Stephen Clapham (How to spot a good investment – and a fraud!)
- 00:00:33 How Stephen got started in the world of finance and what motivated him to write his latest book.
- 00:10:05 What is the basic premise of Stephen’s analysis of financial statements (forensic accounting)?
- 00:21:01 What is the fine line between fraud and creative accounting?
- 00:27:22 What is Stephen’s analysis of the Wirecard fraud?
- 00:32:27 How well do the current accounting standards actually work for provide transparency into profits/ losses of banks?
- 00:39:51 Where does all the printed money (from Central Banks) actually go? What is the best option to ‘weather the current low growth environment’?
- 00:51:10 How ‘money printing’ at this huge scale seems to be deflationary instead of inflationary?
Stephen Clapham is a retired hedge fund partner who now trains stock analysts at some of the world’s largest and most successful institutional investors. Stephen is also the author of The Smart Money Method: How to pick stocks like a hedge fund pro and hosts his own podcast.
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Stephen, thanks a lot for coming on the Judgment Call Podcast. I really appreciate it. Wow, thank you for having me. I’m looking forward to it. Hey, absolutely. I’m sorry about my improvised setup here today, but I hope you can still manage that. So you run a company called Behind the Balance Sheet and you also recently published a book that’s called The Smart Money Method. And both I thought are really interesting and we want to dive a little deeper into both of the topics that you illuminate there. Maybe you can give us a very quick intro into how you got into the financial world in the first place and what inspired you to write the book and what’s kind of the 30,000 feet view of what’s in the book. Okay, so nothing inspired me to get into finance. It was purely accidental and serendipitous. I had accepted a job at a very senior level, one of the largest companies in the UK, where I was reporting to somebody that was reporting to the CFO, Finance Directorate. I was interviewed by the CFO for the job at a relatively young age and they gave me the job and they were delighted to have me and I accepted the role and they then called me up and they said, oh, we made a bit of a mistake because you’re too young. You can’t be this grade until next year and I said, well, what do you mean? And they said, well, you know, don’t worry, only a little bit less money and there’ll be a slightly fewer benefits and we’ll make you up next year. And I said, well, I’m very sorry, but you know, as far as I’m concerned, we had a deal and I’m not allowing you to renege in that deal. If you have such a stupid philosophy that somebody has to be a certain age before they’re qualified to do the job, then I suggest you go and look elsewhere because I’m not really interested in working for an organisation where merit doesn’t overcome age. And I was recounting this tale and a friend of mine said, oh, well, that sounds a bit upsetting, but why don’t you go into the city? And I said, well, don’t be stupid. I don’t know any of the cities for people with privileged backgrounds that won’t suit me. And he said, well, no, I think you’ll find that things are opening up and I said, well, how would I do that? Well, I don’t know. How would I get? I don’t even know where to start. And he said, well, I don’t know either, but my secretary’s husband, he works at a stockbroker and I bet you he’ll see you and explain, you know, what sort of things you might be able to do. And I said, well, that’d be fantastic, so he called up his secretary at home and she said, oh, yeah, of course, he would be delighted to see Steve of Egan come in next Wednesday at 8.30. So next Wednesday at 8.30, I rock up to this stockbroking firm and this very nice chat Bob Carl spends half an hour telling me what it’s like to be a research analyst. And I’m thinking, oh, man, that sounds like fun. And he says, well, why don’t you come and work for us? And it was, you know, I hadn’t gone there to get an interview, I’d gone there simply to learn and understand what the city was about. And I, you know, I went to work for him and it was a brilliant job. I really loved doing it, found it incredibly interesting, incredibly exciting. And I never really looked back. And so my career spanned the sell side where I was an analyst covering various sectors for many years, and I then was asked by one of my clients, a big hedge fund, if I would go and work for them. And I did that and I thought, oh, wow, this is even more fun because I’m doing the work that I really enjoy, which is, you know, researching companies. And I don’t have to deal with a pesky clients because when you’re an investment bank or you’re on the sell side, there’s a reason it’s called a sell side because you have to sell to people. And although I really enjoy the relationships, the marketing part of it was, you know, a bit dull, you know, I mean, I remember one firm I worked for, you were given a big cardboard sheet every month and you did it all the days of the month and tick boxes and you had a list of clients you had to call and you had to make a hundred phone calls a month. Surely not anything to say, you know, I thought you shouldn’t call people unless you had something interesting to say. Anyway, so I moved to the buy side and it was really an amazing journey, absolutely fantastic fun. And I then ended up setting up my training and research consultancy behind the balance sheet in 2018, the fund that I’d worked for, we decided to close it with the performance hadn’t been very good and it really wasn’t a lot, it really wasn’t much fun coming in every morning at 7.15 and leaving at 7 o clock and not making any money and we decided to close it. I had assumed that I would just get another job, I found it more difficult because nobody wanted to employ an analyst aged 50. So I set up the consultancy and it’s been fantastic fun and, you know, why did I set up the book? Well, I started the book because I’ve been doing all this training and I thought, well, maybe people would, you know, find the book helpful, I could write a book that was interesting and I had the basis of it and so the book was published in November last year and somewhat to my surprise it’s been really very popular and, you know, loads of people have emailed me saying, oh, this is the book I wish I had when I was started in investing. Loads of people email me saying, oh, this is fantastic because we now understand what we should be doing. Some people email me saying, this is brilliant because you convinced me that I don’t want to do my own investing because it sounds a bit difficult, but I’ve had all sorts of very positive feedback and the book, essentially, it’s kind of got some of my actual real life experiences woven through it, but it’s really a book about the process I developed as an analyst at very large hedge funds to research companies and so it’s something like a how to guide, but it’s a more practical how to guide. We don’t really talk about any of the theory at all, we just go through how do you invest and how my process developed and how do I look at a