As we observe the ever-evolving political landscape in Washington, D.C., investors are facing a moment of profound uncertainty. This uncertainty is, in part, driven by the current administration’s policies and their potential long-term economic effects. Specifically, we believe there is a compelling case for shorting U.S. Treasury bonds, based on two key catalysts: first, the inflationary nature of the President’s agenda, and second, the possibility that Congressional Democrats could tie the debt ceiling to the removal of President Trump from office. Together, these factors create a potent mix that could put force bond yields higher and trigger significant market shifts.

Catalyst 1: The President’s Agenda is Inflationary

At the heart of the inflationary argument is the economic agenda put forward by the current administration. Specifically his policies on tariffs and immigration. I’m going to spare the reader the reasons why tariffs and the deportation of a significant portion of the agricultural and services workforce would be inflationary. If you are significantly pro-Trump, you likely wouldn’t believe it no matter who argued it. If you are moderate to liberal, I think the inflationary logic is pretty self explanatory.

If we learned nothing else from the Pandemic…when you crimp supply…eventually prices start to head higher. Those costs (along with tariffs) will eventually be passed to the consumer. The result is inflation. The solution to inflation (at least in modern economics): Raise Rates, Fast and Hard.

Catalyst 2: The Debt Limit Crisis and Constitutional Conflict

While the inflationary pressures created by the president’s policies could be significant in their own right, there is a second catalyst at play. In recent years, the U.S. has repeatedly faced crises related to the debt ceiling, with Congress often engaging in high-stakes brinkmanship over the nation’s ability to borrow more money. However, this time the situation could be even more volatile, particularly given the political dynamics at play.

The debt limit is essentially the cap that Congress imposes on the amount of money the U.S. government can borrow. If the debt ceiling is not raised or suspended, the government risks defaulting on its debt obligations, with catastrophic consequences for the U.S. economy. However, what’s different this time is the potential for a constitutional showdown.

It goes without saying that the first few weeks of Trump’s presidency have seen unprecedented challenges to the constitutional authority granted the executive branch of the government. Namely, he’s bypassed them completely in creating DOGE and granting them access to highly sensitive data. Additionally he’s overridden legislative decisions about funding. To say that Democrats are desperate is an understatement.

Here’s the question I’m posing — Would the Democrats be willing to nuke the whole economy to get the ultimate scalp?

If Congressional Democrats believe that the president's policies are unconstitutional or financially reckless, they may be willing to leverage the debt ceiling as a means to challenge his leadership. Republican Congressmen and Senators could be faced with a choice, remove the President or watch the economy explode.

While this may seem unlikely at first glance, the political climate in Washington is increasingly polarized, and both sides are willing to take extraordinary steps to assert their agendas. Regardless, even without a default, Ratings Agency may downgrade US Treasuries if the political stability continues to deteriorate.

The Implications for Investors

Given these two catalysts—the inflationary nature of the president’s agenda and the potential for a breach of the debt limit—the investment case for shorting U.S. Treasury bonds becomes more compelling. The combination of higher inflation and political instability creates an environment in which Treasury bonds may see significant volatility compared to historic norms.

Investors may begin to question the stability of U.S. government debt, and the once-pristine reputation of Treasury bonds could suffer. This could set the stage for a significant market correction, with Treasury bonds at the center of it.

For investors, shorting Treasuries in this environment could be a potentially profitable strategy. By taking a bearish position on bonds, investors could benefit from falling prices as inflation pressures build and political risks rise.

Conclusion

In conclusion, the case for shorting U.S. Treasury bonds is rooted in two key catalysts: first, that the president’s policies are inflationary and will drive up interest rates, and second, that the political situation in Washington, particularly surrounding the debt ceiling, may undermine the stability of the U.S. government and its debt. These factors create an environment where the value of Treasury bonds could decline sharply, making shorting them an attractive strategy for those looking to capitalize on these economic and political risks.

As with all investment strategies, caution is warranted, and thorough research is necessary. However, in a time of political instability and rising inflation, Treasury bonds may no longer be the safe haven they once were. Investors willing to take on the risk of shorting Treasuries could stand to profit as these risks materialize over time.

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During that same time frame, the monetary damages have increased by nearly 300%.

With this in mind I want to explore whether natural disasters could begin to have a destabilizing effect on financial markets?

I think there are 3 issues that markets need to be thinking about:

1. Does insurance truly have unlimited pricing power?

2. Can an over concentrated real estate market exacerbate risk?

3. Tail risks of catastrophe (CAT) bonds

Limits to Insurance Pricing Power

One assumption I’ve seen in financial markets is that insurance will always earn more after these disasters, via a combination of de-risking and premium increases.

This belief has a logical fallacy inherent in it. It overlooks the fact that most of the premiums come from a handful of properties. And the locations of these properties matter. Consider what properties insurers view as being most “at-risk” — Florida coastal properties and properties in fire risk areas such as the Pacific West Coast rank highest in this category. These properties have two things in common (besides their high risk nature for insurers):

1. They tend to be higher value properties (see map)

2. As such they are owned by the individuals who are NOT as price sensitive to insurance premiums.

In dropping these properties, insurers have sacrificed the significant premiums that they pay out. At the same time they’ve raised prices and lowered coverages on less riskier properties. But these properties may not have the incentives nor financial means to absorb these increases.

The cost of coverage on homeowners

Homeowners insurance has gone up at a compounded rate of 5% per year over the past 20 years.

At the same time the average sale price for a US home has increased at a compounded rate of 3% per year over the past 20 years.

Said differently, in the past 20 years the cost to insure a home has gone up 50% relative to the home’s value. This begs the question, at what point does the insurance become so unaffordable that it causes financial distress for homeowners? For some owners, dropping coverage is not an option due to their mortgage requirements. Could insurance get to a point where it makes holding a mortgage financially unsustainable? I’ve heard whispers from multiple clients that escrow is becoming a real challenge for them. The stats back this up. We are dealing with an affordability crisis in the United States.

Home ownership costs have spiked beyond median income, to the point that for many Americans 45% of their income is being set aside per year to pay for the costs of homeownership. The question is how much further can this spread stretch?

Pricing Power of Insurance in Rentals

American homeownership is at lower levels than it was 20 years ago. At the same time the housing supply has increased by a meager 20% in the past 20 years, less than 1% per year compounded. Home vacancies though are down nearly 3%. Said differently, less people own more homes, but the homes aren’t empty…they are being rented out either as long term or short term rentals.

Long term rentals do have certain advantages over short term rentals. Their demand is more inelastic and they tend to have more pricing power. This doesn’t mean however that said pricing power is unlimited. Nearly 30% of American housing is occupied by 1 person. However more than 70% of housing units are designed with 2 or more bedrooms.

This would suggest that while pricing power in long term rentals is likely strongest in terms of it’s ability to pass insurance costs down to renters, it’s not unlimited. At a certain point single member households would likely look to consolidate. Just because it’s hard to build, doesn’t mean that properties can’t be used more efficiently.

Short term rentals are a different story. In 2023, there were 2.5M rental listings hosted by 785k hosts in the US on AirBNB. Unlike a primary residence or a long term rental, short term rentals don’t fulfill a basic human need. Because of this they have very little pricing power.

As seen in this graphic from AirDNA, revenue per available room dropped meaningfully in 2023, it’s 2nd straight year of decline. Not good since as we’ve previously seen that real estate is getting more expensive to own and maintain. Mix that with the leverage which is inherent in investment properties (typically at 4-6x) and the fact that owners typically hold multiple properties. You now have a potent cocktail for distress.

Is a storm brewing?

It’s easy to see that stress is building in housing. When that stress causes economic injury is unclear. Perhaps this may be why insurance companies are so eager to issue catastrophe bonds. Because they know that relying on premiums to go up forever isn’t sustainable. As a result the amount of capital outstanding in these CAT bonds has increased nearly 10 fold in the past 20 years.

CAT bonds have also performed very well for investors. In exchange for tail risk, investors have gotten equity like returns with low volatility and low correlation to other asset classes. Insurers have been able to pay out CAT bonds with a mix of good market returns and the bounty of increasing premiums. Still, one has to think that eventually so much shifting towards tail risk is going to cause a problem. Especially when bankers create a way to apply leverage to these bonds. (Synthetic Tranches of Collateralized CAT Bonds anyone?)

Conclusion

The purpose for writing this piece isn’t because I have a solution, but rather that I have questions which trouble me:

1. Is there any risk to housing created by rising costs of insurance?

   1. I believe there is. I think we could see costs of insurance lead to abandonment of properties within the next few years.

2. Is that risk exacerbated by the concentration of ownership in housing and poor usage of existing housing?

   1. I believe so. I think we may see distressed short term rentals being converted to long term, or sold on the market at discounts to current prices.

3. Is there a risk that markets get overly cozy with Catastrophe Bonds?

   1. Absolutely. It’s a tale as old as time. New product comes out and offers high returns with less correlated risks. Market splurges because the quantitative metrics are fantastic. Wall Street finds some way to leverage the product. Something breaks and causes an economic panic.

4. Is there some cataclysmic event in which Risks 1,2 and/or 3 create a significant negative event for financial markets.

   1. I think this is absolutely the case. In the midst of a housing recession, a significant natural disaster in a densely populated area topples some over leveraged fund which went ham on a specific CAT bond with previously never before seen losses.

5. Is there some way to profit from this?

   1. I have no earthly idea, but if someone smarter than me reads this and figures it out, let me know.

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Here were some of the ideas I was toying with at the time:

1. Small Caps Could Lead Out of Correction

2. Mega Caps Regress to the Mean

3. A Meaningful Corporate Debt Wall

4. Surging Dollar in Asia

5. Watching Municipal Bond Yields

6. Staying Short Tesla

7. Dumpster Diving/Special Situations

Realistically I invested in 3 of those themes (Numbers 1,2,6,7).

Here’s how I did and how it played out:

Small Caps Could Lead Out of Correction

I don’t know that I would say this was entirely correct, however as seen here in the Morningstar Style Box 1 Year Performance, Small and Mid Caps performed slightly better than large caps across the value and growth sectors. I played it using AVALX and a few mid, smaller large cap health care and tech plays (more on these later). AVALX is one of my favorite mutual funds due to the high insider ownership, great track record and singular focus. However the performance has trailed the small cap value style box generally. In a bull market, it’s hard to beat the index. I suspect next year might show some underperformance as well, although it’s high energy focus could benefit from looser regulation.

Mega Caps Regress to the Mean

This one I was completely wrong on. It’s a lesson I continue to struggle to learn. Just because something is expensive doesn’t mean it can’t get more expensive. That being said I was quick to abandon my strategy (Arrow Reverse Cap 500) and switched to Gotham Enhanced 500 ETF, which is an ETF run by Joel Greenblatt with more of a focus on quality. It marginally underperformed the actual SP500. Again, it’s hard to beat an index in a bull market.

