February 1, 2021- Online Brokers Cut Off Retail Trading as Record Volumes Cause Liquidity Crunch. Are These Firms at Risk of Going Under?

Noted Short Seller Andrew Left Swears Off Shorting, Transitions to Long-Only Investing. Will Activist Short Selling Go Extinct?

Electric Vehicle Company Faraday Future to Go Public Through SPAC Property Solutions Acquisition. Is the Market Still Hot for EV Deals?

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Transcript:

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by Accelerate financial technologies. Accelerate, because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome investors do episode 113 of The Absolute Return Podcast. I’m Julian Klymochko. 

Michael Kesslering: And I’m Mike Kesslering. 

Julian Klymochko: Today is Friday, January 29th. Done the first month of 2021. And boy has this been a pretty wild month, unprecedented with respect to GameStop and AMC and these other so-called meme stocks driving the market. I mean, these stocks are up, the market’s down negatively correlated. It’s just wild, pinch me, right? Have a few things to touch on this week. 

  • Online Brokers, cutoff retail trading as record volumes cause quite the liquidity crunch on the street. Are these firms at risk of going under? Specifically, we’re going to talk about Robinhood and the emergency financing they had to conduct. 
  • Noted short seller, or should I say former short seller Andrew Left, he swore off shorting. Transitioning to long only investing. Will activist short-selling go extinct? 
  • And lastly, electric vehicle company Faraday Future to go public through SPAC Property Solutions Acquisition, as we always say, SPACs and EV deals, hand to glove. Is the market still hot for these types of transactions?

Julian Klymochko: Let’s talk about the topic dejour. Popular trading app Robinhood was forced to suspend trading this week and raise 1 billion of emergency capital from investors because of the liquidity crunch caused by the recent record trading volumes from individual investors really spurred by this dynamic, this movement out of individual retail traders. Really trying to stick it to the man. And initially they were trying to blow up a hedge fund called Melvin Capital, in which they’re actually surprisingly largely successful. This contingent of online investors, they noticed that GameStop, which was a relatively cheap stock, but most importantly, it had a massive short interest. Meaning over 130% of the entire float of the company was sold short. So, hedge funds had a massive bet against the company and these individual investors. They gathered on this Reddit forum called r/wallstreetbets to effectively use highly levered call options and the so-called gamut squeeze to push the GameStop shares massively higher. And they did succeed in squeezing out the hedge funds, forced to cover. Melvin Capital, had to take a bailout which is just absolutely amazing. So, it looks like the Reddit meme, traders winning this battle, but one unlikely and quite ironic potential casualty is because a lot of these meme traders are going through Robinhood. They almost made Robinhood become insolvent and go bankrupt just through their recent frenzy trading of all these so-called meme stocks such as GameStop and AMC. 

Because how it works is, you know, trading all the underlying securities from the broker perspective is relatively complex. So, they need to put up cash to cover these trades until they settled. Because of a lag between when investors book new positions on a stock and when their cash has actually exchanged for securities. Brokerages, like Robinhood, etc, they have to maintain deposit accounts at these clearing firms that help finalize the trades. So, there’s this firm called DTCC, Depository Trust & Clearing Corp. It operates the main clearing house for your stock trades. They require brokerages to post more margin or more of their own money and riskier times to ensure against potential losses. Just to give you a sense of some of the numbers here, industry-wide collateral requirements for stock trades, rose about 30% from 26 billion to 33.5 billion just on Thursday. So basically, Robinhood was facing a massive margin call. They had to go to existing investors, Sequoia Capital, and Ribbit Capital to do an emergency fundraise in mere hours. They raised a billion dollars because a clearing house asked the company to cover a dramatic increase in deposits for Thursday’s trading. So, they’re lucky to have deep-pocketed investors, Sequoia and Ribbit to step up, put up a billion dollars. So, Robinhood was no longer in solvent and in terms of valuation, we don’t know, but we do know that they’re valued at nearly $12 billion dollars in a fundraising round in August. And in addition, I guess the $1 billion dollars wasn’t enough. They also board about half a billion from their banks this week. So, Mike, a crazy knock-on effect and you know, these meme traders almost killed Robinhood. It’s shocking.