company, so how do I start, how do I find an idea and then once I’ve found an idea, what do I do with it, how do I examine it, how do I explore it, how do I look at an industry, how do I look at a company and I then go through, I don’t go through in great detail with the financials, you know, obviously I sell training courses which help people how to read a balance sheet and how to understand a set of accounts and that could be a whole book and I wanted the book to be something that anybody could pick up and that they wouldn’t be turned off by it, that they wouldn’t be put off because it was all about reading balance sheets, so we cover a bit about the balance sheets, we cover how to look at management and also stuff like how do you think about the macro, we put in, I finished writing it just as COVID started at peak, so I probably made June last year, I finished the book and I thought I really should put a paragraph or a chapter about COVID, started out as small and then I ended up doing a whole chapter on it which with the benefit of hindsight, I’m not sure that I should have included that, I think the book would have had a longer validity, a longer shelf life without it perhaps, but some of the points that I made there, initially they didn’t look that smart because I had been talking quite a lot about the issues in supply chains because when COVID happened I felt that supply chains would get very stretched and it was interesting, you know, now I hadn’t anticipated how long it would take for that to feed through into the system, but obviously there’s huge supply chain pressures now. Yeah, I mean that’s a whole other avenue we could talk about, but I love how positive you see your own career over the years and how you combine that part of that’s what I love to do and obviously we know the financial industry pays really well and the interesting way you found your way into it, I think that’s pretty unique, that’s really awesome. I think one point that you’re really famous for is being in forensic accountants, so looking into a company and just from their financials and whatever they have in their public reporting to see if this is a company that maybe makes things look a little bit too good to be true or is probably on the verge of being fraudulent, and we know there’s a couple of really active investors who kind of do this all the time and there was a bunch of cases with Rebian where a lot of people said, well, this is the biggest fraud ever, there’s so little technology, there’s so much potential opportunity that everyone who is investing into this company basically doesn’t want to see what’s actually going on, it’s empty promises and the balance sheet is basically, it’s all cooked up and the technology as well. Maybe you can give us a glimpse, what are the things that you’re looking out for when you do this? How do you determine there’s a pattern of fraud or there’s a pattern of something fishy going on? It’s very kind of you to say that I’m famous, I don’t think I’m famous at all and the forensic accounting is only one aspect of what I do and the thing is that I don’t understand I don’t believe you can be an effective investor or as effective as you might be without having due regard to the financial statements. Now, obviously in today’s markets, there is a lot of stocks that are making very large losses that are very highly valued and people aren’t really paying a huge amount of attention to today’s profitability but you do for a very large number of companies, a very high proportion of the stock market, you do have to understand how the company makes its money, how it generates cash flow and even for those companies that lost making today, you do have to think about how they’re going to generate cash at some point in the future and I know there’s lots of people who invest without even opening their accounts, a funny story was I was approached by a group of private investors in London to do a course, an in person course for them and these are a group of value investors, they invest predominantly in small cap stocks and I agreed to do the day with them because I had some clients that paid for a day and I didn’t have enough critical mass and so I put the two groups together and I said I’m going to go through a particular example, bring a copy of their accounts because they normally when people did this in my office, I would give them copies of the accounts but these people being value investors, they were chiselling me on the price and they didn’t want to do it in my office, they wanted to do it in their premises so I didn’t fancy carrying bags, the accounts are quite long right, so you’ve got 250 pages of accounts and you’ve got multiple copies, it would be quite heavy to carry with your laptop and everything else, these guys came, two of them came, they didn’t bring their accounts, they brought the preliminary release and these two people were full time professional investors and they didn’t even know what a set of accounts was, which I find this just bizarre, now they would argue that they’d been perfectly successful and they’d done well and they didn’t need anything more than this, obviously if you’re in a bull market and we’ve been in a bull market for over a decade, you can get away with shortcuts, however it’s my view that no analysis, no proper research can be done in a company, it can’t be complete unless you look at the financial statements and obviously if you’re a professional investor and the bulk of my business is doing training for professional investors and every single one of them have a fiduciary duty, they can’t not look at their accounts, so their accounts to me are central to an understanding of a business because of a financial representation of what’s happening in that business and I can go through a balance sheet and I can tell you, if you showed me a balance sheet today right now and you didn’t tell me the name of the company, I could tell you with a surprising degree of precision what sort of business it was, just by looking at the balance sheet, well without looking at being now, without looking at the cash flow and I think people just underestimate the power of financial statements, they’re very much less used than they should be. But aren’t they, and you outlined a couple of those ways in publicly, aren’t they, and I think this is where I come in, I always feel we have all this regulation in financial markets, but it’s kind of a, it’s a tug of war between the regulatory fiat that’s out there and says, well this is how you should construct your own balance sheet, this is how our gap works, right, there’s certain accounting practices that are important to you and we have public accounting companies and we have regulators, but it seems like it’s a cat and mouse game, you can always hack this, you can always come up with a way where you defer losses, where you bring profits into, that will be future profits, you bring it into the present, it seems like it’s so easy to fake that a lot of people are discounting it and say, well, why don’t I even look at this, if the company’s basically can, well we know that Tesla has very strange cash flows that are definitely not positive, but they’re