Staying Short Tesla

I liked this idea substantially up until Nov 5, I had successfully been in and out of this one. I’d found 220-240 to be a good range to short at, and around 180-200, I would typically close. Of course I foolishly left my short open on election night and subsequently paid the price. For now I’ve closed this short and walked away with a small loss on the net. But I don’t believe this is a good investment idea going forward.

Dumpster Diving and Special Situations

I liked the Spirit Airlines deal, which of course was foolishly killed by regulators. After that deal, I stepped away from M&A as the writing on the wall was clear. However we did take a chance on the Atmus Filtration Spinoff and that paid off quite nicely.

Finally in June of 2024, we identified 4 tech names that we thought were significantly mispriced. They had quality earnings, great cash flow and the growth in their cash flow more than offset the dilution from Stock Based Compensation.

These companies were:

• Docusign - Up 58%

• Zoom - Up 43%

• Atlassian - Up 53%

• Applovin - Up 334%

We would never have imagined that Applovin would have performed so well. We still hold it but have trimmed our position meaningfully.

Of the 4 names my favorite is Zoom. I believe it’s still only valued for it’s web conference capabilities, and most analysts don’t understand the value that Phone, Chat (Slack Like Feature), Clips (Video Messages), Docs (Notion-lite), Scheduler (think Calendly) and Whiteboard (think Figjam).

Zoom is becoming extremely well rounded, and it continues to deliver valuable add-ons to customers at fair prices. In the previous quarter RPOs accelerated for the 2nd straight quarter after 10 quarters of declining to flat growth. We suspect part of this is the right sizing post covid, another part is the land and expand model that they are successfully executing upon. In my small business, we’ve seen our Zoom spend increase significantly in the past year, while our total spend has decreased. As more APIs and integrations come onboard for it’s docs and schedulers function, we expect them to take market share from Notion and Calendly.

As the market for M&A becomes easier during the next 4 years, we think Zoom is a great acquisition candidate for a larger company like Alphabet or Amazon which on paper would create “synergies” around cloud spend while giving them a diversified revenue stream. Particularly in the case of Alphabet, Zoom could give them a legitimate product suite to contend with O365 by integration Google Drive into the Zoom Workplace offering.

Overall our 60% equity portfolio performed solidly, right in line with the market. We expect 2025 to start strong for the markets, but are nervous looking forward as the impacts of tariffs and immigration policies threaten the soft landing narrative. Currently we’ve diversified into equities outside of the US, in countries which are less exposed to the US and who performed well during the previous trade war. However we still think the 4 tech names we bought in 2024 have meaningful upside (except maybe Applovin but we aren’t prepared to cash out yet).

If you’d like to discuss any of these ideas further, contact us by going to our website. If you’re reading this for the first time, subscribe now for our free newsletter.

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One of the hallmarks we tend to associate with market bubbles is an insatiable risk appetite which evidences itself in speculative investments. However the current market strength is being driving by companies who are generally all financially strong. Over 10% of the companies S&P 500 are up nearly 25% YTD. Because of this, it would be easy to just overlook what’s going on as just a typical bull market.

Furthermore AI does have the potential to revolutionize society. It's a compelling narrative, and it's easy to understand the hype, especially given how meaningfully Tech grew 10 years post the Dot Com burst. But there are a few factors which deserve consideration:

• Soaring Valuations: Here’s the data. Currently CAPE ratio is at a whopping 35.73. While significantly lower than the Dot Com Bubble, and about 10% off the SPAC Bubble, it’s still 2x the average Ratio (Mean 17.13, Median of 15.98) and far above the typical range of between 10 and 25.

  

• FOMO (Fear Of Missing Out): Historically a 15% pullback takes place every 216 days when using the median average and 584 days when using the mean average (which was heavily skewed by a nearly 7 year bull market between 2011-2018). We currently see that it’s been 631 days since a 15% drawdown.

  

• Selective Hype: While most have been mesmerized by AI and GLP-1 names, the reality is a number of swaths of the market has done well. Here is one factor that binds the winners together, Momentum:

  

  It’s impossible to ignore the way momentum has outperformed over the past year. It’s simply blown away the rest of the market.

So let’s review what we’ve seen:

1. Valuations are elevated

2. We’re 50 days over due a draw down in an extreme environment, 400 days over due a draw down in a more normalized environment.

3. Momentum stocks are blowing the rest of the market away.

Should we be using the ‘B’ word to describe the current market? Not saying we can’t run higher, in fact I suspect we will. However it’s hard to ignore the evidence which suggests trouble could be brewing on the horizon.

A little tax law background to this story: Sec. 1256 Contracts are a type of option or futures contract that has a unique tax treatment.

Unlike most positions which don’t experience a taxable event until either expiration or sale, Sec. 1256 Contracts are marked to market at year’s end, and unrealized gains/losses are counted as if they had been realized. Of which 60% is treated as LTCG and 40% as ordinary income.

In my client’s case, his 1099 reported to the IRS that he generated 130k in profits during the year, with an aggregate unrealized loss of 7k heading in to 2024. In total, the IRS was told that his taxable income from trading was around 123k.

My client came to me saying the 1099 was wrong and that he lost money. Typically I don’t tend to believe this sort of story. However in order not to leave a bad taste in a potential client’s mouth, I decided a simple reconciliation would flush the truth out. After reconciling his account balances, much to my surprise I found that my client was right. The math wasn’t mathing, and to get the bottom of it, we’d have to go line by line and look at every trade and see why.

In the end what it boiled down to was a few small transactions and one major transaction. A Dec 29 23 short option on which my client had a 137k loss. In reviewing the 1099-COMP transaction list, this transaction was not found. TD Claimed that the transaction was not realized during 2023 and thus not included.

Whether or not the loss was realized or unrealized is debatable. In my opinion, as of Dec 29 2023 he had accrued a loss which he was contractually obligated to fulfill and his custodian was holding funds to fulfill that obligation. Thereby for tax purposes the transaction would meet the requirements for realization even for a cash taxpayer (because the money was constructively paid).

However even if I’m wrong, it’s a moot point, since as we mentioned earlier unrealized gain/loss is marked to market for Sec. 1256 contracts and treated as if it had been realized. How multiple TD reps wouldn’t have been able to understand that boggles the mind.

So whether or not the transaction settled or not, the transaction should have been included in his 2023 1099. Either as a transaction in his realized gain/loss as of December 31, or one in his unrealized gain/loss as of December 31. Yet TD somehow didn’t include it in either category (I suspect due to the Schwab integration). Had it not been for outside intervention, my client would have had a major tax problem!

I share this horror story as a lesson to investors. If you think your 1099 is wrong, don’t ignore your feelings. You can check by reconciling your account balance to your 1099 P&L. If a large discrepancy exists, pull a CSV of your transactions and compare them to your 1099. Pay special attention to transactions at the start and end of the year, along with wash transactions.

The morale of the story: we often work hard reading over financial statements to try and find alpha, but maybe alpha can be found by looking at our own financial statements.

Capital Gains Advisory is a tax advisory business based out of Duluth, GA. Steve Harrison is the owner of Capital Gains Advisory and offers investment advisory services as a representative of D. L. Fields Advisory Group, a state registered investment advisor. If you need help navigating the tax consequences of an investing strategy please visit our website at https://cg-advisory.net

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I had some big winning ideas including going short a couple of the banks that eventually went to 0. But no investment paid off better than my investment in Facebook.

I had some big losing ideas such as going long consumer discretionary and personal credit after the sector had taken a bath, only to watch it take a further bath. I also bottom ticked a disastrous short in Coinbase, and didn’t exit my Tesla short quickly enough to turn a nice profit.

For the year I’m flat with a caveat…I have a substantial portion of my portfolio in defined outcome UITs. As these are less liquid, they trade at a discount to their current liquidation value. If these liquidated today, I’d be slightly positive for the year. Nevertheless not the outcome I was targeting in a year where the Index is up big.

Lessons Learned

1. My best investments were ones where the economics of the companies were so clearly out of line with the stock price that the result seemed nearly inevitable

2. Any investment where the result wasn’t a near certainty seemingly went against me

Perhaps then the key takeaway for 2024 is to not take so many fliers. In fact this has probably been my key takeaway for years. As I write this up, I just took two fliers on a couple of names which I think have 10x or greater potential based on special situations, but in both cases I feel the asymmetry is closer to my first lesson than my second.

Looking Forward

As I look towards 2024, here are a few ideas I’m looking for ways to invest in.

1. Small Caps Could Lead Out of Correction.

   1. If rates are in fact going to be cut, I like the idea of being overweight small caps. To hedge my risk, I’ll play in Small Cap Value by owning a Fund with a good record of outperformance, and a manager who’s highly incentivized to be right.

2. Mega Caps Regress to the Mean.

   1. If you look at the markets performance this year, it’s been the largest of the mega caps that have driven a bulk of the gains. That isn’t sustainable. The math doesn’t math. The graph below highlights why. The values of equities to GDP is still at a higher level than seen even during the dot com and GFC eras. When margin expansion reverts to the mean, you could see a large hair cut on all of the mega caps which make up a bulk of the margin expanders. YPS is a reverse SP500 index fund which I think looks interesting. An equal weight fund is another way to play it.

      

3. A Meaningful Corporate Debt Wall

   1. Bankruptcies have accelerated in the past 12 months. Commercial real estate has shown distress, banks have shown distress, and a number of zombie companies have already gone bankrupt. This seems like the type of environment where smaller distressed debt funds can deliver outsized performance. I’m looking for funds that have few restrictions coupled with managers that have skin in the game.

4. A Surging Dollar in Asia

   1. The dollar has been surging in Asia against a number of currencies. This means it’s a good time to be able to buy Asian equities with U.S. Dollars. I don’t know much about the space, so I’ll be looking to find fund managers with the right incentives to invest with.

5. Watching Municipal Bond Yields

   1. If last night was any indication, Democrats may do well in 2024. Given the path laid out in 2022 to increase government spending, and fund it via the IRS, logically it seems Municipal Bonds could see increases in demand. Especially if rates remain higher for longer, or start falling. I’m not particularly interested in the space, but for an active bond trader OR high net worth investor, this may be a space worth watching.

6. Staying Short Tesla

   1. If I’m bearish mega caps, I’m even more bearish the ones with no rational investment case outside of hopes and dreams. Especially with mounting legal and economic woes.

7. Dumpster Diving/Special Situations

   1. Baby’s get thrown out with the bath water. In the past 3 years we’ve had so many SPACs, IPOs, Spins and Mergers that it might be time to start sifting through the rubble.

   2. Speaking of Mergers, looks extra tempting right now. The fact that it’s a cash value per share added with a weak DOJ case, suggests an option play could have a massive payday ala Twitter. Unlike acquisition of this one won’t have to clear EU.

