Motley Fool Hidden Gems Investing - FTX Collapse: Lessons for Investors

Episode Date: November 30, 2022

The Dow closes out a strong (relative to other indices) month, and we take a closer look at the collapse of FTX. (0:21) Jim Gillies discusses: - Why the Dow Jones Industrial Average is "the dumbest index" - Where investors can find ballast for their portfolios (15:12) What actually happened with the collapse of FTX? Dylan Lewis and Ricky Mulvey take a closer look at that, as well as some key takeaways for investors. Stocks mentioned: SHOP, AAPL, KO, MSFT, COIN, HOOD, MSTR Host: Chris Hill Guests: Jim Gillies, Dylan Lewis Producer: Ricky Mulvey Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Chris Hill. It's time to talk about crypto. Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst, Jim Gillies. Thanks for being here. Jim Gillies. Thanks for inviting me. So before we get to the collapse of FTX, today is the last day of November. The Dow Jones Industrial Average is on pace to finish up 3% for the month, which is not a lot, but if we could do that every month, that'd be pretty great. And barring a collapse,

the Dow is going to finish well ahead of the S&P 500 for the year and even further ahead of the NASDAQ, which Jim is leading some of the people in financial media to pound the table, and there's a little bit of, see, I told you so, going on, and pointing to the NASDAQ and saying, that's why I've always said you got to stay away from these, and pointing to the Dow and saying, and that's why you got to get behind companies that you see in the Dow Jones Industrial average. I understand why someone in that position might take a little bit of a victory lap or even pound the table a little bit. However, I'm curious what you think of all this, because when I think about you and your investing style, you strike me as someone who is certainly open

and embracing of the idea of ballast in a portfolio. Sure, yeah, have some growth in there, but particularly as you get older, have some ballast. I'm wondering, do the pro-Dow Jones industrial average people hold any sway over you? Well, as someone as well who looks at quite often at a lot of the companies in the Nasdaq and say, see, I told you so. I've done that once or twice or 3,000 times. Yeah, I suppose I'm the natural guy to come along and pull one of those, but I'm not going to. I have some thoughts on how you can get some growth into your portfolio. As you mentioned, I am very much someone who likes ballast. But we are Fools, and one of the tenants of Foolish Investing is we think long-term. So, yes, the Dow is going to win the month. Well,

that's lovely and I don't care. You are right, again. I feel like we're attacking a straw man we've just constructed, but why not? It's the construct for the show. I'm going to defend myself. I don't think this is a straw man. As someone who looks at the financial media every day, and I think that part of what we deal with as investors is, yes, we want to be focused on the businesses, but we also live in an environment where there is all this news swirling around us and the news has narratives. I feel confident in this prediction, this is absolutely going to be a narrative in the month of December as people start to do their year-end, their look back and it's like, oh, look, boy, this was the year you wanted to,

You should have been in the Dow. Let's talk about the outperformance of the Dow then in this year. 3% in the month, whoop-de-doo. Chris, the Dow is in fact leading the charge for the major American indices in 2022. The Nasdaq as of last night's close is down 29.8% for the year. The S&P 500 as of last night's close is down 17% for the year. Note, I'm not including dividends, I'm just going straight numbers. The Dow leading the charge down only 6.8 percent. Oh, it's still down. How is this me winning? But again, we want to talk total return. I shouldn't really call it total return because I've not bothered to grab the dividend numbers, but the absolute numbers over the past decade. Of course, as Fools, we like to talk about,

you know, expect to hold a minimum of five years. We encourage you to buy at least 25 stocks. I've got several multiples of those numbers myself. And as far as the length of time, I've got several stock holdings that are older than both of my children. And I've got one child in university, so I should tell you how old they are. But over the past decade, the leader of the pack, and it's not close, with a 265% total return that is 13.8% annualized, is drumroll, the Nasdaq, the thing that you're supposed to avoid. So, if you bought, held, didn't worry about it, then shut up, you are beating the Dow with its 160% total return, which is roughly 10% annualized. The S&P lands in