suddenly making enormous profits and made it in the S&P 500, if something is at odds there, I mean the stock price was only moved because they went into the index, not because they suddenly made millions, billions of profits. Yeah, I mean obviously, you know, when you prepare a set of accounts there’s a certain amount of judgement involved, there’s a certain amount of estimates involved and of course an unscrupulous CFO and an unscrupulous CEO can bend the numbers and make them appear as they wish and you can do that for quite a long period, if you want to commit a fraud, you can do so, but I think, you know, every fraud that I’ve looked at has given off signals that would have enabled the competent investor to avoid and know that there was something wrong and to steer clear of it and, you know, the problem with a fraud is that, you know, it can do very well for a time because if you’re making up the numbers, you can look very, very good, right, people don’t make up the numbers to show a declining revenue, they make up the numbers to make them look good and so obviously what happens with all these situations is the stock goes up and sometimes goes up very steeply and can continue going up for years until the fraud is uncovered, but when the fraud is uncovered, usually it’s a zero or a near zero, so I think the smart investor understands what they need to look at in order to identify these situations and then once they’ve identified them, they either steer clear of them or if you’ve got the appetite for it, you can go short and, you know, going short of fraud is a dangerous activity because the fraudster will force the price up against you and often you’ll be in the company of other people who identify the same thing as you are, are also short and as you get this ebb and flow because the fraudster sees the share price going down, ramps it up again, the shorts get scared or forced to cover, the share price gets ramped up even more, more shorts have to cover, then more shorts cover, so you get this seesaw effect, but the ending is always the same because, you know, you can’t continue a fraud forever because sooner or later you’ll get found out and so if you’re smart, you understand the rules, the accounting rules, you understand when companies are taking undue advantage of them and you avoid those situations and maybe, you know, have a long dated put option which will pay off over time or, you know, if you’re a professional investor and you’re prepared to ride the ebb and flows, then you’ll be able to trade on the short side, but without having that knowledge and those skills, I think you’re at a massive disadvantage and pre COVID, I’ve been pointing out that the number of companies in the S&P 500 and indeed in the mid cap space who were exaggerating their numbers was a record, I mean, it was like the latter half of the 1990s when there was a huge amount of fraud, there’s a series called NEPA and the NEPA corporate profit margins after tax, if you plotted them against the S&P 500, in the second half of the 1990s the S&P 500 still carried on going up and the NEPA margin started to go down because there’s crocodile jaws and exactly the same thing happened from the second half of the 2010s and the S&P is still going up through the roof and the NEPA margin is going down through the floor. Now, there are certain inconsistencies between these two measures because obviously the S&P 500 includes a lot of overseas earnings, more so than it did 20 years ago and the NEPA margins includes a lot of SMEs because they’re based on the filings with the Inland Revenue Service, the Inland Revenue Service in the United States, so they’re based on tax data, so there’s an inconsistency between the two but generally speaking those two numbers, those two trends have always, when they started to go apart, they’ve always met again, they’ve always started to recover again and the same thing will be true this time, we’ve been in a period in which there’s been an undue amount of fraud and if you’re exposed to it, your bull market will end because if you’ve got a big position in a fraud and it goes to zero, it will really damage your portfolio and I think people have been too complacent. Yeah, I’m with you, I’m fully with you. What I’m interested obviously in is that where do you see this great line that someone goes to a fraud from a creative accounting standard, right? So when people ask me about Tesla, what I think about Tesla, I think it’s one of the most creative accounting frauds ever but it’s also one of the most forward looking, most interesting companies I’ve seen in a long time that also has massive scale effects that isn’t a small player, so I’m really not sure what I should think of Tesla is that something I endure and I tolerate because I know this company has that potential in terms of making the world a better place, right, very utopian, not necessarily making a lot of money, hopefully that is part of the game but it’s obviously very far out cash flows but how much should them, when you see these signs, where does fraud begin and how much of this would you discount? Where would you say, well I accept that because there is so much to this company that even if they are fraudulent, maybe it’s just the CFO and the CEO has no part in it, like do you make this distinction or do you say okay there’s one ounce of fraud in this thing going on? Well, I mean I’ve never said that Tesla is a fraud, I’ve criticised for that, that’s coming from me. Yeah, I mean I’ve criticised Tesla’s accounting and certainly there are a lot of things that are wrong with the way Tesla does its accounting and it’s been able to present the numbers that it wants to present because it’s been very inconsistent in the way it approaches various issues and the Tesla earnings are not really a proper reflection of what a more conservative finance guy would produce but it’s slightly irrelevant because whether they’re making $1 of earnings or $2 of earnings is not, today is not what Tesla is about and it doesn’t necessarily make any difference to the share price but generally speaking, if I feel a company is fraudulently representing its earnings then I will not invest, it doesn’t matter how good the story is because I believe that if I’m going to put my capital to work, I want to put it to work with people who have a high degree of integrity and honesty and if they don’t have that, I’m slightly nervous, I think in the book, I can’t recall exactly sometimes as I wrote it but I talk about investing with billionaires, family owned businesses have tended to be a very good place to invest, you run the risk with a family owned business or founder led business, you do run the risk that there could be a fraud because they’re much more capable of doing something fraudulent but that’s in a very small minority of cases and generally speaking, founder led businesses tend to do quite well and if you invest with billionaires, you tend to do even better and I talk about in the book, investing with crooks so if you have someone who has been to jail and they’ve come out of jail and they’ve started a business and the business has been highly successful, many institutional investors feel