I started writing this article on Monday 11/13 before the market started to rally on soft landing hopes. Russ 2K and QQQ have both outperformed SPY which is somewhat to be expected. It will be interesting to see if we get a Santa rally this year, or if Christmas has already come early for investors.

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When you rent an AirBNB, it’s highly unlikely that you wonder about how the owner is taxed on that income. If you bought their stock, it’s even more unlikely. However starting in 2023, the tax rules will change substantially for AirBNB, and the implications are not favorable.

AirBNB, Etsy, Ebay, for tax information purposes fall into the category of payment processors. The same category that fintechs such as Cash App, PayPal, Venmo, reside in. As such, they are required to provide form 1099-K detailing the volume of transactions that they processed for any one individual.

Currently there is a threshold for reporting these transactions. Until 12/31/2022 the threshold had been $20,000 for any single individual entity. Legislation has now lowered this threshold substantially.

As of 1/1/2023 this threshold has been lowered to $600

Take a moment and ponder on the implications of this. Imagine you rent an AirBNB out for $200 per night. This means if you rented it out for 100 nights or less, you did not get any tax paperwork from AirBNB. The IRS was none the wiser. No filing, no problem. Expanding on this further, imagine that when you purchase the home it was 300k with a 3.5% mortgage. This means, you might have a monthly payment near $1,350 or about $16,000 annually. Obviously you have other expenses, but imagine the equity that you could have built up in your home if you didn’t respect the honor system.

Lets speculate even further however, because in my case I’m an unscrupulous tax evader. AirBNB asks me to supply a W-9 which requests my EIN for tax reporting. But because I’m an unscrupulous tax evader, I figure that I can set up an unlimited number of LLCs (especially in a state with favorable privacy laws). I can then also get a separate EIN for all of them, and submit a separate W-9 for each of the houses.

I can then rinse and repeat this process, I then lever up on low interest HELOCs and use it to fuel my tax free binging.

Whether these entities are US individuals, corporations or even foreign investors, I couldn’t say. To be fair, I can’t even say that one single person has tried to pursue this tax evasion strategy. But I’d be willing to bet on it. It doesn’t seem AirBNB would be incentivized to combat this, as it generates inventory and fees for them.

All that has changed. Every individual with $600 will receive a 1099-K, and if they ignore it because they’ve never seen it before, it’s going to create an income mismatch and automatically trigger either what we will call an “audit” (technically it’s not, but I’m simplifying). Take this same core concept, and apply it Turo, VRBO and any other rental platform. How many of those Tesla Turo HODLers were paying taxes? I’m gonna guess not all of them.

Etsy and Shopify are different stories, but will also face 1099-K issues. Running a retail business is hard. Competition is fierce and margins are tight. However for those just selling a passion product, it’s very reasonable to believe they may have earned less than 20k. It’s also very reasonable to believe that many individuals would think:

Of course none of this is true. You do have to report it and then claim your expenses, regardless of how much your preparer wanted to charge you and irrespective of what you’d get back.

Furthermore, if you aren’t making money, then by IRS definition you have a hobby not a business.

Hobby expenses (except for Cost of Goods Sold) are disallowed per the Tax Cuts and Jobs Act. This means that any tools purchased, software used, or home office expenses would be disallowed. Bonus though, it’s not taxed for Self Employment if it’s Hobby Income

The real problem for Etsy the company is what happens when these passion projects see 40% of any profits handed over for Federal Income, SECA and State Taxes? How many small business owners will decide it’s no longer worth the hassle? I’d bet a substantial amount have already come to that conclusion and substantially more will in the future. I’d also bet that these small owners make up an outsized portion of purchasing volume on Etsy. This too likely changes as they spend less time on the platform.

Now let’s talk about the FinTech platforms. If you regularly go out to eat with friends, you may use Venmo or Cash App to split the cab and tab. This is not income. Only for tax reporting purposes, if you receive more than $600 via any of these apps, they now have to issue you a 1099-K. You have to then file the $600 as income, and then back it out.

Tell me if you can see this happening:

I deal with stupid things like this on a daily basis. This will happen.

Chad will get his situation resolved. However it will be an absolute pain in the rear.

What Chat will eventually find out is that if he uses Zelle (ACH Transfers) then he doesn’t have to deal with this garbage.

Will Chad still want to use PayPal, Venmo or Cash App to receive money? Would you?

Personally I don’t mind, because I know how to do the tax work (two entries on Schedule 1 for those interested). And the solution will spread on the internet. But I could certainly see this rule having an impact on both Square (don’t forget small service businesses (like Barbers) who process business income) and especially PayPal.

This isn’t all bad long term for platforms like AirBNB and Etsy. The new 1099-K rules will likely kill off excess inventory which can push prices down (especially for Etsy). Businesses who thrive will be able to flourish with less competition as some parties head to the sideline. This is healthy as it will allow thriving businesses to continue to thrive and to weather storms more easily. However in the short term, these rules could crimp immediate profits in the next 1-3 years.

Couple this with the resumption of Student Loan Payments, and millennials/Gen Z may have to set aside more money for adult stuff, and less money for discretionary stuff.

You could go the short route and short some of this stuff, but the simpler play is this:

Consider Buying Anything Tax Related (HRB, INTU, TRI, etc.)

For the record I’m long both HRB and INTU but for different reasons. HRB looks the better value IMHO.

Reasons why:

1. 1099K for business income will lead to more Schedule Cs which are a high margin item. I’d estimate margins will expand 3-5% on this change alone.

2. More people will get notices from the IRS for failing to pay. Audit resolution is another high margin item.

3. Currently there is a systemic shortage of CPAs and large companies are better equipped to scale to meet the increased demand

If you are looking for shorts, of all the companies I’ve talked about the ones that I think could be most negatively impacted by these rules in the short run are Etsy (owner churn), Paypal (Venmo), Square (CashApp and small service businesses) and possibly AirBNB (tide’s going out, time to find out who’s swimming naked).

You’ll likely see the impacts starting in Q1 2024 for Tax Companies and likely Q2, Q3 for other businesses as users are caught off guard and start to adapt.

Find this useful. I don’t post often, but when I do, I hope it’s been worth your time.

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Actually, there are a few things which get lost in the hype : Opportunity Cost, Compounding, Time Value of Money and Effective Tax as a retiree.

Opportunity Cost

What so many overlook, is that for many, electing to choose a Roth means saving less money. Most individuals can not afford to maximize both their 401(k) with company match and their IRA contributions. This fact is often overlooked in these theoretical discussions.

Assuming that your employer offers you a 401(k), then a traditional IRA can offer an effective Federal income tax benefit of up to ~16% depending on your tax bracket. In a state like California you could tack on another 5% benefit on state income taxes. For simplicity sakes we will just use 20%. This means that for every $1,000 you contribute to a Roth, you could have put around $200 extra more in a traditional IRA.

Compounding and the Time Value of Money

Another factor not included in these calculations is the time value of money and the magic of compound interest. Money now is worth more than money later. Taxes saved now are worth more than taxes saved later. How much more? This depends on the rate at which you compound those excess tax savings.

Let’s assume at age 25, we generate a $200 benefit by using an IRA ($1200) versus a Roth IRA ($1000). We compound that until age 72 at a rate of 6.5% per year. The math says $200 will nearly 20x to $3,859. If use the same rate of return for the original $1000…the traditional IRA will be worth 40% more than the Roth. Of course as each year passes the compounding effect lowers. Contrary to popular wisdom, the time to consider a Roth might be towards the middle of your career, not the earlier part. You may not receive a tax benefit at this part of your career and you’ll also be more likely to be able to max both the IRA and your 401(k).

Taxes in Retirement

The final point that’s often overlooked in the conversation is taxes in retirement. Most individuals pay substantially less taxes in retirement than they do when they are working. This is because they can live off less income (house is paid off or they use a reverse mortgage), and some of that income is tax advantaged (Social Security).

Assuming you need 50k to live off as a retiree per year. Average Social Security per year is $29,800. This means you would need $20,200 in retirement income per year. At these levels only 50% of your social security would be taxable income (higher income can lead to 85% of your SS being taxable income). Your effective tax rate would be somewhere around 7.8% for Federal, and depending on where you live, 0% for state.

Going back to our original example.

At age 25 you realized a $200 tax savings by using a traditional IRA. You compounded that into $3,859 by age 72.

Using the same rate of return for the $1000 base in both the Roth and traditional…your Roth would be worth 19,294.40. Your traditional would be worth 23,153.28

Applying our 7.8% effective tax rate to the traditional IRA, you would pay $1,805.96 in taxes. This would leave the traditional IRA with 21,347.32 in post tax distributions. In this scenario it beats the Roth by over 10%.

Conclusions

The objective of this post isn’t to argue that the Traditional will always beat the Roth. It won’t. However some people may be leaving money on the table by opting for a Roth without thinking the whole equation through. If you can’t max out your contributions AND you realize a tax benefit from a Traditional IRA, you need to weigh those factors. Simple framework:

• What rate of return can I generate?

• How long can I compound these contributions for?

• What is the extra tax benefit generated?

• How much extra money does that allow me to save?

• What style of life do I expect to lead in retirement?

The purpose of investing should be to grow your wealth, and what better way to grow your wealth than to avoid giving it away to your rich Uncle Sam. However in an effort to side step Uncle Sam, some have fallen into pits of schemes where the money they once were paying to him, now goes to some offshoot of the accounting/finance industry such as payroll or bookkeeping. Or worse, where unethical non credentialed professionals are filing inaccurate and even fraudulent returns.

To say it bluntly…if you own/operate a small business or even work as a contractor, you need a tax professional or at the very least you need to have a conversation with one. That conversation can center around optimizing your entity selection for either tax benefits, retirement planning, health care, etc. A good tax professional can add value.

The problem is understanding what makes a good tax professional. Credentials are important. Are they a JD, a CPA, an Enrolled Agent? If not, why not? If they don’t have credentials you should probably walk out the door. This coming from someone who once thought that credentials were meaningless. Having done both tax and investments, put bluntly, tax credentials are far more difficult to come by than investment ones. However just having credentials doesn’t mean they are the right person for the job.

Does this individual talk about your financial goals and situation? Most CPAs and EA offices are completely booked. Many I know are no longer accepting clients. The ones who may squeeze you in, might just be doing that, squeezing in your returns without the necessary financial goals conversation. It’s the goals conversation that really can add value, especially when an individual has control over certain benefits structuring and accounting methods.

Speaking of goals, a realistic view of business goals is critical. The jump from sole proprietor to being a S or C Corp is a large one. Most businesses are making the jump before they are ready. This sets a tax trap under the new strengthened IRS. The IRS has made it known that one of the things they will be pursuing more aggressively is the reasonable compensation rules which many S Corp Shareholders are unaware of. In order to meet the reasonable comp guidelines, you have to set up payroll. You also have to have proper accounting to be a corporate entity. This amounts to 1000s of extra dollars that most small business owners have never planned for, and are unaware of when unscrupulous individuals pitch them on certain entities.

