purchase the stock. There’s a formula that tells them how much they have to purchase. Even when, let’s say, that $10 stock is at $10.50 cents, they’re not completely hedged in the stock, but they’ve gone from owning none of it to owning quite a bit of it when all they received was pennies. And then they close out that position as soon as the option has expired.
So, it’s like a weapon of mass destruction. I know I’m stealing from Warren Buffett who called derivatives weapons of mass destruction, but it’s like a suitcase nuke or something where you’re taking something that’s very small and innocuous and cheap and not very sophisticated and you’re using it to create mischief. You’re not necessarily going to make money, because you’re probably going to lose money. Your expected payoff is really low, but that’s not why you did it. You did it to create mischief. And so, that’s something pretty new, right? That is something that did not exist before, where the whole payoff to these people was psychic in terms of the damage that they caused to some cartoon villain out on Wall Street who was shorting this thing.
They conflated shorting a stock with trying to destroy a company, which are two different things. They want to destroy this company. That’s part of your childhood. How dare they do that? Those greedy bastards. I remember what happened to my parent’s neighbor, lost their home, and that was hedge funds too, and let’s have some fun and ruin their day, and cost them a few billion dollars. So, it was all a lot of fun. For the vast majority of people who participated, it wasn’t very profitable exercise. The options dealers loved it. The amount of turnover even today is far higher than it was. It’s a casino basically, because your expected return is negative in purchasing calls or puts as an individual investor, for sure, because the bid ask is really wide. We could discuss. I’m sure you and most of your listeners understand that, but- [crosstalk]
Jake: The friction is hard to get over.
Spencer: -don’t speculate on options. Don’t do it. Yeah.
Tobias: Yeah. They say sell vol until you ball. Sell vol. Don’t buy vol.
Jake: Until you ball. [laughs]
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AMC’s Surprising Survival: How Meme Stock Traders Rescued the Chain
Tobias: That revolutionary fervor, you say that the revolution wasn’t, but I certainly see that revolutionary fervor in lots of other names besides GameStop. I think that the crowd started in GameStop, but they’ve moved on to other things. I don’t know if you follow AMC at all. I don’t really follow it closely with–
Spencer: [crosstalk] the goings on there. Yeah.
Tobias: It’s such a strange place to have made the stand. Do you know what I mean? They’re in there expecting this mother of all short squeezes to occur at some point. I find it a little bit hard to look away every time I see it. I want to get an update with what these guys are doing, but the tape in it is terrible. The price is down so much. I don’t know. It would really have to be the grandmother of all short squeezes at this point, get back to break even. Do you feel like that’s the same attitude that we’re going to stick it to they, whoever they are?
Spencer: Yeah. Except in the case of the mother of all short squeezes, it’s based on– You take two or three facts that are actual facts some financial information that’s available to the public or available for a subscription through FactSet or whatever, and you conflate that with there are counterfeit shares and these hedge funds haven’t closed their positions. For those not au fait with the mother of all short squeezes also, this goes by the acronym MOASS. Go on the internet and do hashtag M-O-A-S-S and read away, but don’t buy it.
[laughter]Spencer: So, it just takes a few facts that are true, and a few conjectures which are not true, and conflates into like there’s this gigantic payoff that’s going to bankrupt all these big hedge funds because they haven’t closed their short positions in AMC, which is a movie theater chain. AMC went up a whole bunch during the same time that GameStop went up. There were seven stocks or eight stocks, 13 in all, if you want to really broadly define them that were meme stocks, but seven or eight. What they all had in common was they were all these relics of the recent past that were really either hurt by their faulty business models or hurt by the pandemic.
You had BlackBerry. Before the iPhone took over, the maker of the leading smartphone maker. You had Bed Bath & Beyond, which was putting Amazon out of business, and that was out of business. You had GameStop, of course, and you had AMC and a few others. You had a wired stereo headset maker and a bunch of other stocks. What they all had in common was people just did a scan on Yahoo Finance or whatever, and they saw what had very heavy net short interest, and so they started picking on those. They tended to have those in common. AMC was the place where, of course, all these people went to go see all the Avenger movies and whatever. And so, that was also a business being put out.