uncomfortable because they think if this goes wrong, people are going to point the finger at me and say how could you not have known because that guy went to jail and as a consequence, there have been instances where it’s been possible to make very, very profitable investments simply because many institutional investors would shy away from the stock until the story became too good to ignore, once it becomes super successful, a much larger company, you’ll go okay and you get that sweet spot where nobody wants to touch it, the business is doing really well, you can buy it really, really cheaply and then when people eventually get on board, you’ve made a fantastic return and you haven’t taken a huge amount of risk because at the end of the day, that guy that started off in jail, he’s found in the company always wealth is in the company, you’re in the same, exactly in the same position as he is and I found those that can be really attractive and very profitable opportunity. With that exception, if I feel that there’s something dishonest about a company, dishonest about management, usually it’s better just to stay away because even if you think, oh yeah, I could make money in this, I think a big part of investing is being able to sleep at night and if you, you don’t want to wake up at night wondering about an investment, you want to be able to sleep at night and devote your attention to the next opportunity or to managing your portfolio or whatever, so I believe that honesty and integrity and management is a must have. I don’t know if you’ve had the chance and now we know the result, but if you’ve had the chance the last couple of years to look into Wirecard and Wirecard was a European business actually based in Germany that seemed to have cornered the market for credit card payments in Europe at the time. It turned out that basically none of their revenue actually existed, so they just swapped revenue between different subsidiaries and different third parties that partially existed, partially didn’t exist and so they did this with a relatively small amount of money. So if I remember correctly, it was worth and market cap $100 billion, they were supposedly having about a billion dollars in revenue, a few maybe 100 million in profits, but the actual cash that has been found so far was way less than this. So it seems like with very small amounts of money they could create a massive balloon of revenues and then a massive balloon of market cap because the story was so good. That seemed almost too easy to be true and yes it was a little opaque, but it wasn’t completely difficult to say, well something really strange is going on because nobody who was a user of this potential merchant service, nobody knew them in the market, right? There was always a big red flag, nobody really used them, but apparently they made a lot of money, nobody knew who actually used, which companies, which customers actually used that software. Well I mean, Moircard is pretty obvious, I mean the FT did the big expose, I think it was February 2019, if I remember correctly, I remember having an exchange on Twitter with Lucy McDonald who was then the global CIO equities at Allianz and Lucy is a fantastic person, brilliant investor and she didn’t own Moircard and she said, well Steve, what is it a fraud? I never like to say in public, yes this is a fraud because if you say that and it is a fraud, they’re going to come after you, they’re going to start suing you and they’re going to cause all sorts of trouble. So I didn’t say Moircard is a fraud, but I said there are all sorts of question marks about this and there were some very clear question marks about Moircard. It had, if I remember correctly, a billion and a half of cash on its balance sheet and then it went and raised a Euro bond or, yeah I think it raised a Euro bond and then it did another one and I think at the end it had 2.5 to 3 billion euros of cash on the balance sheet and it had a billion and a half of debt, I don’t know why would you, why would you have that, you know, if you’ve got a billion of cash, why would you be going out and raising debt, that makes sense, sounds like Uber to me, I’m sorry, it sounds like Uber, Uber has this massive cash pile right from the equity investors but they keep on raising debt as well, so they’re taking money from wherever they can, that’s how they formulate it. Well, you have to ask yourself, if a company has a lot of cash in its balance sheet, you have to ask yourself, well why would it be raising more equity or why would it be raising more debt, I mean cash, you know, in some European countries you’ve got to pay to hold cash, you know, why would you, why would you want more of it, most genuine companies are desperate to get rid of their cash and you know, I’ve been very involved with the Greensill de Bac and you know, highlighting what went wrong at Greensill which we started highlighting, I don’t know, well over a year ago and one of the, one of the interesting things about the supply chain finance business is that many European corporates that’ve got cash are funding supply chain finance because of a way of investing the cash profitably in the short term without having to pay interest, negative interest rates on the cash. So you know, any, I think particularly today, any business that you see that has got a big pile of cash in its balance sheet and is then going to the market either for equity or debt, you’ve got to ask yourself, well is there a good reason for that? Now you may, I don’t know the particular case you mentioned, I can’t think of why there would be a good reason but maybe there is, you know, I don’t, I’m sure there are companies that might do that, I mean one reason you might have is if for example you had a large lease book and you had a lot of equipment coming off lease and you had a lot of short term expires so you might just need more liquidity in order to manage that but generally speaking and certainly in the case of water card, the cash balances and the need for more capital was a very clear indicator that all was not well. Yeah, yeah that’s a really good point, when you look at banks and particularly the ones that you know they’re a little less step fast so to speak, what do you think of the accounting practices in the banking industry especially? I always feel it’s kind of a big leap of faith that you have to take if you look into banks accountants accounts because simply most of what they own are securities that are marked to market and that can change at any time right, so there’s a drawdown 40, 50% and then whatever was their profit for the last couple of years just evaporates in a few days. What do you think of the accounting system and how well banks are reflected in this because it seems to me it just doesn’t really fit them or maybe I’m just seeing it incorrectly from the outside. Yeah, before I get on to the banks I should have just said on water card what was remarkable about it was that the FT, the big campaign, I think it was February 2019 and then you know Baffin said the other journalists are wrong but it took until June 2020 for the whole thing to unravel and this is the remarkable thing about some of these frauds