Crisis Talk – John Hempton, CIO of Bronte Capital: ‘good things happen to bad people’
John Hempton, the Australian short seller and self-styled eccentric, believes fraudulent companies will soon become evident in the corporate rubble left by the coronavirus pandemic. Hempton, who has bet against 1,100 companies over the course of his career, explained how his hedge fund Bronte Capital goes about finding rotten eggs in business and finance.
Hempton started professional life as a financial gamekeeper, working in the Australian Treasury in the 1990s alongside Ken Henry, the economist and public servant who later became chairman of National Australia Bank.
Developing a knack for sniffing out tax avoidance, Hempton has said the Treasury is where he learned how a company can fake an income. He moved to ANZ for a brief spell before a chance encounter with a headhunter on a ferry to Canberra brought him in touch with Kerr Neilson, the billionaire investor who founded Platinum Asset Management.
At the turn of the millennium, as Hempton joined Platinum, he said he could see fraud everywhere, and starting toying with the prospect of short-selling.
His first short was VoiceNet, a speech recognition software company listed in Australia, which claimed large revenues from selling its product in Chile. VoiceNet said a top Chilean telephone company was its customer, which was easy for Hempton and his merry band of sceptics to verify, or not, as it turned out.
He was a junior partner at Platinum when the firm went public in 2007 and left the business with enough money to allow him to retire. Instead, he set up Bronte Capital with Simon Maher, an investment banker he had met on a stock chat board called The Chimes in the early 2000s. It now has roughly $600m of assets under management.
A restrained short seller, Hempton rarely puts more than 0.5% of his portfolio on a single short. Unlike others, such as Carson Block or Marc Cohodes, who make a living shorting stocks before going public with their evidence, he keeps his short positions close to his chest, employing them as hedges for what he owns. In fact, many companies that have been publicly outed as frauds by other short sellers, like Sino-Forest, had already been shorted by Hempton.
He touches on why he uses this particular strategy in this interview, while also explaining the value of his database of individuals who have worked for fraudulent companies, whom he regards as red flags for prospective shorts.
Valeant, one of his most famous shorts, first appeared on his radar by way of one such person.
His near-obsessive research into companies that he both likes and loathes has taken him down some a number of paths.
On one occasion, Hempton and his friend, the economist Jonathan Tepper, set out to see if there was a housing bubble in Australia in 2016, and whether there was a case for shorting Australian bank lenders. Pretending to be hunting for a new home in the suburbs of Sydney, they met 20 mortgage brokers and said they were looking to borrow 10 times their collective annual income, which they claimed was around A$125,000. They concluded there was a pretty strong case.
But he is perhaps best known for his tangles with billionaire investor, Bill Ackman. They were on different sides of two trades: Herbalife, which Ackman was short, and Valeant, which Hempton shorted.
The market took Hempton's view on both stocks, though the Federal Trade Commission fined Herbalife $200m for "deceiving customers" in 2016 and, earlier this year, the company said it would likely pay $123m to US authorities to settle bribery allegations involving its business in China.
On Herbalife, and Ackman’s famous short of the company, Hempton pulled no punches in his blog in 2013: “Bill Ackman is wrong. And it does not matter how beautiful Bill Ackman is, how smart he is, how rich he is, or whatever. He is still wrong. And there isn't any room for argument about it.”
He labels himself a "Herbalife distributor" on his Twitter profile.
In turn, Ackman called him "certifiably crazy" in an email made public in a court hearing over Valeant.
Hempton's puckish blog, which has a cult following, is a mixture of in-depth analysis and nerdy wit. In a recent post, he compares the words coronavirus and sex using Google trends, and concludes that in all the countries he had tried other than South Africa, the former has been more frequently searched. “Is that because the South Africans are really into sex or that they are not scared of coronavirus? I have no idea,” he writes. “Not all research is productive.”
Bronte’s offices are less than 10 minutes' drive from Bondi Beach, where Hempton surfs — mostly bodysurfing — regularly. He spoke to GlobalCapital from the discomfort of an outhouse — he calls it his “asbestos fibro garage” — having ceded his Sydney beach home to his 20 year old son and his friends.
GlobalCapital: After a crisis which will undoubtedly prompt a sharp rise in unemployment and administer a severe knock to companies' earnings and indebtedness, why are equity markets so strong?
John Hempton, Bronte Capital: The short answer is I don’t know and the long answer is I don’t know.
There are a bunch of puzzles here. One hypothesis is that markets are seeing straight through the pandemic.
If you believe in perpetual 1% or 2% bond levels, and also 30 or 40 times earnings are the right valuation, then one year earnings doesn’t take anything off the value. If you believe in a V-shaped recovery and one year of earnings not taking anything off the value, then it was the dip that was crazy and not the bounce.