Michael Kesslering: I believe in terms of the structure of the investment into Robinhood, I believe it was structured as a note with the ability to purchase at a discount. Now they didn’t say at a discount to what or whether it was from the previous finance round. 

Julian Klymochko: I think it’s at a future round. 

Michael Kesslering: Yeah, so, you know, like take that for what it’s worth. Like, I mean, that future round is likely to be quite a bit higher because on the whole, all this increased volume and exposure that Robinhood is getting is very good for its valuation. So, this is a short-term kind of band-aid solution that was very much needed, but presuming that they do escape from this like Robinhood. It’s going to be very good for their valuation overall. But yeah, let’s just go a little bit more into the clearing house dynamic and how that works. Like I don’t want to put our listeners to sleep, but just a few other points that as you really gave a good breakdown, Julian. But I mean, really what happens is as volatility increases, Robinhood itself just has to put up more margin. So, more volatility equals more margin requirements. And ultimately that just really gets passed through to their clients. So, if Robinhood can’t meet their own margin requirements at the clearing house, they themselves get a margin call and keep in mind that they’re not getting a ton of notice here. Margin by definition is very short-term. 

Julian Klymochko: Yeah, like the day of. Like when you get a margin call, it’s not good. Especially if you can’t cover it, if you don’t have the cash, you’re like, oh crap.

Michael Kesslering: Yes, and in Robinhood zero as a client of Robinhood, I mean, they don’t have to give you really any warning, same with many of these discount brokerages. They just start closing positions to make their own… 

Julian Klymochko: Liquidating. 

Michael Kesslering: Yes, exactly. But you know, they just moved this downstream and so really like, you know, their mechanism of how they close out and liquidate positions. I think that’s a fair criticism, but I mean, ultimately, they have their own obligations and you need to be aware of that when you’re trading and using margin debt, as margin debt is very risky. In especially in times when you kind of need it most, you need that buffer most, it’s likely to get pulled. So that’s just a reminder for investors. It’s kind of an interesting dichotomy right now because Robinhood, their CEO Vlad Tenev, he had made a good point actually, I think it was just either today when their financing was announced, but he kind of made the point where they’ve had a lot of critique from politicians. Especially near the end of 2020 during the pandemic where, you know, we’ve had a lot more day trading. The criticism was that Robinhood, they were game modifying trading and that they weren’t providing enough safeguards for investors. And then investors can, you know, come out of financial loss. And so, their argument was, not enough safeguards. Now the critique from politicians is that there should be no frictions. I mean, it’s just kind of a bizarro world right now where the complaint is that they’re having too many restrictions, that people should be able to do want. You’re getting a very libertarian bent. But, I mean, yeah, it’s a crazy situation. And I mean, just in terms of last week, we talked about GameStop and to show how little I know apparently, I mean, both you and I Julian, we’re talking about how crazy it was that GameStop was trading at $65 dollars a share. I made now it’s just closed Friday, it’s at $325 dollars their shares

Julian Klymochko: Yeah, I think it reached around 500, which is crazy. It really caught everyone’s attention. And many people are just staring at the screens. You wouldn’t believe how many messages I got from people who are not investors and probably have never bought a stock in their life. Asking if they should be buying. And you know, I had the same advice that I said, last episode, don’t get involved in battleground stocks, long or short. I mean, it is crazy volatile and who knows where are they going to go? 

Mike, I wanted to touch on, you know, some of this political backlash. And I thought it was quite ironic that AOC came out and criticized Robinhood for allowing hedge funds to trade and not allowing regular folk to trade stocks. And I made the joke that she should find out about the accredited investor requirements for certain investments, which obviously I don’t think are fair, but has been in place for a very long time. The other thing that I wanted to note is that Robinhood, they say they have this mission of democratizing investing, but how they really work is they sell retail investor order flow to hedge funds like Citadel. And there’s this movement of these Reddit traders, meme stock traders. They’re kind of like stick it to the man against anti-Wall Street and trying to blow up hedge funds. But the big winners from this whole thing are hedge funds, specifically high-frequency traders, such as Citadel, who are making money off every single trade that Robinhood puts through because the way that Robinhood business model works, their product is retail investors and their clients are hedge funds. So, Robinhood makes money by selling retail investor orders to hedge funds. And that’s their business model. How else do you think they can offer zero commission trades? Those commissions have fees and the fees are, you know, basically what they’re paying hedge funds to take those trades.