But AMC, the difference there was that the people who were in the management of AMC embraced this movement. And so, Adam Aron, who is still the CEO of AMC, was really bailed out. They were months away from bankruptcy. They had a bunch of converts that were headed to zero. They had taken on very, very unfavorable debt during the pandemic, and they were just breathing their last breaths. They’re not profitable today, but they have been recapitalized to a large extent because of the meme stock traders. And so, people ask– How is GameStop too to a lesser extent. “How are they still going if they were businesses that were supposed to be going bankrupt?” Part of the answer is that they recapitalize themselves. If you want to talk about it later, we can put Tesla in the same bucket. Tesla-
Jake: The equity issuance.
Spencer: -three years or four years ago—Yeah. If you have a very high stock valuation, but you’re running out of money by making people believe or creating a kind of cult status around your stock and then raising money at that unrealistic valuation, you can do it again and again, and you can turn yourself. It doesn’t necessarily make that investment that people made at that very rich valuation a good investment. It usually doesn’t, right? If you sell overpriced stock to people, the people who bought the overpriced stock are not going to be happy. Well, they might be in Tesla’s case, if they sold today because it turned out to be a good buy. But AMC is the poster child for that. It’s also a poster child, in my opinion, for executives just being in the right place at the right time.
Adam Aron, my math might be wrong, but I think he’s personally sold about $94 million in stock, either sold or given to relatives, $94 million in stock. He has a lot more to sell. They got to the point where they couldn’t raise more equity because they had no more authorized share capital. They were- [crosstalk]
Jake: We need a board vote. [laughs]
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AMC’s Unorthodox Stock Tactics: The APE Preferred Stock Saga
Spencer: -on that front. And so, with a bit of financial engineering, they launched and the people who were in the stock are called Apes. They call themselves Apes. They launched- [crosstalk]
Tobias: Apes together, strong.
Spencer: Yeah. Apes together, strong. They launched preferred stock, which they did have. The terms of the preferred stock, the special class of preferred stock were economically identical to their common stock, but it was preferred, and they could sell much more of that one, and that had the ticker APE. Inexplicably for a long, long time, APE and AMC traded at a very wide gulf. Jim Chanos, the short seller, actually, and I’m not sure where that stands today. APE doesn’t exist now, but there was a long period of time where APE and AMC, despite being economically identical, because all the people who owned it didn’t know what they were doing had a very, very wide spread from each other. But that didn’t matter. That was all part of the plan to recapitalize the company.
Normally, you’d think if you have any kind of fiduciary duty, you have two classes of stock that are economically identical. Am I going to sell and dilute my shareholders by selling the much cheaper version of that equity? Well, it doesn’t really seem like a totally upstanding thing to do, but that’s what they did, because that was the security that they could sell to stay in business. And now they’ve unified the two classes of stock. And so, there’s way more shares outstanding than there were at the time of the meme stock squeeze, and that company probably will live to fight another day.
They have enough stock to keep going. Of course, the pandemic is– well, I guess technically we’re still in the pandemic, but the acute emergency phase of the pandemic is over and people are going to movie theaters again. And so, the real cash crunch period is behind them. But it’s a crazy story with many crazy chapters. MOASS, look it up and [Tobias laughs] don’t take it too seriously.
Jake: Careful.
Spencer: I get a lot of hate mail whenever I raise it in a tweet or in an article.
Tobias: I didn’t know they could read.
Spencer: [crosstalk] Wall Street Journal and sister publications. If they write about it, they get cyberbullied, basically, by people who– I don’t know, I think it’s not nice, but it’s the QAnon of finance, I guess, is what someone called it. I think that’s not–
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Navigating the ‘Q’ Designation and ‘Greater Fool’ Theory in Investing
Tobias: It’s not far wrong. One of the other interesting things that happened through that period was anytime a company went into bankruptcy and it got the Q on the end of it, it was like a seal of approval.
