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The London Brief - January 31st, 2021

The London Brief

January 31st, 2021

“I went in thinking that even if this goes to zero and I lose everything, I like being a part of it… At this point I don’t care what my financial return is as much as sticking it to the man.” This was spoken by one of the Reddit crew that helped implement a short squeeze strategy on Melvin Capital. Short squeeze strategies are not unusual; many hedge funds have actually utilized the technique in the past. It tends to work in times of excess liquidity. The last time I seriously saw it implemented was in 1999 and hedge funds were the ones doing the squeezing against other hedge funds. If a stock has over 20% of its free float short, it’s generally a tricky short. GameStop was over 100%.

The ripple effect of GameStop tipped into financial markets as relative value strategies that manage books on a value at risk basis were forced to de-gross, or lower leverage. Depending on the amount of leverage or how concentrated these bets were, performance for long-short strategies could be down as much as 4%-5% to 80%. Hedge funds comprise a much larger group of strategies than just relative value and short-selling, and there were concerns that perhaps something more systemic could be taking place. But overall, it seems like the larger, more leveraged multi-strategy funds had diversified their risks, such that there was little impact to credit markets (a good gauge). Other strategies weakened for a day but are more or less stable.

I’m not sure what this achieved exactly, other than articulating that people really dislike hedge funds. I have some thoughts on the origins of these sentiments later in the brief. However, I do think that it might be better for hedge fund managers to be quiet rather than Tweeting, “Hey stock jockeys keep bringing it.” (Stevie Cohen’s Twitter account has since been deactivated). In an era where many people feel left behind or angry, it’s better to just quietly make money in the background without too much publicity.

Nearing the End of COVID Lockdowns?

Potentially more disconcerting to markets is some of the recent COVID news. First, vaccinations are slower than expected. The NHS calculator says it will take 2.1 years to vaccinate everyone. Based on 1m vaccinations per week and a 70.6% take-up rate, my first dose of the vaccine will be between July 15th and September 29th and my second dose will be between October and the end of December. There are between 26.7m to 37.5m people ahead of me based on my health category. As vaccines are rolled out, the number of people going to hospital will become exponentially less, which is great, but there will still be a lot of risk in the near-term.

Second, some of the vaccines may not be effective against the new strains. If the vaccines can make the new strains less virulent such that COVID becomes more like a bad flu rather than an existential moment in a person’s life, that would probably be acceptable; but if the vaccines are wholly ineffective, then markets will become apoplectic once more. Goldman research showed a few charts from Israel that shows a step-change down in hospitalizations and severity in the above-60 population that have gotten vaccinated. In fact, I noticed some articles that hospitals are reporting that a higher percentage of cases are younger people, which should be the case if the vaccine is effective (as mostly only the older population is receiving the vaccine). Only time and more data will let us know for sure but so far, so good.

Provided that vaccines are effective or can be redeveloped to handle new strains such that we can normalize by summertime, we will have an extended period of monetary and fiscal looseness that extends to the fourth quarter, which leads us to our next topic.

“Party Like Its 1999”

Arguing that shrinking consumer credit-card debt, ballooning savings and record amounts of funds in money markets will drive markets higher, SPAC billionaire Chamath Palihapitiya said, "It is rocket fuel for assets. Whether those are housing markets, or whether those are capital purchases like cars or vacations, or stocks in this case if we're still under a lockdown, these things are just gonna go to the moon for a while and so you just have to be long. Everybody who's trying to understand why you shouldn't be long, I think is going to regret it for at least the next 18 to 24 months."

Back in 1999, I remember randomly meeting two plumbers in a bar. Both of them had minted it in Yahoo. They suggested how the Internet would replace every possible facet in life such that we would no longer need physical stores. They were 20-30 years too early on most of their thoughts, but you can argue they have sort of been right, but also probably much poorer as Yahoo was priced to deliver much sooner and wasn’t the ultimate winner of their thesis.

Signs of 1999-like excess are all around. As of early January, SPACs had $70 billion of firepower to fuel $300 billion of expected deals. At least five a day are being listed. Roblox was valued at $29.5 billion. They are now expected to do a direct listing. This is 7x the value from February 2020 reporting $1.2 billion in revenue a quarter selling its virtual currency to gamers (although it’s still loss-making). Nikola had losses of $117 million and no revenue and was valued at $25 billion; even now it’s $6 billion. Emerging cloud companies are valued at $1.8 trillion up 150% from the low point of the pandemic. Crowdfunding for revenue-less software start-ups pulled in $20 billion last year. IPOs of all classes are surging. Bitcoin’s value surged to $580 billion at the start of last year hitting $700 billion the first week of January. Tesla is valued at $750 billion or 750x P/E. On January 6th, retail data showed that retail’s share of volume was 40% at highs (versus 20% on average) and close to 30% of value. Recent events around GameStop have only encouraged more retail flow. Last Wednesday, the Robinhood trading app had its most downloads ever. Two of the largest U.S. share trading volume days occurred in the last two weeks. Six of the ten most active stocks were priced under $1 and those six traded 2.6 billion shares or 18% of market volume. Volume executed on broker-operated venues (favoured by retail) in December exceeded that of the NYSE for the first time on record. Russel3k stocks priced under $2 per share are up 13%; under $5 stocks are up 10% and over $100 stocks are only up 3%. Goldman estimates that the U.S. consumer accumulated $1.3 trillion of savings through 2020, so there is plenty of dry powder remaining.