Michael Kesslering: Julian, can I just add something on the flow? The flow is, why would a hedge fund or an institutional investor want to buy this flow from Robinhood? And it’s really fairly simple is, if they were buying institutional flow where, you know, it’s heavily researched and ultimately the market maker, they view institutional flow as a little bit lesser quality as they think that there’s a higher probability that institutional investor is directionally right. Now that may not be 100% accurate, but it is on average. And they’re kind of playing in a game of averages with market making. And so, if you compare that to retail or order flow, say from Robinhood, it’s viewed as more random. So, if it’s more random, the more volume that they can get, the better chance that they have at making money from a market-making perspective.

Julian Klymochko: Yeah, so a market maker just tries to buy low and sell high. And so, they can basically buy retail order flow and make money off of it. So, hedge funds are getting rich off of this. Yeah, I just find it so ironic that the company is called Robinhood, but they’re basically taking from the poor to give to the rich. So that’s quite ironic, but you know, in reality, that’s how things work. On to the next one

 

NOTED SHORT SELLER ANDREW LEFT SWEARS OF SHORTING, TRANSITIONS TO LONG-ONLY INVESTING 

Julian Klymochko: Vocal short seller, Andrew Left, the founder of Citron Research, longtime activist, short seller. He announced that he would no longer be publishing short recommendations on stocks, basically hanging up the gloves on short selling. After more than a decade spent as an activist short seller, which included a stint as a key critic in the unveiling of fraud at Valeant Pharmaceuticals in 2015, which at the time was a huge story. Left decided to hang up short selling for good. After he became the victim of online harassment for short selling GameStop stock and talking about it. Remember last week’s episode, we spoke about how he recommended shortening GameStop and thought it would trade back down to $20 dollars. Man, did that trade not work out. Nonetheless, Left stated that he would take quote, “The skepticism and mentality of short selling and apply it to the long side. The risk reward of being a short seller is not worth it. It’s not worth it for me or my family. When we started Citron, it was to be against the establishment, but now we’ve actually become the establishment.” So, a change of heart, he says, he’s going to be focused on only investing, specifically trying to find stocks that could be multi baggers, i.e., could double triple or even more. Certainly, his activist short-selling dead? Well, I think so. Activist short selling is where you short a stock and you vocally speak out against it, which used to work. However, with this massive contingent of retail traders on wallstreetbets, a new force in the market to be reckoned with. Those guys can quickly form a group. And that activist short report, in my opinion, puts a massive target on that stock for a short squeeze. Mike, what are your thoughts?

Michael Kesslering: Yeah, I would agree with your sentiments here. Cause I mean, with short selling and many things with investing. A diversified basket of shorts just makes so much more sense from a risk management perspective and using shorts, tactically, as opposed to you know, a really concentrated position, because for example, in this activist short selling approach, you’re actively seeking concentrated positions on the short side and by nature, it has to be a very high conviction trade.

Julian Klymochko: Well, not just high conviction, but what you’re seeing with GameStop is that even if you’re short and the stock goes from $10 dollars to $400, like, it doesn’t matter how much conviction you have, you’re going to be insolvent and you’ll be forced to exit.