Jake: [crosstalk] [laughs]
Tobias: Yeah. [laughs] When Hertz got the cue, it went absolutely bananas. Did you follow Hertz?
Spencer: Yeah. The crazy thing there is because it had happened before. So, imagine, you’re a young person and you heard about a friend or a friend of a friend or you read online, someone who doubled or quadrupled their money when the stock got the cue. Not all cues are created equal, right? There are some stocks in bankruptcy where there is some recovery, where you can make money if you have a very sophisticated understanding.
Jake: Is Q for quality? Is that what the–?
Spencer: No, I think that that–
Spencer: Oh, okay.
Spencer: I think that might not be it. But obviously, there are many companies where it is very clear that you’re not going to recover anything that this thing still trades, but you’re not going to make money. But it doesn’t matter. If you bought it at a buck and sold it at 2 bucks, you made 100%. The poor guy, the kind of the greater fool who bought it at 2 bucks maybe, he or she sold it at 3 bucks and made 50% and so on and so forth until someone got left holding the bag. It’s just like someone winning the lottery. Mathematically, I think the vast majority of people, it’s not right to call the lottery like a tax on numeracy, because I think most people understand that the expected return of a lottery ticket, a Powerball ticket is negative, but they still buy it because they read about someone who made a lot of money and they want a dream. They think that-
Tobias: It’s their hope.
Spencer: -it’s lucky this time. And so, I think that greater full– That is the saddest thing about this whole episode and all the kind of echoes of it is that the young people who have gotten into investing, I view it as a good thing because young people were not interested enough investing and having brokerage accounts and having starting 401(k)s or IRAs or what have you before this. And now they got into investing, but too many of them view this—
First of all, they view it as a get rich quick and greater fool theory, which is obviously not the path to riches. You’re going to be a net loser as a group doing that, because you do need a greater fool, and the greater fool is when things are really elevated is definitely going to be coming from that cohort. It’s not going to be coming from some hedge fund. So, you need someone to lose in order for you to have that walk away with that gain.
But the other thing is that then there are all these MOASS and other conspiracy theories where they blame some shadowy cabal of being behind their losses rather than their own stupidity and greed, and then they just get disgusted with investing with Wall Street. And what’s the most expensive thing? If you lose $500 or $1,000 when you’re 23 years old, it’s not that big of a deal. You lost $1,000. So what? In terms of tuition, that’s pretty cheap, if you wake up.
I do know people and you probably do know people too, who made dumb financial and investing mistakes and said, “You know what? I’m going to just follow the straight and narrow and maybe buy a book, or watch and Acquires Multiple podcast, or whatever and understand–”
Jake: No, they’re trying to make money, sir.
[laughter]Spencer: Understand what the long-term formula is for success over decades. That’s a good thing. But unfortunately, that’s going to be a small minority of the people who got caught up in this thing. I think also a small minority get wrapped up, and it’s a really small vocal group of people who believe in MOASS and what have you and think it’s a conspiracy. I don’t think that’s that many people, either tens of thousands maybe, who are really obsessed with this. The remainder, I think, are just going to be disillusioned and say the stock market is rigged and it’s not for me and I’m going to, I don’t know, buy cryptocurrency or not save or not set up an account. That measured over decades is going to cost them a lot of money, the fact that they’re not multiplying their wealth.
You can add up your wealth. You can put your money in a bank account, and addition will only get you so far. It’s multiplication that gets you a big NASDAQ and compounding and they’re going to forego that, which is really a shame. And so, that I think is the saddest, most expensive outcome of this ethos that emerged the last few years among the newest investors.
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Understanding Naked Shorting and its Impact on Stock Markets
Tobias: What do you think about naked shorting?