But if you believe monetary printing will wind up with a heavy dose of inflation, then you want to own real assets rather than financial ones. The bounce has been much more pronounced in real assets than financial ones.
The belief that it’s a straight monetary phenomenon — as in liquidity’s a very powerful drug — I think makes sense, as banks that are boring don’t go up so much. It also makes sense of why fraudulent biotech is in a wild boom, and marijuana stocks too.
And some odd little numbers start to make a bit of sense, too. For example, the single best month for opening online brokerage accounts was March 2020, and the third best was April. The volumes of small trades going through E-Trade and Robinhood and other interactive brokers is astonishing. Just have a look at E-Trade daily average revenue transactions (DARTS), the numbers show an astonishing growth.
But the question is what happens when the liquidity disappears? And how does it disappear?
In the short run, so the joke goes, the stock market is a voting machine, but a weighing machine in the long run. I wish I understood the transition between the short and the long, because I don’t. Keynes would just say by the long run you’ll probably be dead anyway, or in other words the market can stay irrational longer than you can stay solvent.
I guess it’s like how Ernest Hemingway went bankrupt, which is slow at first, then all of a sudden. So as I said, the short answer is I don’t know and the long answer is I don’t know, but in a lot of words.
Have you found it easier to invest long or short during the pandemic?
I have to say that during the pandemic I sat there like a deer in headlights. We did a lot of buying but it was primarily buying to cover. We had some strange options that paid extremely well and forced us to buy things. We actually bought €300m worth of stock during the pandemic but €200m of that was buying to cover.
In hindsight I should have shorted more and longed more.
Our gross came right in, our net short came in, our long came in and our betawent down. Did I find it easy in the crisis? No, I find it easier when it goes at a pace I can intellectually keep up with. The common view of Covid is a lot of things are accelerated. Shifting online from offline shopping, increasing touch to pay, improving communications such as conference calls over travel. And dare I say it, increasing inequality in some societies.
If you think markets are incomprehensible most of the time — and I’ll put my hands up and say I don’t have a fucking clue what’s going on — then comes a crisis and I have even less of a clue. All we do is find businesses we want to own, but we find a lot more things we want to short.
There have been few frauds uncovered so far in this crisis. Why is that? Or do you expect more to emerge in the coming months? Is there a reckoning ahead for frauds?
We haven’t had time to uncover the frauds yet. It takes a while — the revulsion stage is several months down the track.
You have to remember, virtually nothing has filed for bankruptcy. If you look at retail bankruptcy statistics in Australia in the past few months, they are actually down. Plus the subsidies are so intense that your liquidity squeeze doesn’t happen now. Big things filed for bankruptcy, but they were problematic big things.
Frauds get exposed by going bust. They don’t usually get exposed by activist short-sellers.
You short a lot of companies that you believe are either fraudulent or close to that. And yet, you rarely make your shorts public. Don’t you need someone like a short seller to reveal a fraud?
I’m not averse to exposing them myself, but it’s fraught with risks. There are certain jurisdictions you struggle to do it in. The UK is hard as your defamation laws are insane — I know talking to UK journalists about UK defamation law is like teaching grandmas to suck eggs. But it makes it very hard to go public.
In Australia, you can’t defame a corporation with more than 10 employees but you can defame the executive. And, if a particular executive is heavily associated with that corporation, you can be got for defamation through that.
And that’s a problem. Most of these fraudulent companies have some guiding power; the person who makes it all work and who everyone believes in.
Australia has a bad combination of a historically weak financial regulator, a large amount of dumb money, and very strong defamation laws. If you put those three together it will be no surprise if we find A$30bn, A$40bn or A$50bn lifted by various frauds along the way. I know one or two of them but I can’t tell you because they’ll sue me for defamation.
But there’s another problem, which makes shorting frauds fundamentally very dangerous. As I say, don’t do this at home.
The iconic example is a fake gold mine. As Mark Twain reportedly said, a gold mine is a hole in the ground with a liar on top. Gold mining frauds are as old as the hills.
Imagine I have two gold mines.
Both have a small capitalisation of around $250m and are thought to have roughly 1m ounces of gold in the ground, both with a plan to extract between 2024 to 2037.
In one mine, the gold is really there and is run by a guy who spent his entire life developing this gold field he found. His politics may be to the right of Gengis Khan — think of him driving around in a pick-up truck with a dog and a shotgun — but he’s triangular shaped and hard working. If he wanted to marry your daughter you wouldn’t be unhappy about it.
The other one is run by a crook and if he wanted to marry your daughter, you’d want to grab a baseball bat. But he’s slick and a good salesman and manages to convince the market there’s a good amount of gold in there.
There’s a few ways you can work out he’s a fraud.