The currency of choice for the 2021 economy is virtual. Stanley Druckenmiller made an interesting point on Bitcoin in that it’s exactly the opposite of a currency: thinly traded and less liquid, so it can be more volatile than gold. While monetary debasement can empower gold, Bitcoin and Ethereum can give you a much higher return on that theme. "Can you play the clip in 2012 and 2013 when it was at $200 and everybody was laughing at me on CNBC every time I would talk about Bitcoin? Where is it going? It's probably going to $100,000, then $150,000, then $200,000," said future California governor nominee Palihapitiya. There are small hedge funds doing virtual currency arbitrage trading strategies. I did a tutorial on it the other day. They were talking about ‘Ether’, and at first, I thought maybe I had inadvertently jumped onto a cannabis call, but Ethereum, Doge, and Polkadot are all different sorts of virtual and stable currencies that facilitate the virtual currency economy. It feels like the number of different currencies are being created at the same pace as SPACs.

Although the bubbles being formed are disturbing, there are good political reasons to maintain the present course. First is political stability. In mid-January, we saw an angry mob almost kill Congress. Most people blame Twitter and Facebook, and I see the connection. But I also think a lot of these people may be unemployed. If they are busy and wages are rising, then they are more likely to work than Tweet. Focusing on unemployment may be the better narrative than focusing on inflation despite the bubbles being formed in financial markets. As long as those bubbles don’t involve banks and too big to fail institutions, then when the bubbles burst the pain will be felt by the wealthy and the speculative rather than the average person (although as events this week show, the average person is getting long GameStop).

Chamuth Palihapitaya and the SPAC community disagrees with me that there is a bubble: "Building products, cars, energy systems, batteries, retail infrastructure, robots, transforming financial services to be fair for everybody — that's not trading derivatives and playing gotcha. That was not real value, those people were just shuffling shells around. This time it is different because people are making tangible things you can touch and feel." But that was sort of the plumbers’ argument in 1999. Technology companies did make it but just not at the high valuations of the time. This past month I saw countless electric vehicle SPACs without a scintilla of revenue suddenly worth billions on basically a business plan.

The comments from the Fed are very clear: the punch bowl stays. Richard Clarida said to the Council on Foreign Relations, “My economic outlook is consistent with us keeping the current pace of purchases throughout the rest of this year.” As things stand, the Fed is buying at least $120 billion a month, split between a minimum $80 billion in Treasuries and $40 billion in mortgage-backed securities. “I think it could be quite some time before we would think about tapering the pace of our purchases the way I look at the data, and I’m relatively optimistic about the economic outlook. We want further progress in the labor market and moving toward our 2% inflation objective, and I think that’s some ways away before we declare victory on that. Right now, I think maintaining the current pace of purchases throughout the remainder of this year is my expectation.”

At some stage the music stops. The musical chairs are then pulled and whoever was still dancing finds that they have lost a lot of money. But for now, we defer to the late Prince and don’t see why you should leave the party.

Brexit Malaise

The nightmare scenario of unstocked shelves, lack of medicines and general chaos did not materialize on Brexit day. It felt quite similar to every other day. In financial services the City of London lost €6.3 billion in daily stock trades to EU venues. But bankers and asset managers were disruption free. The only other major change I saw was that Britain turned down visa-free travel for musicians. The musicians union has said that the costs of visas and the process of applying for them could make touring for European artists to the UK and vice versa only economic for the wealthiest of musicians. We may never hear German polka music in the UK again.

The bigger change may be years from now. In a poll of money managers, banks and insurers, 76% believed the EU would grant some sort of equivalence in the next round of talks. Only 26% of respondents planned to move UK staff to the EU and only 3% said the moves would be significant. But if the financial sector is wrong, and equivalence is not granted, then they will have to rebase these expectations.

For instance, about 3,000 to 4,000 investment bankers may be moving out of London to the continent, according to several officials at banks. The industry employs 1 million people, 7% of the economy and 10% of the tax revenues. Bankers in London cannot directly pitch to clients about potential corporate transactions. They need a chaperone – an EU based person – to make the first move. German, French and ECB officials say they are closely watching whether banks are following the rules. Reverse solicitations and creative solutions were banned. If bankers want continental business, they will have to move back.

Cheese manufacturers in Britain who had direct to consumer models to Europeans, now find that they need to pay for a special license to make sure their product is safe for consumers, which practically means they can only sell wholesale into Europe now. Good for Europeans; not so good for the cheese manufacturers. These tweaking of rules will disadvantage UK-based players but will only happen over time.

Another casualty may be the “United” in Kingdom as Scotland looks to do another independence referendum. This time I think they would be successful. What Mel Gibson couldn’t do in Braveheart, will now be accomplished by Nigel Farage and his cheery band of Brexiteers.