Currently I’m going over my friends 2022 individual tax return. The preparer didn’t realize they had 2 S-Corps, 1 of which hasn’t been filed yet. The 2nd S Corp which I believe was filed by this business, was done improperly and possibly needlessly (as they set their Amazon sales account under their personal name not the corporation name). Their AirBNB was filed improperly and they missed the depreciation on the house. They also missed nearly 4500 in eligible EV credits by overriding their software to produce the minimum credit on a vehicle eligible for the maximum credit. All while maxing out Section 179 depreciation (which given that the QBI deduction currently is set to sunset in 2025…may not be strategically the best thing for the family).

While this may sound like the tax return for a very wealthy family, it’s not. He’s an HVAC contractor from a middle class family. The problem is we are at the intersection of a growing, digital platform economy and an arcane tax system. One that has become more complex with the Tax Cuts and Jobs Act, CARES Act, Secure ACT and now the Inflation Reduction Act.

Unlike markets where the best of advice can still have a poor outcome, tax has a more stable ROI…if you choose the right expert. We are at the point of the article where for the first time I’ll shamelessly plug my firm. We specialize in helping small business owners and those who’ve recently experienced large capital gains or other financial windfalls. But even if your situation doesn’t fall into one of those buckets, if you ever want a once over of what your current expert is doing, visit my website and book an appointment.

https://cg-advisory.net/

What we know?

Silicon Valley Bank surprised the market by announcing the liquidation of it’s available for sale portfolio at a loss along with a capital raise. These actions suggested a liquidity problem which has sparked a bank run. Unlike most banks, Silicon Valley Bank has a disproportionate amount of HNW (High Net Worth) clients, such as tech founders, VCs, and PE firms. The mechanism designed to prevent bank runs (FDIC) caps insurance at 250k, a paltry amount for billionaires.

Balance Sheet

Prior to the bank run, as of year end SVB sat on 13B in cash. They had an available for sale portfolio of 26B (which they sold for 21B and recognized a 1.8B loss on, suggesting they had already been selling since December).

They also have held to maturity securities with a book value of 91B but a fair value of only 76B.

Of the “held-to-maturity” securities, 95% are over 10 years and the weighted average yield is 1.63. Given the rise in rates, the fair value of this has likely dropped closer to 70B.

Term Borrowings

Another way they’ve added liquidity is by increasing term borrowings by 15B

Let’s do math!

13B in cash + 15B in borrowings + 21B proceeds from sales + 70B held to maturity securities.

119B in total liquidity (HTM isn’t really liquidity but we will pretend it is).

Deposits

Total deposits were 170B at year end.

That means they have a 50B shortfall in liquidity.

However they do have other long term assets

Other Assets

The bank has about 74B in loans valued at amortized cost on the balance sheet. So the key for any investor looking to step in here…what’s the long term value of these loans? Remember the Held to Maturity securities could offer a 25B payout that we aren’t accounting for if they could in fact hold them to maturity. This means the loan portfolio would need to be able to cover 25B in deposits and 30B in borrowings.

This is the makeup of the loan portfolio:

Lets focus on Global Fund Banking and Private Bank

From the 10-K.

Global Fund Banking (segment and class) – The vast majority of our GFB portfolio segment consists of capital call lines of credit, the repayment of which is dependent on the payment of capital calls by the underlying limited partner investors in funds managed by certain private equity and venture capital firms.

Private Bank (segment and class) – Loans to our Private Bank clients who are primarily private equity/venture capital professionals and executives in the innovation companies as well as high net worth clients acquired from Boston Private. We offer a customized suite of private banking services, including mortgages, home equity lines of credit, restricted and private stock loans, personal capital call lines of credit, lines of credit against liquid assets and other secured and unsecured lending products. In addition, we provide owner occupied commercial mortgages to Private Bank clients and real estate secured loans to eligible employees through our EHOP.

So Silicon Valley Bank is highly dependent upon capital calls for the repayment of loans. What is a capital call?

Investment funds are often structured as limited partnerships. The investors are limited partners and the general/managing partner is the fund manager. The investors commit to offer a certain amount of money when called upon to do so. This capital commitment is called as needed to fund investments.

Of course if those investors fail to pay up because of financial hardship or for some other reasons, the fund could find itself strapped for cash. Unless some bank had lent the fund in money in advance on the assumption that investors would always pay up…or at least that they could force payment via the legal system quickly…in this case well that bank would probably be in trouble. SVB is certainly in trouble. Considering the high valuation at which many of these funds were created, it’s unsurprising that investors aren’t willing to hand over their capital. Especially if the bank were to concentrate it’s loans in the hands of just a few clients…

Larger loans and syndicated loans. In addition, a significant portion of our loan portfolio is comprised of larger loans, which could increase the impact on us of any single borrower default. As of December 31, 2022, loans equal to or greater than $20 million to any single client (individually or in the aggregate) totaled $46.8 billion, or 63 percent of our portfolio. These larger loans have represented an increasing portion of our total loan portfolio over me. They include capital call lines of credit to our private equity and venture capital clients and SLBO loans, as well as other loans made to our later-stage and larger corporate clients, and that may be made to companies with greater levels of scale but also debt relative to their equity, balance sheet liquidity or cash flow. Additionally, we have continued our efforts to grow our loan portfolio by agenting or arranging larger syndicated credit facilities and participating in larger syndicates agented by other financial institutions. In those arrangements where we do not act as the lead syndicate agent, our control or decision-making ability over the credit facility is typically limited to our participation interest.

Conclusion

The bank run underway at SVB isn’t just about rising rates. Nor is it about the capital raise. What’s really going on is you have sophisticated fund managers who understand this business, and I suspect they can clearly tell that some of these capital call loans are going to default/be wrote down. Possibly because they themselves have struggled to get clients to pay the funds they committed.

Could SVB be saved? Yes. Is it worth it? Maybe. A buyer would need to have deep pockets, and the overhead to force investors to pay commitments. The equity value would also need to fall. This of course assumes that said investors can do so. Given the way some tech billionaires have seen their net worth cut in half, this may not be a possibility. My math suggests they would need to collect about 83% on the value of the loan portfolio to break even. This assumes that they don’t have to start selling HTM securities at a loss. If they have to start selling that portfolio then they are a goner unless the bank run stops or a buyer emerges.

I don’t believe a buyer emerges for more than 2B given that they will have 30B in debt on the balance sheet as a result of these actions.

It this is true (and SBF’s tweet suggests it is) then Silvergate is done for. They could have their banking charter revoked for something like that. Fed won’t hesitate to make an example out of them.

From an equity point of view a couple of known names that are now on watch are Microstrategy, Coinbase and particularly Robinhood which likely will see 50M shares liquidated at some point (if it hasn’t already happened).

In 2019 the bank had 1B in deposits…it now has about 12B….mostly from digital asset customers.

It’s cash and asset backed (US Treasury Bonds) positions at FMV is 12.8B.

FTX/SBF are featured prominently on Silvergate’s website. So it’s safe to speculate they are customers.

The question then becomes how much exposure does Silvergate have?

5.2B of all deposits on hand are from foreign accounts.

The 10 largest depositors combined have >6B in deposits.

And crypto exchanges are 7B of it’s deposits.

I think it’s safe to say that FTX was likely a large, foreign, crypto exchange with money in Silverbank.

The company also has 1.2B in unfunded but committed loans which would be backed by some combo of real estate/digital assets. Were any of those to FTX or Alameda?

Silvergate is a traditional bank which generates it’s income via interest. They get funds from crypto exchanges, put them into non yielding accounts and then turn around and buy yielding safe assets like government bonds with the funds. How much of those funds are USD denominated, forex denominated or crypto denominated is a question I can’t answer. However the worst case scenario at the moment is USD denominated and the company has matching USD denominated assets.

Obviously losing a potential 10% of your deposits is a huge blow for any bank. As is the risk that any loans which were funded to FTX, Alameda, or any contagion blowups will now be written off. However the stock prior to today’s premarket move was trading at reasonable valuation relative to it’s earnings (10x earnings) and book equity value (slightly under 1x).

When I started to write this I was expecting to find something I thought would be an interesting short given their bitcoin backed MSTR loan. I’m not so sure now. I think if anything this would be the last domino to fall in a rout given what assets they hold against their deposits from crypto customers.

Now comes the difficult part…figuring out whether the selling continues.

Here are the numbers as I have them.

Elon currently owns including options 627M shares of Tesla

Of which 450M are shares and 177M are options.

In November 2021 he exercised 25M (75 split adjusted) stock options at an exercise price substantially higher than the current market price. Since he paid income taxes on those at the time, he will now recognize a capital loss on those shares if he were to sell.

Based on market prices at the time, the 25M had a basis of around 975-1000 (not split adjusted

In April he sold 9.6M shares (split adjusted 28.9M). The realized price (not split adjusted) was on average 869. This would imply a capital loss of around 1.25B if the basis was 1000

In August he sold 7.9M shares (split adjusted 23.7M). The realized price was also on average 869. This would imply a capital loss of 1B.

So using split adjusted numbers. He had 22.4M he could sell at a big capital loss to loss harvest prior to his November sales. Which amounted to 19.5M shares so far. Assuming that he is selling from his freshest batch of options again…these would have created a capital loss of 2.5B.

So where to we stand. Elon could sell another 3M shares to recognize capital losses…before having to sell shares to recognize capital gains. Assuming a similar share price he would likely be at about 3B in capital losses

If he decides he wants to use those capital losses to sell more of his original shares which have essentially 0 cost basis at this point due to the appreciation of the company, he would be able to raise another 3B in funds essentially tax free.

To date his sales have generate 19.2B in tax free cash. Of course his 44B dollar acquisition of Twitter is going to consume that cash. Considering his outside equity was only 7B, he will be on the hook for 37B. Of which 13B is debt he’s taking on for the company, 12.5B was supposed to come from a margin loan which it’s unclear if that came from his existing pledged line (value of 13.2B as of 3/31/2022) or if he’s added to that amount .

That would leave 11.5B unaccounted for. As seen here he’s raised far more than the 11.5B. Which to me suggests this cash also is intended to lower his debt load.

Assuming he’s footing the primary bill on both Twitter’s debt (which is junk rated) along with his own margin loan…his interest bill is likely to be between 2-3B annually.

He gets 0 cash salary, and Twitters ad revs are disintegrating before we speak.

So I suspect he’s not done selling. At least 3.3B more worth of shares is what I suspect he’ll sell.

As Zuck and Marne Levine (Chief Business Officer) spell it out, Meta is making significant investments designed to improve measurement targeting and delivery.

By investing in AI they can make better recommendations and help advertisers to run better campaigns. By investing in messaging they can track the contact point of an advertiser and the customer, thus allowing them to monetize the ad. This is one of the major pain points from Apple ATT.