the middle at 180% total return, 10.8% annualized. Buying and holding, dollar-cost averaging, and look, you can buy a Dow ETF, you can buy a Nasdaq and S&P ETF, but these are the types of returns that they have delivered. This includes the fact that the Nasdaq has blown past on an annualized basis, has blown past the Dow by almost four percentage points. That's after the 30% drop this year. Where I come at the growthy growth names, it's generally purely on a valuation basis. Paying 70 times sales for something, sorry, it's dumb, shouldn't do it, in my opinion. I think my opinion is holding sway with what's happened in the last year or so. But buying at 10 times sales, say, we'll call that company Shopify in 2016,

when those sales are, in fact, going to the moon, even when it drops 75% in 2022 or whatever the number is, you're still up 10, 12-bagger territory. Growth absolutely has a place, just don't overdose on it. But there's a few other criticisms I had for the Dow. The Dow, and again, I like to get hate mail, so I'll say it. The Dow is the dumbest index, I look at the Dow as almost worthless as an investing track. So, anyone who's encouraging you, especially once the Nasdaq is down, encouraging you to get out of the Nasdaq index or out of the growth names, and we're playing index games today, so we'll stay away from individual stocks as investments. I'm going to mention a few. Someone telling you to sell

low effectively with the Nasdaq off 30% and buy the Dow for its relative success of only being down 7% year-to-date. They're basically encouraging you to buy a flawed, poorly constructed, idiotically constructed and poorly managed index that is far less diverse. There's, by definition, 30 names in it. The Dow Jones Industrial Average only has 30 names in it. The NASDAQ index, I believe, is 100. The S&P 500 obviously has slightly more than 500. It's poor on a returns basis, it's poor in a diversification basis, and it's constructed stupidly. But other than that, it's fine. It does speak to the power of both nostalgia and inertia that the Dow Jones Industrial Average continues to get the attention that it does because it's been around for so long.

As you said, if you were starting from scratch today, you wouldn't build the Dow. You wouldn't build an index of 30 stocks, unless it was concentrated in a particular industry. Exactly. And it does a bad job of what it is supposed to do. So, the whole point of an index, and by definition, the index is to supposedly attempt to measure the incredibly complex breadth of American business. I'm not going with an American index. But I mean, of course, so many of these companies have international. The largest company by market cap in the world is Apple, at least in America. I'm not sure where Saudi Aramco sits today, so maybe I shouldn't say world unless I'm right and I meant to say it. But Apple,

largest company in America. Apple sells one or two products outside the borders of your fine nation. you know, I think there's about 17 of them in this room. You know, these are international companies. Coca-Cola sells one or two beverages outside of America. But the whole point of an index is to try to capture and measure the health of publicly traded American business. And so, the S&P 500, pull up my quote here, the S&P 500, which again is 500, it's slightly more than 500 companies, but we'll pay no attention to that. It's the largest 500-ish companies in America. What it does is it captures about between 70% and 80% of total market capitalization in America. It does a pretty good job. What it doesn't capture is a whole host of tiny little

companies that are the 1,000th or the 2,000th largest company by market cap. It's a pretty good job. If you go out and rank, go find the 10 largest companies by market size. Those 10 companies in America are, I'm going to run them down really quickly, Apple, Microsoft, Google, Amazon, Berkshire Hathaway, Tesla, United Health Group, Johnson & Johnson, ExxonMobil, and Visa. Those are the 10 largest market cap companies in America. The first nine are also the top nine holdings of the S&P 500. Visa, the 10th largest company, is actually 13th in the S&P 500, but you're starting to get into one and two digits after the decimal point. Of those 10 largest companies, without looking, Chris, how many of the 10 largest companies are actually in the Dow?

Not just in the top 10 of the Dow, are actually in the Dow. I want to say four? You missed it by one. Five. But then you get into, well, what's the largest company by market cap in America, Apple,

is, oddly enough, the largest company, the largest weighting in the S&P 500. It's the 19th largest weighting in the Dow. It's almost in the bottom third. Microsoft, the second-largest company in America, No. 2 in the S&P 500, is No. 6 in the Dow. The largest weighting is UnitedHealth Group. The reason for this is that the Dow Jones Industrial Average is what's known as a price-weighted index. Your price is what matters, not your size,