Spencer: Well, so, naked shorting became much more difficult. Naked shorting, to be clear, is shorting a stock without locating a borrow. So, you can sell a stock short pretty easily, but if you’re a hedge fund or whoever, you need to locate a borrow. There was not a lot of naked shorting that went on during this episode, because it has become much more difficult because of regulation SHO. But naked shorting did occur and it happened because of something I don’t want to bore you, put your viewers to sleep, but the details, something called rehypothecation, which is that imagine that you have a hedge fund and you located a borrow and you shorted a stock that you thought was going to go down in value, you sold it to someone–
There’s a buyer on the other side, and that buyer has it in their brokerage account, and their broker then says, “Hey, there are some stock shares here, and this stock that I can make a lot of money lending out, I’m going to lend it out to someone else,” and it gets lent out twice. And so, that’s how you get to 140% net short. It shouldn’t happen, but it does. It’s not a shadowy conspiracy. Of course, it shouldn’t happen. It’s a clerical issue more than anything than an evil plot to drive shares to zero. Again, I just want to emphasize that if you find a company that’s overvalued, or perhaps fraudulent, or there’s a lot of red flags about it and you sell it short, you’re not destroying the company. You are making a bet against the company. It’s two different things.
But as a matter of fact, there’s a great study that came out in the early 2000s. I apologize, I’m forgetting the author’s name. It’s academic study saying that executives who complain about short sellers, including naked short sellers, those are excellent stocks to short. The odd- [crosstalk]
Tobias: [laughs] Red flag.
Spencer: -a company like that going bankrupt. There’s a great story, and I’ve verified that this is true that Dick Fuld was given a copy of this academic paper by someone and just said, “This is bullshit,” and said, “Don’t show me this.”
Jake: [laughs]
Spencer: But we all know how that ended. So, companies that complain about short sellers are maybe not in the short run, because obviously, you can lose your shirt in the short run, but in the long run, it tend to be good companies to bet against or like poor stocks to buy, let’s put it that way.
Tobias: The research is pretty clear that you don’t want to be short things that are too heavily shorted because you’re competing for the short. It’s a crowded short. You’re going to pay a lot. We have a comment here that says that, “One of the reasons that the AMC, APE spread remained so wide was that the short lending cost was very high evidently to get in that.”
Spencer: I spoke to and quoted Jim Chanos for a piece that I wrote. So, I didn’t follow it over the– I guess, more than a year that it was outstanding or yeah, maybe not. Maybe not more than a year, but the many, many months, it was outstanding and was a security. The cost to borrow was like 20 something percent. So, not astronomical at that time, but it could have changed. Yeah, it probably was difficult to short. 23% is pretty high given that for– Let’s say, during the meme stock squeeze, a typical stock would have cost you less than a percent to short in terms of cost to borrow. That’s when interest rates were zero, of course.
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Short Interest Reporting Changes Amid GameStop’s Market Turbulence
Tobias: There’s a question here. “Didn’t they change how the short interest report–?” There has been a change to how shorts are reported. I’m not sure. Do you know, Spencer, what’s happened there?
Spencer: There was a proposed change. I don’t think there was any rule change. Of course, the SEC comes out of this– Who do you blame for the episode? You blame short sellers for the episode, which is, I think they really should have looked elsewhere. They did also look elsewhere, but the reports that came out of it said, “Well, we need to reform the way that short selling happens and there needs to be fuller reporting of short positions, even small short positions.” I don’t think that the rule changed, although I’m not an expert on market regulation. But yeah, obviously, you have to be much more careful and you have to be much more cognizant of what’s happening on social media, if you short a stock that where there’s heavy short interest.
First of all, obviously, as you said, it’s very dangerous to short a stock where a lot of people have noticed the same thing you did and sold it short because Keynes didn’t say it, but he’s widely quoted as saying the market can remain irrational longer than you can remain solvent, and that holds true. Your losses are capped at infinity for a short sale, and your maximum gain is 100%. So, it’s a very asymmetric payoff and you need to be really, really careful about what you’re doing, even if you’re Gabe Plotkin, and it’s just one not particularly huge short position within a very large. I think the fund was $13 billion at the time, and summer of 2020, the market value of all of GameStop was a few hundred million dollars.