Michael Kesslering: Yeah, and it’s also a capacity issue because of the amount of conviction that investor may have. They can only engage in so many campaigns at one time. So, I mean, they’re going to have a very concentrated portfolio and that really puts you in an emotional position as an investor. So, think of Bill Ackman with the Herbalife disaster, right? Where your reputation is at stake on being right. And so, you just have a ton of cognitive biases, right? Because your entire reputation is wound up in this particular trade that you’re putting on. You have all these blind spots; it just doesn’t make any sense to do. And from a risk management standpoint, you can see how all the sudden risk levels are really not taken into an account. And it’s kind of gets away from some other good use cases of short selling. But yeah, from our perspective, I 100% agree that some of this activist short-selling approach just doesn’t really work because also you have to get timing right as well. I mean, we’ve talked a bit last year about Wirecard. Now that was a massive, massive fraud, but that fraud continued on for like almost 10 years. And so, as a short seller, can you endure 10 years of just a multibagger stock where you’re losing a ton? I mean, no, you can’t really withstand that. So, dealing with frauds or anything like that. Even as they’re going to zero, there’s going to be a ton of volatility and you know, that you’re seeing some of the negative aspects that volatility right now, that’s for sure.

Julian Klymochko: Yeah, this situation reminds me of the old Japanese proverb, “The nail that stands up gets hammered down.” And basically, I think if someone is publicly shorting a stock and has a large position that makes them so vulnerable for a short squeeze and I think these Reddit traders are going to be overly focused on that, at least for the foreseeable future. So, if you’re an activist short seller, good idea to consider a new business. Onto some SPAC news. 

 

ELECTRIC VEHICLE COMPANY FARADAY FUTURE TO GO PUBLIC THROUGH SPAC PROPERTY SOLUTION ACQUISTION 

Julian Klymochko: Special purpose acquisition company, Property Solutions Acquisition, somewhat ironic because their mandate was a real estate deal. As you can see from the title, however, they pivoted. Announced a business combination with Faraday Future, which is a California based global shared intelligent mobility ecosystem company, which is what business schools speak for an electric vehicle manufacturer, Los Angeles based Faraday. It was founded by a gentleman named Yueting Jia, an entrepreneur who filed for bankruptcy in 2019 after running up billions of dollars in personal debt, trying to get this company off the ground.

So, it has a somewhat tainted history. Nonetheless, this deal values the electric vehicle company at 3.4 billion, which includes approximately 1 billion of capital raised in the merger or the going public transaction. This consists of 775 million pipe financing. And the remainder on the SPACs balance sheet. In terms of this evaluation, they indicated that it’s at evaluation multiple of 2.9 times 2024 EBITDA. However, you got to be somewhat, take that number with a grain of salt, just because the company’s so early stage still. I mean, they don’t really have much of a manufacturing operation yet. So, it’s still basically in startup mode and they’re predicting a massive growth in EBITDA.

Faraday, the latest in the string of EV makers going public via SPAC following Nikola, Fisker and others, man, and you look at the price action. You can guess that shares traded up. Like obviously a market continues to love EV deals. Property Solutions SPAC shares traded up 65.5% this week on the news. Once this deal closes as expected in Q2, it’ll be listed on the NASDAQ under the symbol FFIE. Got to disclose that Property Solutions is one of the largest SPAC positions in The Accelerate Arbitrage Fund. So, no doubt we are like in this one, Mike, what are your thoughts on it?

Michael Kesslering: Yeah, it’s an interesting transaction. I mean, I only had a few notes on it. Really, like very large pipe financing. So, $775 million dollars, as you’ve mentioned, that’ll bring along what the trust value. They’ll have over a billion dollars after the transaction closes, to execute on their business plan. But weirdly one thing to note is that we typically do comment on these pipe financings and they didn’t name any of the investors in this financing by actual name. I mean, they mentioned that there is a city in China. I thought that was interesting. One of the top three Chinese OEMs and a number of other US investors, but none of them were named in the initial press release, which, you know, typically they use that initial press release when they announced these deals to kind of show off some of the buy-side horsepower that’s backing them.

So, I just thought that was just an interesting note. But you know, my other comment not specific to this deal already are any thing is, you know, we have seen some volatility in the SPAC markets lately, and perhaps you’re seeing on the retail side, you’re seeing some of these investors are, you know, moving some capital from SPACs into some of these names like GameStop or names like that. But as well, like on the hedge fund side, do you know Julian, do you think we’re going to see some of these generalist funds reducing their exposure to SPACs because of other problems in their short portfolios? What do you think can happen here?