not your actual financial results. That is asinine. The No. 1 ranking in the Dow, with the UnitedHealth Group, again, the seventh largest company in America. The No. 2 weighting in the Dow is some vampire squid company called Goldman Sachs. It's the 59th largest company in America by market cap. JPMorgan, which I believe is in the top 15, I think it's No. 11. in March. JPMorgan is way down at number, it's the 20th ranked company in the Dow. It's weird. The other thing is, why is Apple so small? Why is Apple, the largest company in America, 19th in the Dow? It's because Apple had the temerity to split their stock in, I believe, August of 2020. They split four for one. Because this is a price weighted index, Apple basically

removed 75% of their weighting in the Dow, which is kind of amazing, because that then prompted the Dow Jones selection committee to make moves. Would you like to hear the silly moves they made? As quickly as possible. We've got to get to the FTX. As quickly as possible. Okay. When Apple quartered themselves essentially by a stock split, it dropped the technology weighting down from almost 28% to about 20%. So, the folks in charge of Dow Jones selection said, cool, what we're going to do, we are going to take three companies out, and those three companies were ExxonMobil, Pfizer, and I believe Raytheon, and we are going to add three companies

in, Salesforce, so that's your technology waiting back up, Salesforce, Honeywell, and Amgen. Well, that turned out to have been a really spectacular move. The average return for the three companies they added in August of 2020 is negative 0.7%. The superstar there would be Salesforce, who was down 44% over this time. That's really what's weighted it. Honeywell is up a respectable 31%, Amgen's up 11%. That's fine. The three companies they took out, the average return of what they threw away is 91.6%. It's almost a double over a very volatile market. Chief among them, ExxonMobil up 176.8%, Pfizer up 38.2%, Raytheon up 59.7%. This was done because they were reacting to the Apple's price weighting and they felt they needed more technology.

What they would do is eliminate basically the largest energy producer in America, which seems weird to me. But again, I'm not paid to be on the committee, I'm just paid to sit here and laugh at them. I was going to say, I don't know who's on the committee, but it sounds like they got a lot of work to do. We got to get out of here. Jim Gillies, always great talking to you. Thank you. You've probably heard a lot lately about the collapse at cryptocurrency exchange FTX. But what actually happened? Dylan Lewis and Ricky Mulvey give you a rundown on the story and the the takeaway for investors. Let's dive into some of the FTX craziness

and see if we can find some lessons for investors. Dylan, I think let's first start with the recap and then pull out some takeaways. Love it. Yeah, this has been the inescapable story online over the last couple of weeks and it's fun to do a show on it. All right. Let's get your whiteboard and yarn ready because there's a couple of players in this. FTX was a crypto exchange at its peak in July of 2021. You had over a million users. It was the third largest crypto exchange by volume. When it starts, it receives an important investment from another exchange that's called Binance. Now, you probably saw FTX with the ads during the Super Bowl with Tom Brady and Larry David, got an arena named

after it. Its founder, Sam Bankman-Fried, also called SBF, becomes a media darling and makes large political donations. Yes. And I think as crypto goes, FTX is as mainstream as it possibly could be. A name that a lot of people have learned over the last couple of weeks is Alameda Research. And this is a hedge fund that was also started by Sam Bankman-Fried prior to founding FTX. He was involved in Alameda for a while and then later gave leadership to someone else, but was seemingly involved, even though it was apparently a separate entity from FTX. I think the important thing to know about the relationships between Alameda and FTX, the leaders of both sat next to each other and basically cohabitated. People who thought

they were wiring money to FTX were actually wiring it to Alameda. That will become very important later. Yeah, they're giving loans to each other. When you build a trading firm, it's not supposed to take money from people's deposits to make risky cryptocurrency trades. Those decisions is where the organizations start to unravel. One other piece is that FTX and Alameda are using a token that's called FTT. It's a crypto that has been created by FTX and it's encouraging people to buy and sell cryptos on the platform. Because it has this trading volume, they're able to say it has a tremendous market cap. This becomes a little bit tricky because Binance, the rival firm, owns a lot of these FTT tokens. Also, FTX and Alameda

are using this essentially self-created cryptocurrency as collateral for much larger loans. Yes. This is where it starts to get a lot cloudier and probably a lot more confusing for a lot of people. But the easiest way to think about FTT is just they essentially created their own coin. There's nothing necessarily insidious about that. But what we see increasingly as this story develops, is it was a way for them to grow their assets and also exchange money between FTX and Alameda, as well as other people in the crypto industry relatively easily. All this comes to a head earlier this month when a website called Coindesk, who's really one of the leaders in this space, if you follow it, leaked a balance sheet from Alameda showing that if you