Tobias: I wasn’t aware that Keynes hadn’t said that, but now that you say that he hadn’t said that, he would never have said anything in fewer than 50 words. I don’t think he wrote a sentence.
Spencer: No.
Tobias: It wasn’t a run on sentences in his entire life.
Jake: That’s how he does. [laughs]
Spencer: If you keep a copy of Bartlett’s Familiar Quotations, there are a lot of things that people didn’t say. They’re great. Someone said them, but not them.
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Investment Insights from Mimicry in the Natural World
Tobias: JT, have you got veggies there? Was that our veggies earlier?
Jake: No, no, I’ve got something. We can– [crosstalk]
Tobias: Spencer, we serve vegetables every time we do this. We have some dessert later, but vegetables are the learning portion of the podcast that Jake delivers.
Jake: So, this week’s veggies are on Batesian mimicry. This is another segment that I pulled from that book, What I Learned About Investing from Darwin by Pulak Prasad. And so, Batesian mimicry is when a harmless species has evolved to imitate the warning signals of a harmful species, and it’s typically directed at a predator that would be trying to eat them. It’s named after this English naturalist named Henry Walter Bates after he worked on butterflies in the rainforest of Brazil for over a decade, like, from 1848 to 1858. Actually, the first four years that he was working there, he was there with Alfred Russel Wallace, who was famously co-discovered, but doesn’t get as much credit as Darwin for natural selection.
So, anyway, Bates collected all of these hundred butterflies. While he’s sorting them, he discovers that some looked alike, but they actually weren’t even closely related at all. And so, it was a bit of a mystery there. He put forward the hypothesis that close resemblance between unrelated species was this anti-predator adaption. He noted that some showed very striking coloration. They flew around leisurely, almost as if they were taunting predators to eat them, which is kind of funny. But the birds were basically reasoned that these butterflies were unpalatable based on the color and avoided them.
So, basically, they were parasitizing these signals that were honest signals from another particular species, so that this Batesian mimicry gained them an advantage without having to actually go to the expense of arming themselves with poison, or the toxicity, or whatever that might be expensive to create. Maybe the best-known example of this is the milk snake that looks like the deadly coral snake, but it’s actually harmless, right? It can also be used for attraction. So, apparently, these large male green frogs will advertise their size and dominance by croaking at a lower frequency than smaller frogs. That probably just has to do with the size of them and the vibration. And then female frogs will be attracted to these low frequencies.
Smaller frogs have evolved the ability to copy that low frequency of the bigger frogs, [Tobias laughs] and they’ll preserve their territory by fooling larger males from even coming in and also attracting baits. I was thinking maybe the super lifted trucks is the human form of [Tobias laughs] Batesian mimicry of [laughs] pretending that you’re a macho man. Anyway, it also sometimes doesn’t work out so well for one party. There’s a certain species of fireflies that the females mimic the mating signals of another species, and they’ll deceive the males into coming close enough and then they’ll eat them.
Spencer: Oh, okay.
Jake: Yeah. So, then to add to our story here, 1975, an Israeli evolutionary biologist named Amotz Zahavi, I believe is how it’s pronounced, and he proposed this concept called The Handicap Principle. His hypothesis was that a signal that is costly to produce, the receiver can then interpret that it’s actually an honest trait and isn’t Bayesian mimicry, basically. So, the peacock is a classical example of this. It’s very expensive to have this large, colorful tail that attracts a lot of attention from predators, but the females see that and they see it as a sign of biological fitness, and then they want to mate with that male. So, what can we think about this in the world of investing in business? Like, what can we draw from this?