In other words AI will allow them to move beyond things such as physical location and browsing history from cookies. They can learn from the Reels you watch, the accounts you follow, who your friends are, etc. Things that they control on their platform which Apple can’t touch.

Unfortunately the market is doing what markets do. Panic. The opex and capex numbers have investors in revolt and selling off shares.

Three keys drivers of the Opex raise.

1.) 2B is a one time charge. Total expenses as laid out in the call will increase from 86B at the mid point to 99B at the midpoint. Less the 2B brings you to an increase of 11B.

2.) Payroll isn’t expected to grow in 2023 as they will keep headcount flat

3.) Cost of Revenues will reflect depreciation now that new Quest is launching. In other words a non cash expense. Obviously we don’t know the exact amount but seemingly it’s substantial given the billions which have been invested in Capex for Reality Labs.

Numbers 1 and 3 shouldn’t come as a big surprise to anyone as these were known and should have been relatively priced in. Number 2 is a shock. But it begs the question of why.

I’ll reference this question from Mark Mahaney on the call

As stated…there is a 10B hole in the business. Are we shocked that it doesn’t just fix itself?!? And I disagree with Mr. Mahaney, it’s very clear that this is a major investment priority. It’s just that the market bias against the Metaverse (which long term I believe is a zero) has blinded it to what Zuck and the team are saying: The biggest investments are AI and messaging followed by the metaverse.

Again the driver of expenses is not Reality Labs. It’s the AI engine they need to battle TikTok and Apple’s ATT.

Final thoughts from me: Is it possible that they are focused too much on the metaverse? Yes. Does that mean they aren’t doing enough to solve their issues? No. I think their strategy is sound and the results from WhatsApp (WhatsApp messaging revenues up 80%, North America WhatsApp fastest growing market last quarter) speak to that.

This is a platform that touches 1/2 of the world’s population. Perhaps only Google touches more people on a daily basis. It was powerful enough to create the largest upset in election history. And it’s trading at a multiple which is cheaper than the market, and still substantially discounted to it’s historical range. The macroeconomic environment will change in a few years. If Meta’s investments in AI and messaging solve it’s Apple ATT problem, $250/share seems a minimum. To me betting against Zuck and the Meta team to be able to write good code seems a bad bet over a long time horizon.

Currently both trade at around a 20% discount to their agreed upon purchase price. This is a substantial discount that I suspect represents both the higher cost of leverage and increased uncertainty around both deals. In the case of Twitter, the FUD is the buyer. In the case of Activision, it’s the FTC.

A quick look at both cases, and why I think both deserve a look.

The lower risk — Activision

Unlike Twitter, in Activision you have a willing and reliable buyer. You also have a solid business with good IP, and long term cash flows. The issue here is the FTC. Right now the market suggests the odds are 50/50 that this deal goes through, whereas historically only 10% of all M/A deals fall through. (Source: McKinsey)

So the market is betting against historical odds. The reason is FTC Chair Lina Kahn is known to be in favor of antitrust and antimonopoly. I think it’s worth reading some of what she wrote in her 2018 piece “The New Brandeis Movement: America’s Antimonopoly Debate”

Antimonopoly does not mean ‘big is bad.' The New Brandeisians—like Justice Brandeis—recognise that certain industries tend naturally towards monopoly. This is especially true of networks. In such cases, the answer is not to break these firms up, but to design a system of public regulation that prevents the executives who manage this monopoly from exploiting their power. A second goal is to ensure that executives face the right incentives to provide the best service possible to everyone who relies on the monopoly to sell or to buy a particular product or service. In the past Americans have used both direct government regulation, and various forms of antimonopoly law and policy, to achieve these ends.

So the key questions from Ms. Kahn’s own work….does this merger give Microsoft executives the ability to exploit the power gained from the acquisition?

While certainly this would strengthen the offering of Microsoft’s gaming subscription service, consumers would have another option in the form of Sony PlayStation. So in that respect a system does exist which checks the pricing power Microsoft has. Because gaming is such a distributed industry across PC, Mobile and Console, Microsoft is highly incentivized to make it’s games available to all systems, as it’s the in-game purchases which really drive the LT value.

The fact that large makers such as Take Two and EA still exist, suggests that competition in the industry won’t be harmed by this acquisition. This was the key argument in her paper Amazon's Antitrust Paradox. The ability of companies like Amazon to starve out it’s competition was the crux of her concern. This concern will not be on the table for this acquisition.

Adding to the bullish thesis is the fact that the workers union at Activision is in support of this merger. That alleviates another potential pressure point, the effect of this transaction on employees. Support from the union makes it very difficult for the FTC to argue in court that this transaction would hurt employee competition.

Even if the transaction were to fall through, Activision would still be a good company at a reasonable price which hopefully has used this time to clean up it’s culture. A stronger culture would likely justify the stock trading close to the acquisition price and allow it’s developers to focus on delivering the next big hit. The down side is limited, the up side is attractive.

The higher risk — Twitter

Twitter’s situation doesn’t have the same antitrust cloud hanging over it….but it does have a buyer that’s trying to back out.

Here’s a quick timeline of the acquisition and share price:

• April 14 (45.08) — Elon offers 54.20 for Twitter

• April 25 (51.70) — Twitter accepts Musk’s offer

• April 28 (49.11) — Twitter issues Q1 earnings, restates MDAUs for 2019-2021

• May 11 (46.09) — SEC and FTC open inquiry’s into the transaction

• May 13 (40.72) — Elon says the deal is on hold due to bot accounts

• June 3 (40.11) — Antitrust review is cleared

• July 8 (36.81) — Elon announces he is terminating the acquisition

• July 12 (34.06) — Twitter sues Elon Musk

As this has all played out very publicly, I will gloss over the details to get to the heart of the arguments and key points as stated in the merger agreement.

The $1 billion termination fee is not a factor:

“Parent will be required to pay Twitter a termination fee of $1.0 billion. Specifically, this termination fee is payable by Parent to Twitter if the Merger Agreement is terminated by Twitter because (1) the conditions to Parent’s and Acquisition Sub’s obligations to consummate the Merger are satisfied and the Parent fails to consummate the Merger as required pursuant to, and in the circumstances specified in, the Merger Agreement; or (2) Parent or Acquisition Sub’s breaches of its representations, warranties or covenants in a manner that would cause the related closing conditions to not be satisfied. Mr. Musk has provided Twitter with a limited guarantee in favor of Twitter (the “Limited Guarantee”). The Limited Guarantee guarantees, among other things, the payment of the termination fee payable by Parent to Twitter, subject to the conditions set forth in the Limited Guarantee.”

Since Twitter has not terminated the agreement, this will not be settled for $1 Billion unless Twitter’s board decides to terminate the agreement, something they have not shown any inclination of doing. Mr. Musk can only terminate for $1 Billion if Twitter were to sell to another buy, or shareholders don’t approve the merger.

Therefore, it’s worth looking at the allowable reasons for termination as set in the merger agreement:

ARTICLE VIII

TERMINATION, AMENDMENT AND WAIVER

Section 8.1 Termination. Notwithstanding anything contained in this Agreement to the contrary, this Agreement may be terminated at any time prior to the Effective Time, whether before or after the Company Stockholder Approval is obtained (except as otherwise expressly noted), as follows…

(i) if the Company shall have breached or failed to perform any of its representations, warranties, covenants or other agreements set forth in this Agreement, which breach or failure to perform

(A) would give rise to the failure of any condition set forth in Section 7.2(a) or Section 7.2(b), and

(B) is not capable of being cured, or is not cured, by the Company on or before the earlier of (x) the Termination Date and (y) the date that is thirty (30) calendar days following Parent’s delivery of written notice to the Company of such breach;

So to summarize, Elon can terminate the merger if Twitter has breached or failed to perform any of its representations set forth in the agreement PROVIDED that these breaches would give rise to a failure to conditions set forth in 7.2 sections (a) Or (b). These sections state that Twitter will have performed it’s obligations set out in the agreement AND that

Each of the representations and warranties of the Company contained in this Agreement without giving effect to any materiality or “Company Material Adverse Effect” qualifications therein, shall be true and correct as of the Closing Date (except to the extent such representations and warranties are expressly made as of a specific date, in which case such representations and warranties shall be so true and correct as of such specific date only), except for such failures to be true and correct as would not have a Company Material Adverse Effect…

But here is the kicker….returning to the above Termination Clauses,

provided, however, that Parent shall not have the right to terminate this Agreement pursuant to this Section 8.1(d)(i) if Parent, Acquisition Sub or the Equity Investor is then in material breach of any of its representations, warranties, covenants or agreements hereunder; or

(ii) prior to the receipt of the Company Stockholder Approval, if the Company Board shall have made an Adverse Board Recommendation Change.

Is Elon Musk already in material breach of any representations, such as…

Notwithstanding the foregoing, the Equity Investor shall be permitted to issue Tweets about the Merger or the transactions contemplated hereby so long as such Tweets do not disparage the Company or any of its Representatives.

…disparaging the company in his tweets.

Thus Elon will have to prove that Twitter made misrepresentations that were Material to the acquisition AND that he is not in breach of the agreement already by disparaging the company.

Notice that the argument can not solely rest upon the existence of bots or spam accounts. Nor is it simply enough to prove that more than 5% of the accounts are bots and/or spam accounts. Elon will have to prove that Twitter breached the agreement by it’s representations. In other words he will have to prove that either Twitter gave intentionally misleading mDAU numbers, fudged the numbers altogether, or knew that the mDAU metric was materially inaccurate. This is a very high bar of proof. In other words he will have to prove that Twitter has been committing fraud.

Given that if they were committing fraud, Twitter would have to be either exceptionally dumb or desperate to allow for discovery by initiating a lawsuit, it seems highly unlikely that they were fragrantly defrauding shareholders.

At the same time, all Twitter has to prove is that Elon intentionally disparaged the company in an attempt to exit the deal. A bar which won’t be very difficult to meet. If they do so, then Elon is on the hook, even if Twitter did misstate the bot and spam accounts.

Because of this, it seems highly unlikely that any Judge will find that Twitter misstated material facts in an attempt to dupe Elon AND that Elon has in no way breached the contract by disparaging Twitter.

Given the above, I think a speculative position in both Activision and Twitter seems to make sense. If you think, like I do, that both have a greater than 50% probability of closing, you can allocate a larger percentage to the one you feel more confident in (in my case Activision) and allocate a smaller percentage to the on you feel has more risk (Twitter). Since both cases are completely uncorrelated to one another, you hedge the risk of putting all your eggs into one basket.

Synopsis: Everyone is talking about the Fed and rates. Nobody is talking about legislation which could fight inflation. Foreseeing potential changes to the supply side equation may be useful in asset allocation.

Pretty unreal number and likely one that will increase calls to action. It’s hard to predict a tipping point (a moment which pushes people over the edge and leads to dramatic action)…but 9.1% seems like the type of number which could do it. Put the number to the side for a moment and think about what could lie on the path ahead.