looked at its balance sheet, it had roughly $15 billion in assets, but the vast majority of that money was held in FTT tokens. To go back to what I was just saying, this is a token that they created. The value of this is to some extent made out of thin air and really only valuable so long as people continue to feel like it is valuable. FTT is making loans to the trading arm, Alameda, and receiving their own token as collateral. You have this self-dealing that can create a lot of risk in the system. FTX had a number of balance sheet errors, one of the most unfortunately hilarious ones was that they had $2.2 billion marked for a cryptocurrency called Serum on the balance sheet, and the coin's market cap was only $88 million.

There's the revelation from CoinDesk that says that the balance sheet is built on the self-created token. This starts to create a bank run where traders are making withdrawals. Binance, which was that early investor in FTX, announces that it's going to offload all of the FTT tokens, which is worth hundreds of millions of dollars or more. This becomes a problem for FTX because there's now a huge supply, not enough demand in the system, and it can crash the price. This drives down the price of the FTT token, which is the overwhelming asset, and it just compounds the problem from there, creating this huge snowball that you're seeing play out now. Really, the easiest way to think about how this all comes to a head and really

how this all gets exposed is, this is a bank run because people were starting to be concerned that they would not be able to get money out of FTX because so much of FTX was collateralized by money that they had essentially invented. At a very high level, because I know we threw a lot of stuff at people here, the FTX exchange seemingly took customer funds and then made those funds available to Alameda Research to invest without customer knowledge. It seems Alameda racked up losses as they were doing that, but was able to cover those losses and continue to keep a lot of their customers and really generally the crypto industry in the dark because they could transfer FTT between FTX and Alameda to cover the deficit. They were also able to re-hypothecate FTT and some of

the other crypto holdings to continue to boost their overall assets. This all was fine so long as the value of FTT coin held, but it didn't because of actions in the market and recent information that Coindesk was able to unearth. The fallout, I think, is almost impossible to know at this point. But if you're a customer who had holdings with FTX, you are likely never going to be able to access them. There seem to be a lot of other crypto firms that had exposure to FTX, which has created follow-on bankruptcies and concern throughout crypto. I think it's a huge lesson in that a year ago, people were saying, hey, let's not have this financial regulation going on in crypto. Boy, oh boy, has that tune changed.

Yeah, and it's really interesting because part of the poster child of crypto reputation that SBF was able to create for himself was one of, I'm willing to talk to regulators, I'm willing to do the work to legitimize crypto. That seemed to be something that made him trustworthy along with the fact that both of his parents have compliance backgrounds, are very highly regarded in the academia world. He also tapped into effective altruism with his way of pitching both himself and his general crypto ambitions. We are starting to realize that a lot of that may have just been window dressing or marketing. Dylan, what are some of your big takeaways from this story? If you're terminally online like I am, this flood of nonstop information

about the FTX fallout? This is going to sound wonky, but I think one of the biggest things that public investors can really take from this, because this is a crypto story and it may not be something that a lot of people feel like they have access to or exposure to, is related party transactions are rightly scrutinized. And they are a very large part of the way that we look at companies when they come public. There is a whole section dedicated to them in the prospectus. And if you see people waving the red flag when they look at them, they are worth paying attention to. Because when you invest in a business, you want to make sure that the leadership of that business is acting in your best interest. And as we see here, when management controls multiple

entities that are tied up together, it can become much harder for you to understand whether they are acting in your best interest or their own. Or did you see the chief regulatory officer of FTX had previously worked at essentially a poker website where people were given God mode so they could see other players' cards. Yeah. And I think you need to trust leadership broadly. And this is why we think it's so important. And really, with related parties and the ability to kind of deal with entities, as we see here, it makes it so much easier to commit fraud. And some of that is because of lack of internal controls or maybe mischievous behavior on behalf of folks calling things. But also, if you control both the books and the piggy bank

for multiple entities, it becomes a lot easier to do fun with numbers, questionable accounting, and as it seems in this case, commit fraud without tipping off other people because you control everything. And that's where I think the narrative about this being like a series of unfortunate mistakes becomes a little bit flimsier to me is that the chief technology officer of FTX built a backdoor so they could take customer funds and put it in Alameda Research without tipping off any regulatory red flags. It was this deliberate track covering that means that they were not looking out for the best interests of investors. You can understand, though, why a lot of people wanted to use FTX in the crypto investments, because there were these very high promises