is that you would imagine that as soon as the FT started asking questions, people started looking, you would imagine the whole thing would implode, you would imagine that stock market investors would run a mile but no, I mean it carried on and it’s quite amazing to me how people are prepared to just not ignore all the evidence and still hang on to slender thread of hope that this was really something that was going to make them a lot of money. When it comes to banks, I have a sad admission to make so I worked for the largest financial hedge fund in the world and I was one of, I don’t know how many partners we had, seven and eight and we had two portfolio managers, a banks analyst, an insurance analyst, a property analyst and I did the non financial stuff and I used to go out to lunch with my colleagues and the banks analyst would start talking to the insurance analyst and they could have been talking Dutch, in fact the banks analyst was Belgian so they could have been talking Dutch but you know they were, honestly they were talking a different language and from examining up close how some of the best financials investors in the world were looking at banks, I came to the conclusion that banks and insurance companies were for people who were more intelligent than I am. I’m just a simple guy right and banks are incredibly complicated. I remember Sunday Times in the UK was celebrating the 50th anniversary of its business section and they asked me to do a piece on how accounts have changed in 50 years and they managed, I said well get me a set of 50 year old accounts because you know we need to look at what it looked like and only one they could find was the Midland Bank and the Midland Bank accounts in 1967 I think it was, they were something like 30 pages long and it was basically just a balance sheet, there was no data at all and I then got at the successor company which is HSBC and the HSBC accounts that year, I think it was 2017 I might be wrong but the main accounts were 520 pages long, they also published four subsidiary bank accounts each of which was 200 or 300 pages long, just to go through the accounts would have been several man months of work you know because the detail in these things is an extremely difficult thing to do, I work with a guy called Mark Rubenstein who publishes a great newsletter called Net Interest and Mark like me worked at Hedge Fund, he ran the Lansdowne Global Financials Fund which was then the number two financials fund in the world and he knows banks inside out and backwards and if I ever have to do any work in a bank I go to Mark because the point you make is a more general one and this whole thing of having very complex accounts, lots of Mark to Mark accounting, lots of weird spurious investments, that is not a characteristic that is exclusive to the banks, you know if you opened the accounts of any of the Chinese tech companies you would see very similar pattern and they are similarly very opaque because you don’t know how those investments have been valued, you don’t know whether they have been valued on the basis of an open market transaction or a related party transaction, you don’t know who has valued them, you don’t know whether the basis evaluation is accurate and I think many of these companies are carrying investments in their balance sheet where the auditor probably doesn’t know what they are worth, if anything you know I suspect the CFO of the company would struggle to value the businesses precisely and there is an inherent danger in that, the more complex things become the more opportunity there is for obfuscation if not fraud and the more complicated it is the less chance you have of getting an information edge without doing a huge amount of work and people don’t want to do that, people don’t want to invest that amount of time you know so if I, I mean if highly unlikely anybody would make me the CFO of a public company but if I were and if I wanted to cheat what I would do is I would make it super complicated because I know once a guy is above a certain level of complexity people just struggle their shoulders and they give up. Yeah, well yeah eventually you are going to run out of cash, it is kind of this pyramid we are building right so we create transactions between different affiliated third parties, we create these valuations that are not marked to market as you say it could be subsidiary that was just moved around different other subsidiaries and that’s how we got to the market price, in the end I mean the cash needs to run out and currently we are in this space and you said that earlier that we are in this constant bull market but we also have this rise of the loss making companies which we saw earlier in the 90s and we keep seeing this every couple of years in certain stage of the mania but isn’t that slightly different this time and here is why, we print so much money right and we still don’t have any inflation nobody knows where all this money goes so that’s a big mystery maybe you can help me understand this is like a black hole where all this money sinks in like we know there is people who work in the Japanese central bank they print literally billions every day and this money just disappears it’s zero inflation and then the other thing is well if we have such low interest rates generally and the expectation is that they keep on saying though isn’t that the only rational thing to do is to go into loss making now but future extensive cash flow so to just change the risk paradigm we basically just invested the call option that’s what the millennials have figured out right you just buy call options and they hope for the best it kind of worked out the Tesla and a couple of others but that seems to be suddenly rational that you say well I might lose the whole thing but it’s a call option for the future maybe long term in the future and that’s the only thing that works because otherwise the growth the normal growth so to speak it’s gone anyway so we’re never going to go back to three four five percent GDP growth well you’ve you’ve made a lot of very bold statements there I mean you said there’s no inflation I would disagree with that I mean I know that the headline figures say that there’s been no inflation for forever but if I look at what it costs to run my household I can tell you that there is very very real inflation in my household I think we printed 60% including electronic dollars 60% of all dollars I were printed in the last 18 month and we don’t have 60% inflation we have maybe 10% or 6% or whatever the number really is yeah but I mean we don’t have it today you know you should never underestimate the time lags in the system you know economic systems are very complicated and the things take a lot of time to work through and there is this argument about you know is this current burst of inflation transitory or is inflation endemic in here to say I think quite a lot of economic commentators have said that we are in a new inflationary environment I listened to the podcast I’m trying to remember which one I think it was macro voices and they had David Rosenberg on and David Rosenberg I’ve got a huge amount of time and respect for it he helped me a lot