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Proxy Statements: The Key to Honest Investment Signals
Prasad says that we should only look and give credence to those signals from companies which are actually costly to produce. So, you think about press releases, talk tends to be pretty cheap there. Management can highlight whatever they want. They could spin it how they want. Management interviews as well are pretty comparable to that. There’s lots of bromides and talking points, and rarely is it costly for them to point out what would actually might consider an honest signal. Like, every company is innovating, every company is leveraging technology, but what does that–?
Tobias: AI.
Jake: AI. Yeah, exactly. That’s all cheap, right? Conferences and road shows that they show up to not really much different. So, what about earnings guidance? This one’s interesting. The worst case is probably, Jack Welch and his time at GE where they had slush funds that were basically used, so they could hit earnings right to the penny. But there was a McKinsey study that came out about earnings guidance, and it found that there’s no evidence that providing earnings guidance affects valuation multiples, shareholder returns, or share price volatility. The only significant effect that it found, and this ties in, Spencer, some of the things you were talking about, the churn is that it increases trading volumes. So, the brokers are the only ones who win in this thing.
Spencer: Right.
Tobias: [laughs]
Jake: So, true, honest signals then like, what can we look for that? It tends to be more historical, like, them telling you something history like, our average margin over the last 10 years was 12%. Or, based on recent history, we’ve launched one product over the last three years instead of we’re going to do six projects in the next year, but what have you done historically? And probably the most honest statements and signals come from the proxy statement, that’s where you find skin in the game. This is like what you might look at some of Mike non-Gaap’s Dark Arts things that he’s written up, if you want to search for that. How’s management incentivized, what are their salaries, what KPIs are they tied to, are they sandbagging, what are the equity grants look like and the stock price for their options, how’s the board ensuring that talent is retained and incentivized, especially if their existing options are underwater, which is a more recent phenomenon?
Two special things that might look out for especially are what are called like spring loading and then bullet dodging. They’re the same thing, but opposite sides. Spring loading is when you grant options right before there’s a big positive news event. And then bullet dodging is when you delay to grant options until after a negative news event has happened and you sandbag and torpedo the stock price, potentially. Both are fall within a grey area, I think, as far as insider trading goes, but it doesn’t seem to be high up on the SEC’s list of things to worry about.
Anyway, those know, Batesian mimicry in the investment world, I think happens a lot, where people, they talking like the outsider’s book. They’ll pretend to be iconoclastic. But where does it actually show up? What are the real signals that are costly for them to produce, not just talk? Looking for those and trying to separate out costly from not costly will help you to understand, when are you dealing with the milk snake versus the coral snake.
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Cash is King: How Stable Capital Structures Define Reliable Businesses
Spencer: Yeah. This obviously doesn’t really apply to the meme stocks and things like that, but I feel like what’s really precious- I apologize. My dog is barking. He won’t stop if I ask him to [Jake laughs] stop barking- is what a company does with its cash and does consistently with its cash. Cash is precious. You can print up more shares, you can’t print up more cash. And so, companies that act in a very, very consistent way in terms of their capital structure, I think tend to be some of the best companies.
I’m thinking off the top of my head, Costco and AutoZone, that I’ve observed that they are very, very consistent at not expanding too quickly, not empire building. Having a very consistent degree of leverage, a very consistent cash payout shareholder yield between buybacks and dividends. They don’t vary it. They don’t try to time the market. I just find one of the dumbest things that people will say is, “This company did stock buybacks last year when the share price was $90, and now the share price is $60. And as a shareholder, I’m outraged that they wasted money.” Well, you were a shareholder at $90. You didn’t see that the stock [Tobias laughs] was going to go to $60, why didn’t you sell if you felt that way? Hindsight is 2020. We do know that companies are very poor market timers.
Jake: They are counter cyclical.
Spencer: Totally. Unfortunately, it’s countercyclical, and wealth mutual fund investors and everything else. It’s all like, you should zig when they’re zagging. That’s the bad thing about buybacks, whereas financially, it’s very similar to a dividend, except you’re not committing yourself. It’s an embarrassing climb down if you cut your dividend, whereas if you just quietly halt buybacks or a program comes to an end or whatever, it’s totally at your discretion, and so companies tend to make bad choices. Those companies that are very consistent across a cycle in terms of how they deploy cash, which they can’t create, I think those are the ones that have skin in the game.