of return, even for seemingly safe investments. Yeah. This industry is so inaccessible to a lot of people. At core, there's nothing bad about being a crypto exchange. FTX made crypto ownership much more democratic and much easier for a lot of people. It's just they decided to do so many other things that were nefarious or seemingly nefarious. And that's really where it got into trouble. I think one other thing that people should probably be paying attention to with this is as FTX was raising money and as Alameda was raising money, there were some other red flags that I think people probably should have seen. And one of them is there was an Alameda pitch deck from 2018 surfaced by The Block, which basically showed an investment opportunity that included a

15% annualized fixed rate loan with the statement, these loans have no downside. We guarantee full payment, the principal and interest enforceable under U.S. law and established by all parties legal counsel. And I think the thing that you have to remember when you see high promised low risk returns is the only way that someone is able to offer you a high rate of return, like 15%, which is well above what we typically see for the stock market annualized, is because they are going to do something with that money that is inherently riskier than how they are borrowing it from you. Chris Hill Than buying U.S. Treasuries? Jason Moser

Yes, exactly. There is nothing truly risk-free. Even buying a treasury technically has some risk to it. If you are providing funding to someone and they are paying you a relatively high rate for that, the only way economically they are able to pull that off is because they are able to do something that earns more money with those dollars or with that crypto, whatever it might be. You have to question at a certain point the sustainability of that model and whether they can really continue to do it for years and years and years. Very few people have been able to. do. I think that that's something that probably should have concerned people a little bit earlier than it did. They weren't the only exchange that

were offering those. It was like staking returns and, hey, give us some Ethereum and we'll give you a guaranteed six to double-digit return. I also want to talk about, even if you don't own crypto, there are some public market ramifications that are coming to be that will affect stock owners, investors everywhere. Yeah. This is something that dramatically affects the number of people that trust crypto, the number of people that are willing to invest in crypto. I don't personally own crypto, but I think it's an incredibly interesting space to follow. If you have any exposure to a company like Robinhood or any exposure to a company like Coinbase, you're going to take a hit here regardless of whether you own crypto or not.

What we're also seeing is there was a lot of big money and a lot of smart money tied into this. Tiger Global was involved, Sequoia Capital was involved as investors. Also, we're seeing that the Ontario Teachers' Pension Fund was involved, and this is one of Canada's largest pension funds, and they had almost $100 million invested in FTX. They are writing down the entirety of that. This is something that is affecting people that maybe didn't even necessarily know that they had crypto exposure. Yeah. I want to know how many people are invested in Coinbase that don't own crypto. That's got to be a Finven diagram, Dylan. That's right. Yeah. I'm curious. I think this

contagion. It's easy to see a story just being played out and moving on after one cycle. So the price of Bitcoin right now is around $16,000 and you're seeing a lot of lack of faith, people aren't entering the space that much. Back in June, MicroStrategy said that they would face a margin call if Bitcoin essentially fell to $21,000. Right now it's at $16,000 and I haven't heard much about that story. So I feel like you might see some other developments continue to to play out. My kind of takeaway from this is just being careful about investing in things you don't understand. I invested, I would say I got stung, but not burned by investing in crypto. I was excited about it. I thought it was like a really cool, unique beginning of something.

And I'm like, even after this, I'm not totally, I don't own Bitcoin, but I'm not totally unsold on it. Like, cause I still think there's still a part of my brain that's saying, hey, if you bought Bitcoin every time it got cut in half, that wouldn't be a, that wouldn't be a bad way to make money. Yeah. And I think this is not the death of crypto. And I think the people saying that are probably going to be wrong. I mean, there's a critical base of people that are interested in this. And it seems like there are interesting projects and interesting applications for it. I think it is a massive setback for the industry and one that is probably going to just lead to increased oversight, increased regulation, and also just a longer

adoption cycle for people that were kind of on the fence about jumping in. It's not the death crypto, but it is the end of this segment. Dylan Lewis, always good chatting with you. Thanks for having me, Ricky. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow. Thank you.