in 2008 because he was very very she helped me understand the housing market and so on in America and I I respect for him and I thought he did a very good job of a very persuasive job of explaining why there wouldn’t be inflation this time around because under Trump you 3% unemployment and you’d know inflation then so why should we have inflation now but I listened to a webinar with Dylan Grice who I used to know when he was a strategist at Societé Générale and Russell Napier who was former strategist at CLSA and who I’ve known for some years and who’s a Palomine and who I think is one of the most brilliant people I’ve met and you know he’s got an astonishingly powerful mind I mean just amazing and he last year said you know I’ve come to the conclusion that this inflation is coming to an end and we’re going to enter an inflationary period and he’s got some quite extreme views on the consequences of that I mean I just look at this very simply we have I thought when post the global financial crisis I thought they’d injected enough money to create some inflation and I was slightly surprised that they didn’t manage to but you know we’ve done that in spades again on top of you know money being thrown on top of money and then even ever higher quantities it seems slightly impossible to me that we won’t get any inflation and obviously we’ve got a period right now where we’ve got rising energy prices and whenever you’ve had whenever you’ve had inflation it’s usually been accompanied by higher energy prices energy feeds into everything and so we’ve got higher energy prices we got loads of loads of businesses that are struggling to produce supply and what are they doing they’re putting up price and we’ve had an era in which it’s been an era in which the rewards have accrued to the capital owners and labor has had a really pretty bad time and I suspect that labor will seek to have a better time obviously in the 1970s you had powerful unions and they were better able to represent labor and have this cost push inflation labor led inflation and we’re not in a period today in which that’s as straightforward particularly when you’ve got the rise of the gig economy particularly when you’ve got globalization and you can send stuff to India or Vietnam you know I outsource some of my work and some of the subcontracted work to India and subcontract some stuff I had some stuff this morning from Vietnam you know I’ve got a guy in Vietnam who draws does drawings for me because it’s a lot cheaper than doing it in London central London obviously so those will continue to be a cap on the rate of labor inflation but guess what you know globalization has been around for a long time and the people in Vietnam probably want a bit more money and everywhere synchronously is recovering from the pandemic and we have got inflation today and I interviewed Mario Gabelli for Real Vision two or three weeks ago and I was interested to do this because Mario is 79 and he’s one of the very few investors who have lived through the era of inflation in the 1970s in markets you know there are people who have been around then and remember it as a child but there are relatively few people that actually were investing then and I was keen to understand from him you know what it was like working in the stock market when inflation was very high he was slightly reticent on that but he made this amazing comment he said inflation is a bit like toothpaste once it gets out the tube it’s very hard to get it back in and you know I think that’s what we’ll find we’ve got a very high level of inflation today and I think we’ll find it very difficult to bring it under control because the central banks will not want to put up rates and if you don’t put up rates that inflation will carry on because its rate increases that historically have been the cure for inflation and that I think is why in inflationary environments equities have suffered massive deratings and it’s quite possible this time around that the inflation will actually not impact equities so badly Russell Napier’s view is that it’ll be even worse than before and I think that’s a possibility and I’ll be quite an extreme view there’s a possibility that we’ll see deratings in the expectation of higher rates but if there’s slow to go up rates they may be slow to bring inflation under control which may make people even more worried about future rates it’s a very very uncertain picture I don’t have a very strong view on how it will pan out but I do believe that we’ll be seeing higher inflation than we have formally and I should just say on this that the official figures I mean I don’t really understand how they compile the official figures but when I look at my big bucket of spending I suffer and have for the last ten years suffered very high levels of inflation because what do I spend money on? I spend money on my children’s education that’s been going up that has not been a deflationary environment I can promise you if you’re trying to educate your kids in central London it costs a lot more than it did ten years ago what else do I spend money on? Medical insurance. My medical insurance is a multiple obviously I’m older and my children are older and my wife is older so obviously that all affects the premium but I’m sure like for like the premium I’ve gone up a lot. I see where you’re coming from I fully see where you’re coming from and you’re absolutely correct I feel I’m more on the David Rosenberg side and I see it like if you leave this macro view for a second and zoom in what I see and right now here in Kenya what I see is that prices for anything in Kenya have come down they say well this is COVID you know everything is a little down and the tourist economy is down but it’s also food because suddenly there’s all these delivery apps here not just Uber Eats and you could get anything delivered for 50 cents it comes from the other end of the town and it’s still being delivered and it seems so incredibly efficient and in the economy and Kenya is always a little ahead but it wasn’t exactly an efficient delivery economy that existed two years ago now some restaurants were great others were crappy but it was generally expensive I always think of Kenya as an expensive place now I feel like it’s the opposite it’s not just it’s not like Southeast Asia but it’s moved so much in two years with tons and some of these elements where I always thought well food is so important it’s maybe not the big budget item anymore but it is in Kenya way bigger budget and percentage wise than it is say in London and the prices here dropped a lot because suddenly you get food from anywhere in the city and obviously Uber does a lot of promotions all the delivery apps do promotions with investors money so I feel like when I see what happened in Kenya it’s the opposite right it dropped is a huge deflation because mostly of technology entrepreneurship and I always start a little bit with this view if we feel I think we all agree that maybe we have a really good thought on this and I had Mike agreeing on in the last episode we kind of hit a similar topic where we felt so we know the technology is deflationary and see which we know China is deflationary