The two competing schools of economic thought are demand side and supply side economics. Demand side or Keynesian economics basically states that to control an economy you need to either stimulate or curb demand. This is most effectively done by using central bank interest rates, along with other forms of economic stimulus (such as QE/QT — which is the purchasing of financial assets or selling of said assets to infuse or withdraw cash from the economy).

Unless you have been hiding in a cave with no internet for the past 6 months, the only thing you’ve heard about on CNBC is the Fed raising rates and possibly sending the economy into a recession. You’ve likely heard numerous critics blame the Fed for not tightening sooner, and that the excessively accommodative conditions are the cause of the rapid inflation we are seeing.

I’m not going to attempt to dispute or prove that theory. However as I prepare for my exam to become an Enrolled Agent (IRS’ tax expert certification path)…it made me think about ways in which legislators may have tools which can assist the Fed in bringing down inflation….tools which they have not used. This is supply side economics, and it’s worth keeping an eye on while the rest of the world watches the Fed.

To begin, I’ll state what should be obvious. A big portion of the inflationary spiral we are in is directly related to Energy prices…and this is a consequence of Russia’s invasion of Ukraine. This impacts the cost of transporting goods, such as food. It also impacts the cost of making critical raw materials. Any change in energy prices will have a large impact on overall inflation.

However in terms of energy…there is little meaningful, short term action which can dramatically change the costs of energy overnight. So I won’t waste time discussing it.

The second less obvious factor driving inflation is wage inflation caused by a tight labor market. The labor market’s influence isn’t as apparent as energy, but it is a meaningful factor. The largest expense for most companies is the salary of their employees. Without sufficient workers, you can’t package, ship and stock sufficient product…which leads to scarcity…which leads to price increases.

This is one particular area in which legislation can make a direct impact by either increasing the labor pool (via Immigration Policies) and/or incentivizing ‘discouraged workers’ (people who give up looking for a job and therefore are excluded from the unemployment figures) to get back in the labor pool. Specifically they can target certain fields like truck drivers, new home construction, etc. with tax incentives and credits which could be key to attracting workers into these fields. These incentives don’t necessarily have to go to the employers…they can be passed directly to the employees via legislative action, the same way credits are passed for college education, electric vehicles, etc.

There are other actions that the Legislative Branch could take to influence supply, particularly in housing. Rent was up .8% in the latest report. That is the highest increase since April of 1986. It would be easy to say the the increase is just a product of tight supply, but in all likelihood it’s at least partially in response to the increased cost of financing the debt on these properties.

However the only solution to the cost of financing, is lower rates and with high inflation that is off the table. Housing has a somewhat inelastic demand curve. So it’s hard to destroy demand, and doing so would likely bring meaningful repercussions to society as a whole. This means the most obvious solution is increasing supply. Besides increasing the worker pool through legislative action, legislators also have tools which could increase the supply of housing by making it more costly to sit on vacant and underused properties. To understand this, we need to first look at current law, and how these can be exploited for tax benefits.

Imagine you rent a condo out on AirBNB for 100 days of the year. However you use the condo for 2 weeks (14 days) on vacation with your family. At the end of the year, AirBNB submits a 1099 to renters on it’s platform (either 1099-K or 1099-MISC). Yet there is no requirement for them to submit the actual days which the house was rented out on either form. Why is this important?

According to tax law because you used your condo for 14 days…you can only legally allocate (100/365)% of your expenses (utilities, depreciation of property (not land), insurance as business expenses. The rest are considered personal. Let’s do some math.

For simplicity sake we will assign the total expenses a value of 3k per month or 36k yearly. In this make believe situation assume your property rents for $180 per night or 18k in total revenue.

By law your business expenses should be 9.8k dollars (100*36000/365), so you would recognize a profit of over 8k dollars. However tax law assumes that people both know and respect these laws. From my experience, in most cases, one or both of these will not be true. People either don’t know, or don’t care, or at the very least will disregard proper tax law for the convenience of less taxes if a friend feeds them misinformation.

One way around this is claiming that you did not use the property for personal use. In fact a vacant property when not used for personal purposes for >14 days can be claimed as entirely for rental use…and the expenses would generate a passive income loss, even if nobody lived in it at all during the year.

Of course this passive income loss can only offset a passive income gain. However if you have passive income such as income from a Limited Partnership or royalty income…why not offset it with a passive income loss and arbitrage the tax benefits to increase the equity in the property?

How could legislation change this? One way is by completely disallowing expense claims on vacant properties, or the IRS could make platforms like AirBNB disclose the # of days the house was in use. They could disallow Passive Income Losses from Rental Properties to be used against Passive Income from other sources. They could differentiate vacation rentals from SFU rentals and create a whole new set of rules. In other words, there are a number of tools at the disposal of federal and state legislators to make holding underused rental properties less attractive. Would they do it?

That is the million dollar question, and it’s one that nobody is asking…because we’ve all been so focused on demand side, that nobody is watching the blind side…the supply side. It’s worth noting that Chair Powell has been vocal in reminding Congress that they alone have the power to enact legislation. Perhaps he will start to be more vocal about tools they could or should use in the coming weeks or months to alleviate pressure off the Fed.

Of course all of this depends on having a functioning legislative branch of the government, which is a major assumption given the past decade of results.

But if we keep getting CPI readings like this one…they may not have a choice as consumers will demand action.

What it means for investors:

• Don’t assume that rental property/rental property companies are bulletproof because they are inflation resistant. Calls for legislative change could change the equation quickly, and the likelihood increases with each print.

• Homebuilders, Transportation could be a target of potentially favorable legislation in an attempt to increase labor supply.

• Consider potential federal and state legislation when analyzing REITS or other rental/vacation rental investments.

Over the weekend a thread was posted by a Fintwit account with over 50k followers. So far the thread as garnered over 1000 likes and hundreds of retweets. As I read it, I was appalled by the inaccuracy of some of what I was reading. I went backed and fact checked the entire thread. Here is a result of a thorough fact check on the content of this popular thread…

While the overall point of the author about being careful with Adjusted Net Income is certainly true…the majority of the claims made in this thread are either partially or entirely incorrect and/or misleading. Given the reference point of a trader being up 350% this year by similar tactics, it moves beyond the misleading category to that of potentially dangerous. Even more so since it encourages fintweeters to “bet big.”

Tweet 1: Net Income vs “Adjusted Net Income” Just met a trader who’s up 350%+ in 2022! His strategy: 1. Look for one-time expenses the Street is missing. 2. Recalculate adjusted net income. What’s that? Let’s do a deep-dive. 7 One-time items an investor should NEVER overlook

Fact Check Tweet 1: Slightly misleading. Every Company uses different Non-GAAP financial measures. However GAAP Net Income is listed on every financial filing and is provided to all analysts on the street. For a list of different Non-GAAP financial measures, see examples below

• Amazon — Free Cash Flow (Operating Cash Flow - CAPEX)

• Microsoft — Constant Currency (GAAP Income adjusted for Currency Exchange)

• Google — GAAP Income + Stock based compensation - Tax effects of SBC

• NVIDIA — GAAP - SBC - Acquisition and One Time Costs - IP Related Costs - Gains/Losses from Investments - Interest Expense related to Amortization of Debt Discounts - Tax impacts of excluded items.

One of the premises of the thread here is that investors need to recalculated adjusted net income for one time expenses. However in the case of Amazon, Google and Microsoft, many of these one time expenses are actually baked into their Adjusted Income! Furthermore…rather than make a thread about it…you could just state that investors should rely on GAAP financials rather than non GAAP, as every company is required to disclose GAAP financials clearly and prominently. But I suppose that’s not a good path to get to 50k followers.

Tweet 2: Why care about net income? It’s supposed to reflect the company’s steady-state revenues minus expenses — what investors project into perpetuity to set fair value. Why adjust? Investors want to remove “noise” (i.e. 1-time items) cuz not sustainable

Fact Check Tweet 2: Wrong. Net Income is the net after tax profit a business records in a certain financial reporting period. It is NOT supposed to reflect future earnings or be used to project into perpetuity.

Some companies provide guidance. Other’s provide LT targets. Often Wall St. Analysts attempt to project future earnings in their forecasts.

Net Income DOES NOT REFLECT FUTURE EARNINGS. That’s because Net Income SHOULD ONLY REFLECT THE NET INCOME FOR THE PERIOD STATED!

Adjusted Net Income on the other hand is often included with earnings calls, statements and press releases to give investors a “better view” of the performance of the company by removing certain expenses which management deems would impair investors ability to accurately value the future cash flows of the company. For the record, I too share the original authors skepticism as to the validity of the claims to many management teams in this regard. I just think the authors way of explaining it is inaccurate and could lead to bad investment results.

Tweet 3: Why not just rely on ‘adj EBITDA’ or ‘adj Net Income" metrics reported on 10K/10Qs - adj metrics are non-GAAP, i.e. TOTALLY UNREGULATED! - so management con do whatever…it wants - which 1-time costs to add back and which sales to remove — totally up to CFO discretion

Fact Check Tweet 3: Wrong. 10-K and 10-Q filings DO NOT USE NON-GAAP ADJUSTED METRICS. They can not add and remove costs…that is called securities fraud. Management can not add back whatever it wants. It can add in certain categories however it must disclose reconciliation on it’s press releases stating how they derive the Non GAAP metrics from GAAP.

The only place adjusted metrics might appear within SEC Filings is in the Key Metrics footnote.

Were a company to insist on filing adjusted metrics in it’s comprehensive statements of income, the Auditor should state that the numbers reported DO NOT ACCURATELY AND FAIRLY REFLECT the financials of the business.

Side note…adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) is not the same thing as adjusted Net Income (earnings AFTER interest, taxes, depreciation and amortization).

Tweet 4: How can u profit from PROPERLY calculating your own adjusted earnings metrics? 1. make a checklist of red flags to look for in financial statements (this thread is a start) 2. If the Street is missing/overlooking any items, bet big that skeletons in the closet will come out soon

Fact Check Tweet 4: Misleading and Dangerous…big skeletons often take years to come out of the closet. History is full of investors who detected frauds early and lost money waiting for the skeletons to come out. Retail investors could lose their life’s savings if they bet big and are early.

Think about how a retail trader would bet big that skeletons in the closet will come out soon? Put options and shorting would be the obvious candidates. However these are extremely risky and should be for sophisticated investors only. Put options because they have a fixed expiration date, and shorting carries borrowing costs along with the risk of getting short squeezed (SEE MELVIN CAPITAL).

Tweet 5: Write-down on investments Tech Co.’s these days are increasingly investing in other tech co.’s for strategic purposes. Esp. now, those investments can take a nose-dive (or moon) e.g. In Amazon‘s Q1 2022 earnings the Street found out it took a $7.6B write-down on Rivian!