Julian Klymochko: Yeah, there’s a really interesting market dynamic happening that I wanted to expand on at the start of the episode. I noted that these memes stop stocks, GameStop, and AMC, et cetera, Blackberry, and others of those nature. They’re actually negatively correlated with the market these days, because many fundamental long, short hedge funds, so-called pod shops at Capitol millennium, et cetera, et cetera. Melvin, they’ve been long, you know, a number of the large cap growth stocks, largely in the S&P 500. And in short, many of these so-called junk stocks, which have turned into meme stocks and a massive short squeeze. So, what has happened is these large hedge funds had to what we call degross or delever or trim their positions. They got to cover their shorts because they’re losing money. And as they cover their shorts, they have to sell their longs. So, you’re seeing their shorts go up as they buy to cover. And you see a lot of the most popular stocks in the market. Apple, Amazon, Facebook, et cetera, trade down as they’re all selling at the same time. So, this whole rigamarole with GameStop had massive implications on the market, which is one reason why I think we’re going to see regulatory intervention, because this is having real world effects on the economy. You’re seeing the market trade down, stocks trade down in general, which means it’s raising their cost of capital, which means it has negative ramifications for the environment, for employment, for income growth, et cetera, et cetera. And so, it’s just a wild dynamic, all these different offsetting knock on effects. So that’s something important to consider. And with respect to the SPAC market, as these pod shops degross and these pod shops are massive players just recently into the spec market.

I mean, I think Millennium is the largest SPAC investor out there with over a billion dollars. And they’re taking down 5% of many, many IPOs. And so, as they degross, they’re putting less capital to work. They’re seeking liquidity. I expect less participation from hedge funds and SPAC IPO’s. We are seeing the effects, i.e., the first day pops and the trading to premium on IPO date that is less and less. We used to see SPACs trade up 7 to 8% on the first day. Now it’s more like 2%, and I think they’re going to keep going lower. And as that dynamic continues, you’re going to see over subscriptions come down, you’re going to see funds dialing back their subscriptions to these IPO’s. Allocations are going to start getting filled. And if we start seeing SPACs break price on IPO day, I mean, game over. All those fast money hedge funds are gone. And those order books are a small fraction of what they used to be. So, a lot of interesting knock-on dynamics. So even if you’re sick of hearing about GameStop, all the various knock-on effects that are reverberating throughout the market are most certainly worthwhile studying and paying attention to. Mike, do you have any more comments on this one?

Michael Kesslering: Yeah, actually just one more comment. And it was really just on the pod shops and the degrossing within them is, as I had mentioned with regards to the clearing house having their own requirements for Robinhood and then Robinhood, having their own requirements for their clientele in that. Really shifting a brisk, any impact at the top upstream gets pushed downstream. Same at these pod shops is all of a sudden now, all of these shops will be looking at their overall books, and then there’ll be coming to their individual pods, the PM’s within those pods and giving them further risk management in terms of, you know, let’s say individual short selling, short selling as a whole.

Julian Klymochko: And by risk management, you mean Israel Englander taps you on the shoulder, when you’re at Millennium, and you got to cover your shorts and sell your longs and take care your exposure way down.

Michael Kesslering: That type of degrossing, as you mentioned, everything flows downhill. And so, some of these names that they’re looking to sell out. First, they’ll look at some of their more liquid names. 

Julian Klymochko: Apple, Amazon. 

Michael Kesslering: Then they’ll move down into the last liquid names. But yeah, it’ll be interesting to watch these follow-on effects.

Julian Klymochko: Yep, I agree. Well, that’s about it folks for episode 113 of The Absolute Return Podcast. If you enjoyed it, definitely leave us a review, check out more at absolutereturnpodcast.com and most certainly follow us on Twitter. Mike, what’s your handle?

Michael Kesslering: Is @M_Kesslering.

Julian Klymochko: Mine is @Julian_Klymochko, so check it out. And until next week we wish you all the best in your investing and we’ll chat with you soon. Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.

 

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