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Costco’s Modest Approach: A Lesson in Effective Business Management
Then just AutoZone, I don’t know. Costco one of the more surprising things as a financial journalist that ever happened to me was, when I was writing ahead of the Tape, it was this daily investing column in the Wall Street Journal that doesn’t exist anymore. It was in the front of the money and investing section for many years. I was the guy who wrote it every day, and I wrote about all kinds of companies, and Costco came up. I wasn’t very familiar with Costco. And so, in the process of researching it, writing up what their results were going to mean and look like, I called up the company. There was a number at the bottom of the press release. The guy who picked up the phone, it took me a few minutes to realize I was talking to the CFO, like, no secretary– [crosstalk]
Jake: Ah, is it Jim Sinegal? You’re just chatting with him on the– [laughs]
Spencer: Retailer in the US. First of all, he was very helpful and candid, but also, he picked up his own phone and spent time speaking with me. What better sign do you need than that? And so, it’s like another one of those intangibles. You go to their headquarters and it’s not very nice, and the furniture is not very good, and it’s not in a great part of town, and they don’t have a lot of perks. They’re spending the money on the parts of the business that matter. Those are signals as well, if you know what to look for. [crosstalk]
Jake: Yeah. And those are actually costly.
Spencer: Those things mean something to me.
Jake: Management’s, flying coach. That’s a cost to them. So, those are the signals you should probably keep an eye on.
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The Power of Buyback History and Unemotional Rebalancing
Tobias: Great veggies, JT. Buybacks is a good example, because more buybacks are announced than are completed, because people know that you get a little bounce when you announce a buyback and then it’s free. You don’t have to go and complete the buyback, you’ve already got the bounce that you wanted. And then looking back historically, that’s the best measure. Who has bought back a material sum of shares over the last, whatever, one years, three years, five years and is undervalued? But you make a good point, Spencer. If you knew at $90 that it was going down, you should have sold, if you’re unhappy with the buyback at that level. It’s unknowable.
Spencer: There’s a lot of scope to complain, right? There are a lot of companies that did buybacks when times were good and then halted them when times were bad. They should be, in theory, doing the opposite. But if you do it consistently, or if you have very mechanical criteria for doing it, that I think is the best approach. That applies to investing too in my opinion. Not a professional investor, but if you’re an individual investor, I always tell my friends and neighbors who don’t get bored of hearing about it. If you have a certain mix of risky and less risky assets that you feel comfortable holding in the long run, and the stock market has had a great year, then circle the date on the calendar and rebalance on that date.
Of course, there are funds that will do this for you, but rebalance on that date, no matter what the headlines say, no matter how good or bad the headlines are on that day, that’s the day you’re going to do it and you’re going to be, a lot of times, acting as a contrarian. But the results of doing that and being unemotional and being mechanical do pay off in the long run because it takes your personal bias out of it.
Tobias: Preaching to the choir here.
Jake: Yes, preach. [laughs]
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Maintaining Integrity in Financial Reporting: Spencer’s Take on Sourcing and Ethics
Tobias: How do you source for herd on the street? How do you find out what’s happening? What’s the–? [crosstalk]
Spencer: I used to write for the Lex column, which is very similar column at the Financial Times where it’s scrupulously off the record. You might quote, let’s say, a company executive said this, or President Biden said that, or Janet Yellen said this, but you don’t quote anyone you spoke with. We’re a reported column. You can speak with people. You can cite an expert, although we often don’t. There are a lot of smart people who want to speak with us on background. You distill what they told you, and what you’ve read, and you have to do your own analysis as well. We’re a financial opinion and analysis column. So, you have to know how to read a balance sheet. You have to know something about the industry that you’re writing about. You have to have some deep level of familiarity, something approaching what analyst is.