The most extreme way to find out is quite simple. If there’s gold in that hill there’s gold in the creek below the hill, as it’s been eroding for a very long time. If you hire a professional planner, and you find no gold in the creek, there is no gold in that hill. You should be bet-your-life certain.
So, being an idiotic little hedge fund manager you put 5% of your fund short this stock, figuring out it’ll go to zero and you can make 5%.
Now, that will happen eight times out of 10. But one day this crook will say: "Hey, we actually have 10m ounces here," and there’s always a journalist that likes to write a hypey story, and if the market believes it, the stock is going up 10-fold.
Your 5% is now a 50% short position and your capital has gone from 100 to 55. So your 50% short position is really 50 on 55 which is 95% short. Now your good friends at [the bank] are putting you out of business on a single stock in which you’re right!
The answer is, you cannot afford to be 5% short a fraud for long — not more than a day or two. The reason why is that frauds are completely disconnected to reality.
So there are two ways to skin this cat. One way is to do what we do, and just put a slim 0.1% on. The other way is to put 5% on and either be Carson Block or hire Carson Block. Go loud and [for] long and hope you knock 30% or 40% off the share value.
I’ve never known Carson to criticise a company in which he’s wrong. His arguments have always been pretty good but the loud strategy still only makes sense if you’re prepared to be 5% short a fraud.
So the ‘loud and for long’ strategy is too much of a risk for a portfolio like yours?
It’s a risk management decision above all else. The job is to make money for clients without risking the core capital base. The job is not even to beat the index; we would prefer to make money uncorrelated to the index, or even negatively correlated to the index.
This is core to the maths of Bronte. You know the famous 60:40 portfolio — 60% in equities and 40% in bonds — and you rebalance whenever there’s a major move?
If the equity markets go up then I’m going to be unbalanced and will have to sell some equities. If the equity market goes down I’ll have to sell some bonds. You always underperform a rising market and outperform a falling market. Your beta (β) is not 0.6, it is 0.5 and the reason your beta is lower than the equity proportion is because the bonds are negatively correlated.
It turns out a 60:40 portfolio performs pretty well.
If you were [managing] an endowment — say you’re Harvard University and you have $40bn — and you have to draw a billion off every year to pay the university, you could be 100% equities and that will outperform. In fact, you could be 200% equities and that outperforms even more. But the problem is when you draw $1bn off the bottom and you are 200% equities: you go bust.
If I have to run an endowment then the 60:40 portfolio is very good at maximising the draw. Not optimal in terms of total returns, but pretty optimal with a regular draw. For most people — you, me or Harvard — anyone who has to live off the loot, a 60:40 portfolio makes sense.
As a rough rule of thumb, 0.5β portfolios have pretty good characteristics. It’s less good than it used to be because the bond part now earns you 2% or 1%. It was certainly more fun running a 60:40 when the bond yields were 8%.
Now, imagine I have a short book, which in my case is mostly hypey stocks with a beta of two. And suppose I break even over a cycle. This short book made zero, lost zero but is negatively correlated. That could be incredibly value-additive because it will allow you to be more than 100% long but have a beta below one.
This is what we try to do.
Our short book is full of the scummiest, shittiest stuff. I have a diversified portfolio of wanna-get-rich stocks, enough of which are frauds and all of which I’m short.
Then what I could do is say I’ll go 150% long the index and 50% short my 2β stocks. Now my return over the cycle should be 150% in the index. But my risk profile should be 0.5β, but it should be even better than 150% of the index as I get the rebalancing effect as well.
So if we can find a diversified pool of stocks that break even over a cycle and I can short them, I could choose to be 150% of the index and I’d make 165% of the index while having a risk profile of a 60:40 portfolio. As I said that’s the core of what Bronte tries to do.
If you look at Bronte’s history, our short books made small amounts of money over the bull market. It would be a lot more now as we made a lot on the short this year. But at the start of 2020 we had cumulatively made 22% on the short book over 10 years.
Shorting doesn’t look that exciting. We make roughly 2% per year for a lot of work. I am not getting out of bed for 2% a year. But the beauty of that 2% is that it is negatively correlated, which means we run well over 100% long equities but with the risk of being about 0.3β long equities. Which means we make more money taking less risk.
On your "scummiest, shittiest" stuff. I hear you have a database of dodgy people, listing their actions and associations. How helpful is this for a short seller? What are the other essential things to have?
Our database is enormously helpful.
There are also certain hotspots for bad people. The biggest hotspot is Vancouver, then Toronto. In the US, there’s Salt Lake City and Boca Raton. In Australia, there’s Perth and the Gold Coast, in that order. In the UK there’s the AIM market and in Hong Kong there’s all sorts.