Fact Check Tweet 5: Misleading. Publicly traded investments are generally accounted for at fair value (as measured by share price). However, Private Investments which make up the MAJORITY of these investments, are often measured at cost instead of fair value since these have no recognizable market price.

Even this is an over simplification as it’s also important to consider whether the investment is consolidated or if it’s treated using the equity method. The accounting methods used are disclosed on the footnotes of a company’s 10-Qs and 10-Ks. While what was stated about Rivian is true…this was known information. Ford also had a write down on Rivian, but it’s stock didn’t respond in the same way. The problem for Amazon was less about Rivian and more about slowing sales growth, margin pressures on it’s logistics from fuel costs and high capital expenditures.

Tweet 6: Egregious 1-time Stock-Based Comp (SBC) SBC is another super timely item to watch out for now! As SaaS stocks have plummeted, some engineer’s offer packages have lost 90%

To preserve talent, they’re issuing MOAR STOCKS!

Yes, diluting share price even more!

e.g. SHOP

Image…highlighted quote from Shopify Earnings that SBC for the quarter increased 70%

Fact Check Tweet 6: Wrong and misleading. Stock based compensation depends heavily on the mix of options to RSUs as well as vesting periods. An increase in SBC percentage says nothing about options/RSUs issued and more about which vested. It is a trailing expense!

To understand stock based compensation you need to understand how it’s accounted for.

Most companies generally rely on 2 forms of stock based compensation (we’re excluding equity performance awards as these are rarely issued to anyone beyond management):

1. Restricted Stock Units. These typically have a vesting period. They are accounted for at the price they were issued at, and they are recognized on the income statement when they VEST.

2. Stock options. These may or may not have a vesting period. They are accounted for at fair market value. This fair market value is often substantially less than the price of the exercise price as the company has to evaluate the likelihood of these being exercised and what the value of the stock would be at time of exercise. Because of this generally RSUs hit harder as Stock Based Compensation than do options.

Now using the Shopify example which was quoted in the tweet.

Notice the Weighted Average Grand Date Fair Value of RSUs in 2021. $1400+

Compare that to the 2020 Value. $645+

So as those RSUs which were issued in 2021 vest (they vest over 4 years, 25% per year) the company will recognize 150k plus RSUs per year at an average value of 1400.00 (share price at time of issuance).

So the actual quantity of RSUs issues isn’t what’s pushing the SBC up 70% it’s the massive increase in fair value due to the stock price increase IN THE YEAR WHEN THE RSUs WERE ISSUED.

Of course RSUs being issued this year will cause SBC to drop next year (once they start vesting). But for now the income statement is going to look very painful. This is why many investors prefer to look at diluted shares outstanding (a GAAP metric). It tells you the maximum number of shares that are floating around that haven’t vested or been converting. Seeing the % change in Diluted Shares Outstanding is a much better way of measuring how SBC impacts you as a shareholder.

Tweet 7: Restructuring charges

Have you ever met a company that IRL restructures every quarter?

No never!

How bout on paper?

What does “restructuring costs” even entail? Sometimes, just means that CFO needs to add back 2.5B to reported adj EBITDA

Image…Quote the FTSE 100 spent 8.2bn pounds on restructuring their business last year, up 30%

Fact Check Tweet 7: Misleading. Restructuring costs may be legitimate expenses (although they can be abused). Severance packages and one time downsizing expenses may be included in restructuring costs. So too can new hire bonuses and other one time expenses for expansion. These may also include certain write offs. They are allocated to the different components of the income statement. If a company fires and hires people every year, it may have legitimate restructuring costs every year.

Restructuring costs will show up on financial statements as a foot note, however they do not show up as a category on the income statement. Many do not include them in Adjusted Income as they consider them one time expenses. Not sure where the 2.5B to adjusted EBITDA came from, considering the FTSE100 is not 1 business, but 100. Not saying it hasn’t happened as there have been major write downs and impairments on businesses before. However making leveraged bets against a business just based on restructuring costs is a sure recipe to lose money. Unless you are betting on impairments…more on this later.

Tweet 8: Loss from early retirement of debt

When interest rates fall, co’s retire bonds early. Cuz why pay 8% when the mkt rate is suddenly 3%

But to extinguish debt, co’s often gotta pay more than par. Such loss is often hidden in some vague verbiage.

e.g. ‘accumulated other loss’

Fact Check Tweet 8: Wrong. Accumulated other loss is from unrealized gains/losses which are excluded from net income because the gains have not been realized. It includes gains/losses from fluctuation in fair value items which are not readily determinable. Gain/Loss on extinguishment of debt is a REALIZED expense. Extinguishing debt at a gain/loss would affect cash (assets), loans payable (liabilities) and retained earnings (owners equity).

It is true that company’s retire debt early when interest rates fall. As do individuals (we refinance our mortgage when rates are low). It’s the smart thing to do. Would you want to bet against the homeowner who trades in 8% mortgage rate for 3%? Neither would I. Paying a premium over the remaining principal (carrying) value to save on interest makes perfect sense.

Tweet 9: FX Write-downs if u pay suppliers in China but sell to US, there’s huge FX mismatch btw revenues in & costs out! Plus finance depts notoriously suck at hedging. Beware!

Fact Check Tweet 9: Legitimate. Currency risk is a real risk, and companies should disclose it in the footnotes of their financial statements. However some are more opaque than others which is a legitimate red flag.

So currency risk is a legitimate concern and there isn’t much to say about this tweet. Maybe just a more in depth explanation. Earnings must be reported in USD. So if you earn money in a foreign currency, those transactions must be converted into USD using the exchange rate which existed at the time of the transaction. Since there is a delay between the time a transaction and takes place, and the time payment takes place, you have a risk that the currency rate slips and you end up taking a write down on the transaction. Conversely you can also benefit from exchange rates. It is possible to identify companies who are overly exposed to currency risk, and sometimes their financials will indicate what a theoretical shift in currency would have done to their previous earnings.

Tweet 10: Asset impairment

This one I say u usually shouldn’t adjust out.

But most investors + management does.

When to leave it in?

Ask: is the affected asset special/secret-sauce?

If yes, i say keep the cost in ur net income calcs

Like an amputated leg affects the rest of ur life

Fact Check Tweet 10: Confusing. GAAP requires company to plainly disclose any asset impairment. Investors shouldn’t count on historical cash flows from impaired businesses as the purpose of impairment is to tell investors that they do not expect to make the return on the asset that they previously stated they would.

Impairments mean different things in different circumstances. An asset may be impaired due to a change in it’s expected life. Or it may be impaired due to a change in it’s recovery value. Sometimes the impairment is to goodwill or the excess price to book value which was paid to acquire a company. Investors should most definitely look at how impairment affects the business precisely for the reason stated…an amputated leg affects the body for the rest of the life. However, the key question in the thread is whether an impairment is a one time expense you should adjust out? That’s irrelevant for the purpose of making future decisions.

Market’s are forward looking and making a speculative bet based on a mispricing of a company’s past earnings due to an impairment is a foolish bet. What you should do is to determine what the future effects of said impairments mean for the whole of the business.

Tweet 10: Extraordinary legal costs

Management will always obfuscate legal costs / stuff ‘em into “other expenses.” Why?

Increase in legal fees == smoking gun for much bigger (possibly existential) problems.

Where red flags may manifest: - a change in “Risk Factors” language in 10K

Fact Check Tweet 10: Wrong. GAAP requires companies to allocate legal fees to General and Administrative Expenses. Other Income is for income/expenses derived from sources that are not related to the main activity of a business. An example being Amazon’s Rivian Investment, Foreign Currency Impact, Etc.

Factually the statement here is wrong. Any company doing this would be in violation of GAAP and the Auditor should flag this. Not saying that auditor’s are infallible. They are fallible and corruptible (paging Arthur Andersen). However investors shouldn’t bet big on the bad information presented here.

Final Tweet:

End/Happy weekend!

PS I met this amazing trader who returned 350%+ YTD at the @FinTwitConf. Great event! Thanks so much @JonahLupton for inviting me to speak!

P.P.S if u r here, come say hello!

Fact Check Final Tweet: Partially True I suspect

Have no reason to doubt that she met a trader claiming 350%+ YTD at the FinTwit Conference. I also have no reason to doubt she was invited by Jonah Lupton to speak. This all seems about right.

Finally, if any of you would like to really learn how to do proper accounting…I would encourage you to sign up for this free to audit Financial Reporting Specialization class via Coursera. The professors are from the University of Illinois and it’s part of their iMSA (i-Masters of Science in Accountancy) curriculum.

Until the next time I feel like diving into a rabbit hole like this for no reason whatsoever other than this innate urge to either right a wrong or spout off about some crazy thought.

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Essentially what Upstart and a number of other companies have been doing is taking loans, revenue streams, receivables, etc., bundling them…and selling them to banks. Or they themselves even create a special purpose entity (SPE, often a Trust) in which they hold an interest…place the loans, revenue streams, receivables, etc., into this SPE and create a security backed by these assets (ABS) as collateral.

These securities have been in demand. The reason? Yield. With no interest rates in treasuries or yield on mortgage backed securities, income investors have had to find alternate ways of finding yields.

Of course now rates are going higher…and in response treasury yields have shot up. As has inflation, making this a much more tricky market to navigate. As yields rise, existing fixed loan values decrease. At the same time, as inflation rises, credit worthiness falls since borrowers have less income left for repayment. A double whammy if you are sitting on loan portfolios that were generated in a low interest rate, low lending risk environment.

Frankly…we shouldn’t be shocked. Early in 2022 some of these same ABS offerings were pulled by companies like Tesla and Affirm. The reason was a lack of market demand for them. However in light of the Upstart report, what we should be asking ourselves is what this means for companies who have been using them going forward?

Take for instance Tesla.

On the surface, Tesla’s cash position seems very strong with 17.5B in cash.

However a look at it’s Accounts Payables and Accrued Liabilities show that they combine to 17.1B in short term liabilities. When you consider that 1B of that cash is also customer deposits and another 1B is revenues that were received yet still not earned; the cash position may not be quite as robust as some would think. Last quarter the company’s Cost of Revenues was 13B. Total it up and the company needs to be able to generate tens of billions of dollars in cash each quarter to pay its bills.

Of course some would say the company did 18B in sales last quarter alone…cash flow should be fine.

However most people don’t pay for the entire auto up front. Rather they finance it over a period of 5-7 years. Which isn’t an issue if the lender is a disinterested third party like a bank. In the case of Tesla however, Tesla routinely does billions of dollars in financing each year via their financing partners. Currently they show 1.9B in receivables on the balance sheet. What this doesn’t show the amount of loans which they have sold over the years to banks as ABS products (like Upstart mentioned earlier).

In 2021 they reported 1.9B in proceeds from Automotive Asset Backed Loans. In 2020 it was 700M, 2019 857M, 2018 1.4B. In other words, 5B in capital infusions in the past 4 years via the Automotive Asset Backed Loan program. The same loans that they had to pull in March because of a lack of investor demand.