So overall, no Brexit chaos, but certainly a sense of longer-term malaise.

Thoughts on Coups

In January, the United States almost seem to have a coup. In response, Facebook and Twitter suspended the president’s accounts. AWS stopped hosting Parler, a rival service to Twitter that’s more pro-Trump. Apple and Google took services off its app store. Stripe stopped campaign processing services for donations to Trump’s fund. AT&T, Facebook and UPS suspended political donations. Deutsche Bank and Signature Bank won’t do business with Donald Trump.

However, sites still proliferate. The is a website which functions like a forum. EPIK, which supposedly has its funding from Russian sources, is going to host Parler. There are alternative ways to get apps from Android outside of the Google app store. The recent Reddit campaign was merely another front in the populist war against the system.

The question is why do people want to blow the system up? My three hypotheses are (1) globalization; (2) efficiency and (3) technology. Globalization involves the offshoring of supply chains to cheaper overseas locations. Efficiency involves consultants and private equity squeezing every last ounce of profit by reducing the cost structure. Technology involves utilizing automation and artificial intelligence to replace humans with computers. These trends have commoditized labour. As Cal Newport, author of Deep Thinking says, “In this new economy, three groups will have a particular advantage: those who can work well and creatively with intelligent machines, those who are the best at what they do, and those with access to capital.” But a very large number of people, perhaps the majority, do not fit into these buckets and have come to feel the system is unfair and stacked against them. They subscribe to conspiracy theories and seek out populist politicians.

It’s a difficult one for governments to solve, particularly as there are ways for people to de-commoditize what they do. For instance, while certain industries may be under labour commoditization pressure, other industries like renewables need more labour. I read an article about a former auto worker in Swindon who had an unsatisfying, unstable job at the Nissan factory who decided to re-route to East Anglia and work for a renewables company setting up offshore wind turbines. He loves his job working with interesting people and feeling like he’s doing good in the world. The company is growing and treats its employees well. And they need more workers. Yet it takes people to want to do that search and have a willingness to move, and many people don’t. Hopefully the new start-ups and growth companies continue to hire people like that former auto worker, so that the majority feel like the system is fair. But if there is not enough of those jobs, expect to see more populist politicians come to the fore.

Merger Activity

The year started with an unsolicited bid from MGM for £10 billion Entain in an effort to merge offline and online casinos and sports betting although that fizzled at the end of the month as MGM walked away due to a different in price expectations. Couche-Tard made a $20 billion approach to Carrefour. However, this was quickly killed off by the French government, who is facing their own populist attack from Maxime Le Pen next year.

But other M&A continued. In healthcare United Health made an $8 billion offer for Change Healthcare, a deal likely to encounter significant antitrust scrutiny. Perkin Elmer acquired Oxford Immunotec in a $560 million deal. Cantel merged with Steris in a $3.3 billion deal.

There were lots of topping bid situations. Cardtronics got a topping bid from NCR in a $1.7 billion transaction. GIP made an offer for $4.6 billion to buy Signature Aviation topping Blackstone. Akzo made a $1.7 billion bid for Tikkurula topping a deal from PPG. Starwood paid $4 billion for property company CA Immobilien triggering a statement from Aggregate SA said they might bid for them.

The semiconductor space continued its consolidation. Teledyne paid a high multiple for FLIR in a $7.5 billion deal. Coherent merged with Lumentum in a $5.5 billion deal.

In other situations, Brookfield made an offer to consolidate its subsidiary Brookfield Properties in a $16 billion deal. Many of its comparables, like Macerich, have been heavily shorted due to its retail exposure and these names performed very strongly last week. American Tower paid $9 billion for Telxius, Telefonica’s tower assets, entering the European market in scale. SWP bought Scapa, a struggling adhesives company with some interesting medical applications for £410 million. Veritas bought Perspecta in a $4.6 billion deal; they will be merging it into another portfolio company. IFM made an approach to Naturgy in a partial tender offer for 30% of the €20 billion corporate. PPF made an approach to $1.6 billion valued Moneta Bank in the Czech Republic. Bingo entered talks with private equity on a potential $1.6 billion deal. This is tied to the potential for divestments from a deal Veolia is seeking to do with Suez.

End Note

There is evidence that plants reduce stress. According to a four-year study by Lauriane Suyin Chalmin-Pui of the RHS, “We found such a significant response with just a relatively small number of plants. Now we have shown that access to even a tiny patch of nature has measurable beneficial effects for our health.” I saw an article that Gabriel Plotkin, founder of Melvin Capital, paid $44 million to buy 1.97 acres to connect two properties in Miami Beach. While Melvin’s fund performance may be down, at least all those acres has lots of plants, so he should be healthy.

It’s also gotten a bit colder. The UK had its first major snowstorm with a good 6 inches or so of accumulation in my area. I got to build a snowman and have some good snowball fights with my kids. That is also one positive behind the lock-down in that we have gotten more in touch with nature and the outdoors and spend time with our kids. This era will soon be over and maybe we can just enjoy the good part of the lockdown these last few months before we return to the zoom of normal life.

Cobham, Surrey, January 31st, 2021

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