so we’re all good on this but but we also on the other hand feel the productivity growth is low we also feel that entrepreneurship is what it should be and NASA talent obviously is very very very strong in that opinion and I absolutely share that well what’s going on if entrepreneurship isn’t doing this what is creating this this this extremely low yields and bonds that people have been not just ignoring I think they’re tolerating it for a long long time is something doesn’t really add up is entrepreneurship so good and we make the world a better place and make everything cheaper or is entrepreneurship so terrible and we don’t produce any growth rates and like in my mind something is something isn’t add up isn’t adding up from what I see in a micro level and what we just talked about in a macro level well you’ve you’ve touched on an ironic example of how the money flooding out of central banks is created deflation in certain pockets of the world because if there wasn’t so much money floating around highly loss making companies and interest rates were slow highly loss making companies wouldn’t be valued as highly and it would be you know there’s so much capital around that there’s loads of companies competing to do delivery and they’re prepared to lose bucket loads of money in order to be the last man standing well that’s that’s a product of the fact there’s too much capital floating around and it’s too cheap right well guess what when that situation comes to an end as inevitably it will because all that capital is being being burned right because I’ve got no idea how much it costs to get a piece of a meal from a restaurant on the other side of Nairobi to you but I can promise you it’s more than 50 cents right and you know the cheap meal delivery they’re coming at a loss right and you know at some point in the future reality will set in because one or two or three of these players will start to go bust because they’ll run out of capital because their shareholders will run out of patience and the money won’t be free and the money won’t be as plentiful and restaurants right in terms of restaurant delivery they take a 25 to 35 percent margin on the delivery apps so they basically show up say you can maintain your own prices but we you have to drop your prices by 35 percent because it’s all margin if you want to be on the platform and it you know to an extent it needs to be competitive what’s the in restaurant price and this is extremely deflationary because food prices made in restaurants just drop 35 percent worldwide but yeah but I mean in a global sense of the macro sense which I think is amazing for for consumer comfort yeah but I mean look you know we especially in covid we’ve had no choice but have more deliveries but it’s not quite the same experience is it having a delivery versus going to going to the restaurant and yeah I mean they’re they’re taking the 30 percent 25 percent commission but it still doesn’t cover the cost of delivery for many of these for many of these deliveries you know if I just look at just eat and I look at my local if I open my just eat app the the first choices on there are restaurants that have a very very low price point and I’ve never I’ve never looked at any of the delivery companies I’ve got no idea what the real economics are but I’m I would question whether the the current pricing and the current volumes are sustainable because it seems to me that there’s a lot of just to eat deliveries or Uber Eats or you know whatever whichever delivery company you want where you’re delivering a $10 meal or a $20 meal and they’ve got to pay the the rider they’ve got to pay for the petrol they’ve got to pay for the software they’ve got to pay for the infrastructure and it doesn’t make sense right it does doesn’t make economic sense to me I mean it may be that we’ll find out that I’m wrong and that they can somehow manage to scrape together a living but I’m firmly of the view that there’s been a flood of money creating a flood of capacity which is creating a price war amongst the participants and when the flood of money goes away the flood of capacity will diminish over time and the cost will go up and what you have today is likely an artificial construct because there’s too much competition and when that when you know when things settle down the cost of this will will go up to you because yeah it must do I mean you know some of these some of these services they use the restaurants own delivery people so all it is is a platform and you know from the perspective of the restaurant yeah they’re very happy to get this incremental custom because it keeps their kitchen busier and they still can offer seats in the restaurant so it’s very good economics but when the guy the restaurant own delivery guy comes to my house and says here’s your delivery isn’t he going to say well why don’t you order direct next time and we’ll throw in a free milkshake or a free dessert or because why should they give away the economics and I think that’s the that’s a big issue to to my mind it’s an interesting area it’s one that I would like to spend a bit more time on because it’s one that I don’t fully understand today and I would like to understand a bit better so I should probably probably you should never talk about something you don’t understand that you’d probably never talk in public about the theories that you’re still working on and formulating and trying to I stood I do this all the time I think no it’s you know it’s it’s part of this this this mind building that that we do on the internet and I think this is what YouTube is all about is that it’s all unfinished business and yes there is negatives to this and there’s way more chatter than it maybe should be and there is not enough effect sometimes but I think this it really helps me understand who other people think even if the finished opinion might not be relevant yet right it’s not fully formed and I actually was it was just in your boat it felt delivered this delivery business is is a is going to be the graveyard of many many companies and all these billions are gone and I recently changed my opinion I felt like the last 12 month and obviously COVID it was a big boost for them something happened there and people are suddenly I feel these businesses are great and I’m late with that because venture capital investors thought that a long time ago right and some of the public investors too but well who knows maybe they still gonna die who cares I had I wish I had I had some of those answers I don’t anyways what what I want to go back a little is when you look at current and you touched on the Chinese internet companies and we just spoke about delivery companies maybe you have some examples where you feel like well either this particular sector this industry or this this geography you feel like or the specific companies that is something where investors right now should look twice because you feel man these numbers just look too good it better you better if you go along and want to invest in a company you better look twice right now where where would these these companies or these groups classes of companies be well Torsten I produced a report a forensic