Now these loans are stuck with Tesla and their lending partners. And likely more loans will be stuck. How good are their underwriting standards? Time will tell, but it wouldn’t be a shock if they left standards low to juice auto sales. When you can bundle bad loans with good and trade it for cash…you aren’t holding the risk.

In the meantime, how does Tesla fill the funding gap? Again, time will tell. I suspect much to the chagrin of shareholders that at some point within the next few quarters, a capital raise via an equity offering will likely have to come through the pipeline to keep them in hyper growth.

Tesla isn’t the only company that is facing this issue. If you follow my Twitter you’ll notice a number of recent tweets about Mercado Libre which is a double beneficiary of it’s own fintech platform. It gives customers credit cards, which they then spend on purchases on Mercado Libre generating fee revenue. Mercado Libre then sells the credit card receivables to generate immediate cash (Aggregate gains of 575M, 452M, 359M in the past 3 Fiscal years). Which they then give back to their customers in the form of personal loans such as Buy Now, Pay Later. The customers then use said funds on their site again, generating more fees for Mercado Libre. Mercado Libre then securitizes these loans (currently have over 1B) to borrow against them…and repeats the cycle in it’s quest for South American wallet share.

They currently have 1.5B in cash on the balance sheet along with 500M in unrestricted short term investments 1.7B in loans receivables and 2.5B in credit card receivables. But currently their allowance for bad loans is nearly 30% and rising quickly, so it’s uncertain how much of those loans will actually be collectible.

What is certain is that they have 1B in accounts payable, 2.5B in funds payable to customers, 400M due to the credit card merchants and 1.4B in loans due. If you do the math and assume that all of their loans will be repaid…that leaves them with about 900M in liquidity which would just be enough to cover their wages, taxes, and leases payable for the year.

Domestically, Affirm has 2.5B of these securitization trusts. Unsurprising Affirm was down nearly 12% in the after hours as no doubt investors suspect they like Upstart will be feeling the squeeze from high rates. Everyone’s bought now…but will they pay later? I suppose we will find out next week.

So what does all of this mean?

It means you have a number of growth companies who’ve been beneficiaries of extremely loose financing conditions, who’s liquidity is like to be tested in the coming year. It also means we are going to find out how good lending standards have been in the more opaque corners of the market. Finally it’s a warning that investors need to start paying more attention to the risks on their company’s balance sheets. It’s not enough just to look at Free Cash Flow, Revenue Growth or P/E Ratios. You have to know the risks that are hidden in plain sight.

Especially in the eyes of the Department of Treasury and the US Government. So much so that the IRS since the Tax Cuts and Jobs Act offers 3 different, stackable tax treatments for Depreciation. Section 179, Bonus Depreciation and MACRS depreciation.

For some of you these may be new terms as investors are more familiar with straight line depreciation which is depreciation for financial accounting purposes. However financial accounting depreciation and tax depreciation are not always the same thing.

Since we are talking about public companies we will exclude Section 179 since it’s irrelevant to businesses that place over 2M in assets into service in a given year.

MACRS Depreciation (Normal Depreciation) is a system of tables and tax treatments which allows you to depreciate an asset much in the same way that a car depreciates. The bulk of it happens in the first few years and slowly tapers down, over the life span of the asset.

Bonus Depreciation has always existed, but in 2018 was changed so that until 2022 100% of an assets depreciation could be taken in its first year. It is limited to non realty assets. So if you have a very profitable, growing, none real estate, cap-ex intense business…in theory you can buy a ton of the assets you need to fuel growth, depreciate them right away, and instead of paying taxes on the profits…re-invest those profits into more assets to grow the business.

I defy someone to find a more perfect business to take advantage of these rules than cloud computing.

Cloud computing is an extremely capital intense business, requiring substantial server and networking assets. All of which are eligible for 100% depreciation instantly.

Don’t believe me…look at the 10K filings for the Cloud Kings

Google

Value of IT Assets on Dec 31

Pre - TCJA (57% increase over 2 years):

2015-13.6B

2016-19.8B

2017-21.4B

Post - TCJA (114% increase over 3 years):

2018 - 30.1B

2019 - 36.8B

2020 - 45.9B

Amazon

AWS Property and Equipment on Dec 31

Pre - TCJA (78% increase over 2 years):

2015 - 8.3B

2016 - 10.3B

2017 - 14.8B

Post - TCJA (116% increase over 3 years):

2018 - 18.9B

2019 - 23.5B

2020 - 32.1B

Microsoft

Computer Equipment and Software on June 30

Pre - TCJA (50% increase over 2 years):

2015 - 10.8B

2016 - 12.4B

2017 - 16.2B

Post - TCJA (216% increase over 4 years):

2018 - 27.6B

2019 - 33.8B

2020 - 41.2B

2021 - 51.2B

When considering these numbers against the law of large numbers…these growth rates should’ve remained constant or decreased. Yet they accelerated. Likely to take advantage of the tax benefits.

As mentioned earlier…these benefits start to sunset in 2022. Meaning capex should likely slow. This should have 2 effects on the businesses.

1.) GAAP profits could likely decrease temporarily. This is due to the need to account for deferred tax liabilities as a result of front running the depreciation. Because the financial depreciation runs at a slower pace than the bonus depreciation…the tax benefits of losses from depreciation will not be realized…as the bonus depreciation means the item would be ineligible for depreciation.

2.) Free cash flows will likely increase. If you assume that they have front loaded their balance sheet with as many assets as possible to take advantage of the favorable tax treatment…then capex will likely slow substantially. Thus freeing cash flows to be applied elsewhere…like to acquisitions, investments or repurchases.

Another name that could be a beneficiary from this tax treatment is Facebook which has also invested heavily in network equipment over the past few years.

Networking Equipment Component of Balance Sheet

2020 — 22B

2019 — 17B

2018 — 13B

2017 — 8B

2016 — 5.2B

2015 — 3.6B

Semiconductor Companies which actually manufacture might be another industry where you could see a substantial stepdown in Capex after the rules start to sunset and fade in 2022.

In Conclusion

Businesses which are asset heavy, input cost light, are being setup to turn into absolute cash flow machines after 2022 given the ability to lower taxes and reinvest into growth. All of these companies are re-investing at unsustainable speeds in an effort to corner their markets and take advantage of the Depreciation Rules from TCJA. In the case of FB and GOOG they are trading at multiples below the broader market, and have higher growth rates. Coupled with the potential deceleration in Capex after 2022, both may begin to return cash back to investors at higher rates.

Personal Note

I’ve taken a break from Twitter. I find it to be too much of a time waster. Constantly seeing the same stocks shilled at me by Twitter’s algorithm, and scrolling mindlessly wastes hours of productive time each week. So for the time being I’ll be away focusing on education and research.

In it he promises to abide by the results of the Twitter Poll (currently 57% have voted YES).

What could this mean for Tesla shares? A look at his numbers based on the latest Proxy Filings

Tesla 2021 Annual Proxy -- Ownership Securities Section

As of 6/30/2021 Elon Musk is by and large the biggest holder of Tesla shares with 244M shares held, or 23.1% of the company.

Per the footnote 170M of his shares are held in a trust account and 73.5M are options which have not been exercised and are eligible to be exercised. Of the 170M shares 88M are used as collateral to secure loans (he borrows off his wealth to avoid selling and realizing capital gains).

Tesla 2021 Annual Proxy -- Outstanding Equity Awards Section

Entering into 2021 he was sitting on 56M shares which are exercisable at any point. Since then he achieved two more milestones worth ~17M more options bringing us to the previously mentioned 73.5M options #. However these options have different expiration dates (the date by which he must exercise or forfeit the option).

Options for 22.8M shares expire on 8/13/2022

The rest expire on 1/19/2028

He also could potentially earn up to +50M more shares by achieving the necessary performance awards…for simplicity sakes…I will not discuss these.

How much is 10% of Elon’s Shares?

So the answer is…it depends. When Elon says 10%…is he talking about 10% of his shares including options…or excluding them.

Excluding Options:

170M shares / 10 = 17M shares to be sold

Including Options:

244M shares /10 == 24.4M shares to be sold.

If he is in fact including options…is it fair to assume that with 9 months til expiration…he is planning on exercising his 2012 compensation options?

If so then this certainly was a brilliant marketing ploy.

Because he would have had to realize a capital gain on them sometime within the next 9 months.

Scenario:

This is a scenario for what could happen if Elon decides to sell 24.4M shares mostly made up of the 22.8M shares from the 2022 expiring lot.

As of 6/30 Tesla had 984M shares outstanding…so 24.4M represents about 2.5% of float. Not a huge number.

Let’s assume the stock opens down in line 2.5%

Looking at the options market…using delta hedging as a proxy for options hedging…right now options market makers are sitting on about an excess of 3M shares…a sudden 2.5% move downward from the dilution caused by Elon’s exercising and sale would move that number to about 12M. So assume they sell another 9M shares…it’s fair to assume that’s good for another 1% move.

Let’s look at the other major shareholders

Vanguard and Blackrock aren’t selling because they hold shares in Index Funds…so the only way they sell is their are redemptions on their SP500 index funds.

The next largest institutional holder is the Capital Group who also owns about 5% of all of Tesla.

Do they get spooked out by the possibility of Elon, Kimball, Antonio Gracias, Robyn Denholm (current chairperson of the board) and Ira Ehrenpreis all selling in rapid succession? If so…how spooked?

I would assume that even if they did…they would likely trim and not cut to 0. However if they trim 20% of their stake…then you could see another 1% move in Tesla.

So possibly a 4% move assuming a rational, calm market with no panic selling/buying by retail (definitely a risky assumption)

One last group to know…

January 22 Call Holders

Right now you have 42M shares staked against in the money options for January 21 2022 Monthly Call Expirations. Many are deep in the money suggesting they were bought as Leaps possibly well over a year ago.

If you are sitting on the 1M + shares from the 80, 130, 300, 360 Calls…do you consider cashing in now?

Obviously there will be tax considerations…but given that over 4% of the company’s shares outstanding are pegged to the expiration price on one day…it’s feasible that some holder might be willing to take profits. Some may even consider taking profits right away before Elon has the chance to get out.

This also could of course move options holders with nearer expirations such as Nov and Dec Monthlies to also cut bait.

Final thoughts

Of course it’s feasible that Elon may be doing all of this as a ploy and somehow manages to lure and skewer short sellers once again through gamesmanship (tweets a potential partnership with Uber for robotaxis in 2050).

Having said all thought…I wonder what Gary Gensler thinks of all of this? If Elon doesn’t go through with this…could this be a construed as a misleading statement to investors?

Time will tell.

Suffice it to say…if Elon does shed 10% of his shares…I suspect it will move the stock at least 5% downwards…might be worth speculating on a put/volatility strategy for the next week or two.

He always keeps things interesting.