They all have a reason. Why Vancouver? Firstly, it’s a gorgeous place to live, especially if you have some money. A house in West Vancouver on the waterfront, you have whales coming by and the weather’s lovely in summer and in winter you can go skiing 30 minutes from your door.
But the second and important reason is Canada is the only country in the top 100 in the world which doesn’t have a national securities regulator.
There is a British Columbia Securities Commission, which is owned by the stock promoters — it is completely captured. It’s not even bad at detecting fraud, it’s good at encouraging fraud — as long as the victims are not in British Columbia, meaning they’re American, the regulators simply don't give a shit.
To pick an example, an activist put a short on Silvercorp. That’s a famous one as the activist’s researchers in China were arrested and thrown in prison. But the short seller was right, and the BCSC prosecuted the short seller for stock manipulation.
[Silvercorp Metals did not respond to an offer to comment by the time of publication.]
The only other jurisdiction that would do that is Germany, though the Germans are going to wind up being embarrassed about that.
But the BC Securities Commission has no shame, none at all. It should be called the British Columbia Securities Fraud Promoting Organisation.
[The British Columbia Securities Commission declined to comment.]
In the US the two biggest hotspots are Salt Lake City and Boca Raton. Boca is basically Palm Beach, Florida, and everyone’s job there is to fleece old people, whether it’s doctors or insurance agents or hospitals. The basic job is to separate rich old people from their money. A place with a large number of rich old people is a good place for a securities scam.
Of virtual places, my favourite is Facebook. Fraudsters on Facebook are equal opportunity political rip-off artists. There are some classic frauds. For example you only advertise to 58-63 year old people, those who have just retired or are about to retire, and who have expressed pro-Trump or extremely strong conservative views.
The basic schtick is you start hitting them with advertisements saying the US government is going to be completely insolvent soon, with Democrats about to get in and taxes about to go through the roof. Welfare is out of control and the central bank is printing loads of money, and the only asset you can sensibly hold is gold. Hit them with a bunch of stories that reinforce that belief and then lead them to fraudulent gold investing sites. You’ve suckered them on their own political belief.
But there’s a liberal version of the same story. Find the person who believes, as I happen to believe, that greenhouse gases are a major threat and we have to deal with renewable energy in a sensible way. Then lead them to a site and rip off their life savings.
The beauty of this fraud is it’s invisible to everyone except the target. The old penny stock fraud was visible to everyone, including me as a short seller. I have a database of over a one million penny stock newsletters.This one is harder to track.
On other red flags. If you see an international company looking to raise debt in surprising ways, like a niche debt market, what do you think? Is that a red flag?
Absolutely. I love it when my frauds issue debt because it’s the best trade to short. There are all sorts of weird red flags like that but they’re not 100% reliable. Niche debt markets, second tier exchanges, cross-border listings are all really good red flags.
For example, I believe several Chinese stocks listed in Germany are fraudulent.
This is why. Germany is typically a low price to earnings ratio (P/E) market, at roughly 10, 11, 12 times, whereas Shanghai and Hong Kong are typically high P/E at around 20 or something. Now, why would I take my perfectly good Chinese business and list it in Germany, where I get less money for it and also have to translate all my stuff from Chinese to German?
The answer is I wouldn’t do it. So why would I list in Germany? It’s because the local market wouldn’t accept my shit. It’s not very surprising that a cross-border listing is fraudulent, or somebody who raises money in an obscure way.
Has Bronte Capital ever been wrong in its analysis of a company?
Of course. [We've been] not even close — both on long and short. Short ones are more interesting but longs are unfortunately more common. Short we’re right much more, mostly because we are dealing with only the here and now.
Our classic short is someone who claims for example to have a big gold deposit. They either do or don’t and we will be right or wrong on the basis of present information. On a long we need to predict the future. We are guessing as to whether this product will be important in 10 years.
Shorts are easier because it is easier to know more about the past and present than the future.
But we get things wrong on shorts too.
There are three assumptions in our short book.
Firstly, once a scumbag always a scumbag. If you were a fraudster 20 years ago you’re probably a fraudster now. Secondly, if you hang around with scumbags, you’re probably a scumbag. The third lesson is if you invest with a scumbag, you’ll probably lose money.
All those lessons are right on average and wrong in specific [circumstances].
There’s someone called Murray Pezim, a Canadian who died in the 1990s and who in my mind committed 150 frauds. But he also found a really big gold mine at one stage, called the Eskay Creek Mine.
When he found it, he drilled the hole and poured one gramme of gold dust into a tonne before he sent it to the lab. But when the tests came back, he got back 16 grams, so he really had a gold mine with 15.5g.
One of the sad lessons in life is good things happen to bad people. And your mum never told you that, but unfortunately it’s true.
(Representatives for Bill Ackman's fund, Pershing Square were approached for comment, and did not wish to give any statement on record.)