accounting analysis of the five largest Chinese tech companies last summer and if you if people are interested they can go to my website behind the balance sheet dot com and it’s on sale there for I think we’ve reduced the price it was $5,000 I think we’re now charging £3,000 or £3,500 for it and we’ve done a comprehensive review of what of what’s going on in these businesses and I think my clients that have paid good money for that that report would wouldn’t thank me for you know issuing the findings publicly on on air but I mean one of the one of the issues I think that people need to think about quite carefully is if you look at those five companies over the last six years they have invested something like five vision funds or a vision fund each if you like into the hundred billion right so they so collectively they’ve invested nearly five hundred billion dollars in venture capital tech you know there’s the ten cent investment in Tesla some of it has been outside China but they’re predominantly within China and clearly the vision fund itself has had a significant influence in the valuations of tech the tech sector and early stage tech investing course yeah if you if you do five of them and concentrate it in a single country there is no way that you haven’t influenced the price and there’s a circularity to the arguments here because these companies are saying that they’re that they’re that their investments are worth this price and of course you know many of these investments now come to the Chinese stock market and are are still highly valued but the whole chain has been supported by a huge push of capital into it by this by these by these corporations and you know I asked myself well what would these businesses be worth without that now you might argue that that capital was needed in order to create some of these new businesses but I don’t know if you remember seeing pictures of the mountains of bicycles you remember that so that all those like all those bike caps and in Shanghai they had you know mountains of bicycles that were just bulldozed and put in a tip and ended up in the rivers right in tons of rivers in China and I saw it in Thailand that was one of those really cheap car sharing not car sharing bike sharing carts that you could use but we are thinking I don’t know people probably that listen to this they think of electric bikes like Lyft and Uber have those but they were extremely cheap bikes like a $20 bike that was rented out for like $5 a day so they were crappy bikes right and they were just all thrown into the river because people hated that so much and they didn’t use it anymore yeah but I mean the point the point I was trying to make was that there were you know there’s a lot of money burned yeah and a lot of that money has been burned a lot of that money has been wasted I mean you know that’s in a way you know that’s part of capitalism and that’s part of the whole ecosystem in tech because you expect some of the money to be wasted but you know I think we’ll look back on this period with you know a mixture of admiration and trepidation and I think well why did nobody say that these businesses were not worth what they were being changing hands at yeah yeah it’s often you know I think this is this is a really tough question there is and you said that earlier you can’t call them a fraud because once you do you’re you make yourself liable to lawsuits or at least potentially so there’s a lot of voices that that raise a concern we sort of with FT but what when is that moment right when is the catalyst actually ready when when when do these voices actually create a feedback effect that the bubble bursts and that’s so extremely difficult to forecast and I think this the voices are there but they’re being ignored and I remember that from 98 I mean there were tons of people who said well this is unsustainable just not gonna not gonna create any long term effect on these evaluations and something good came out of the bubble right but it was different than what we expected and definitely the bubble burst but I don’t know I talked about that with Mike it’s not very helpful to just stand on the sidelines and say oh it’s a bubble it might go on for the next 20 years right longer than we give we have lifetime left well I mean you know I wouldn’t say the whole stock market is in a bubble but I think there’s certain certainly pockets of stock market which are are so and you know if you look at Nicola I mean I remember saying to somebody you know Nicola had been valued at 20 billion then there was all the who have but they’d fake the videos and all that and the share price fell and it was only but only valued at 8 billion and I said well you know 8 billion I mean what 8 billion for what you know because it didn’t it seems to me like a big 8 billion was a big valuation for for what it represented I think there’s a lot of areas like that where the the valuations just look crazy to me I mean there there’s a UK company I better not say its name but I can remember visiting the company oh probably 15 I don’t remember exactly 10 15 years ago and they do fuel cells and they had this brilliant idea for fuel cells and we’re 10 15 years further on and there are no I mean they haven’t got a working product they’ve burned you know they’ve burned millions millions of pounds but they’re now valued at 10 20 I’ve forgotten how much but you know 20 times what they were valued at when I looked at them and I looked at them and I thought it’s too risky so we’re you know we’re all this time for the wrong this invested they burned all this additional cash they aren’t any I mean I suppose they’re further forward technically but they don’t have a working product that people are buying there’s still an early stage company and they’re valued at 20 times what they were valued at when I wouldn’t put my money in and it’s like well you know I don’t I don’t know the details about that business today but I know for sure that share price is going to fall by 90% you know it’s obvious right and I think there’s lots of pockets of bubbles in in in markets today but you know you always you end of a bull market you always have some bubbles right yeah well that is a great a great way to close this podcast I know your time is very valuable Stephen thanks for for joining us that was awesome thanks for sharing your insights well Josh and thanks for having me I’ll just do before I go it’s a plug for my book the smart money method how to invest like a hedge fund pro if you want to find me I’m on Twitter at Steve Clapham and my website is behind the balance sheet calm where we’ve got a load of useful material if you sign up for our newsletter we’ve got tons of free training content and of course we sell investing courses and these courses are really really helpful if you’re looking to improve your investing skills you’re a private investor you want to do something more than read a book have a look at our website behind the balance sheet calm Torsten thank you so much for having me it’s been a great fun so it’s been awesome and we’re going to put all these links into the episode now just click on us magic thank you all right take it easy talk to you bye bye