That was my first career was being a stock analyst, but not to the same level of detail. I think there’s an advantage there because, first of all, when you’re an analyst, analysts are very bad at picking stocks and telling you their buy, sell, and hold recommendations don’t work out well in part because you have to go through a whole process to change your recommendation, but also, you don’t want to embarrass yourself in front of management. You want to curry favor with them. But also, because you missed the forest for the trees, you’re so close to the subject matter.
When I was analyst, I have a pretty good memory for numbers, and somebody said, “What was that company’s EBIT two years ago?” I could have told you, but is that a very useful piece of information to have at instant recall? Well, not really. You need to be able to see the big picture, and have spoken to their competitors, and have some sense of what’s going on in the world and industry trends and analysts spend so much mental energy with getting those granular details that they tend to miss the big picture. Whereas a columnist, like a herd on the street columnist can– You might not have the same depth, but you’re broad enough that you can sometimes spot things well ahead of Wall Street.
Tobias: You’re not sourcing in the column. But someone has said something to you, what are the ethics of that situation? You have to have that noted somewhere that’s acknowledged that this is a genuine source, so you can avoid– Stephen Glass or whatever his name was. The Jukt Micronic’s
Spencer: First of all, we can quote people. We can quote sources. We say, Bank of America analyst wrote this, said this. The executive, in a conversation with the CEO, in a conversation with us, said this thing. They also can say, this is on background. Let me explain the situation to you. And that can inform our take. You can take out your bullshit meter and say, “Well, this person’s telling me this thing on background does not want to be quoted. How credible is it? I’m going to not take their word for it. I’m going to cross check that with what I’m hearing from others, and then I’m going to write what I write.” So, there are a lot of background conversations that can play into a column.
I think what you’re talking about is a case of someone making up sources, which we just can’t do. Making up quotes, making up sources, that can pretty quickly be found out in a high-profile publication. I’m not aware of that-
Jake: Save that for twitter.
Spencer: -happened.
Jake: [laughs]
Spencer: So, that’s not a danger. I personally, because I edit the column, in addition to writing, I don’t own any individual stocks, because anything could potentially be a conflict of interest. So, as much as I’d like to– Everyone wants to think they’re very clever and can do-
Jake: Kind of a bummer.
Spencer: -great stock picker. And so, I only own stocks virtually. I don’t own stocks for real. I make all kinds of bets with people about, “This is going to go down and this is going to go up and play stock games” and things like that, but just ETFs and mutual funds and stuff like that. I don’t think there’s a lot of danger in the way that we approach things. It’s very ethical, in particular with the Wall Street Journal. I think journalists generally are ethical, but I think we have very, very strict ethics rules at the Journal. I can’t accept bus fare from a company to go talk to them.
Tobias: [laughs]
Spencer: The Journal will compensate me if I get on a plane and go somewhere, but they can’t put me up in a hotel or anything like that.
Jake: My limited experience in this was with Jason Zweig, and I couldn’t believe the amount of background digging that he did before publishing anything. It was very impressive.
Spencer: Yeah, Jason is great. He’s amazing. He’s like a national treasure as far as I’m concerned. You don’t want to bother him because he’s just doing such important stuff.
Jake: [laughs] Right.
Spencer: But if you have a question about anything, investing or securities related, you could walk over to him and he’s just such a generous soul, and we’ll know. He doesn’t have to look it up. He’ll know it. He’ll remember it. He’s like a walking encyclopedia. He’s great.
Tobias: That’s coming up on time, Spencer. The name of the book is The Revolution That Wasn’t. Spencer Jakab. It’s on Penguin Random House. Is that right? Is it combined that now?
Spencer: Plus, the publisher. Yeah, and portfolio is the imprint. Yeah.
Tobias: And portfolio. Spencer, thanks so much for joining us this week. JT, as always. And folks, we’ll be back next week. Same bat time–
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