Monday, May 24, 2010

Jim Chanos: The Power of Negative Thinking (CFA annual conference 2010)

Many companies practice short selling - Airlines sell a seat before they deliver the service, Insurance companies collect premiums before they pay claims, farmers sell the harvest before it’s harvested, etc.

Short Selling is essential for Hedging – estimated that 95-97% of all short interest is due to hedging.

In the past 25 years, every fraud has been uncovered by either 1.) a whistle blower or 2.) someone with an economic interest (short seller, journalist)

Short Selling is not just the opposite of going long since short sellers need to 1.) borrow shares (possibly pay a rebate), 2.) face different regulatory rules, 3.) deal with negative reinforcement and 4.) face outright bans (such as the German one, however that will not affect him since he always has the shares, it’s more of an issue for traders than fundamental shorts since they often buy it back before they secure delivery).

People say that when you’re long, stocks can only go to zero if you’re wrong but they can go to infinity if you’re right. “I’ve seen a lot more go to zero than infinity.”

Good short sellers are born, not trained.

Short selling bans come in near the bottom of the market, which is good news. The bad news is that it’s the bottom in time, not in price. Market often goes lower after a ban, but the bottom is at least close by (showed 1932 and 2008 examples).

Opportunity for short sellers is very good – Large alpha of 10-20%/year, over past 30 years has been 15+% annualized alpha with negative correlation to the market (Holy Grail of finance theory). However the alpha if often lumpy. So you have many periods of zero returns and then a big year.

Short selling is essential to CAPM – in Sharpe’s Nobel Price Acceptance speech he says that it assumed frictionless short selling. Gave the example of PALM/3COM, he said the only reason that palm was worth 3x 3com even though 3com owned 80% of Palm was because short sellers couldn’t get shares to borrow. When his broker finally found shares at 2:30pm the day of the IPO, the stock started sliding as you could finally short. But it took months to get back to a normal ratio, it was an inefficiency created by retail investors chasing the hot stock.

Research process has good and bad news: Numbers are obfuscated, short sellers have no access to management, and the sell side hates you. Those are both good and bad. Recommends not getting close to management because they either 1.) don’t know what’s going on or 2.) are telling you a lie. According to S&P and CFO magazine studies, 2/3 of CFOs have been asked to cook the books by the CEO, while 55% of all respondents did not, 12% did (those add up to 67%).

Sources of Ideas. 1.) experience; 2.) Accounting related 3rd party research; 3.) screens (although no longer a good source since management knows how to trick screens now); 4.) other managers (not necessarily short sellers) – “there are very few original ideas in investing”; 5.) partners/investors in the fund.

Regarding point 5, told the story about how one investor is a restaurant franchisor who told them that Boston Chicken would never work since they were selling “homemade meal” replacement. Since mom/dad bought the meal and took it home, they never bought drinks and drinks are where all the profit is made. This got them looking at BC with more scrutiny and then noticed that management didn’t want to open any company owned stores since they weren’t profitable and had to loan the money to franchisees to open stores.

Some recurring themes in Short Selling:
  1. Booms that go bust – define boom as anything fueled by debt in which the cash flows produced by the asset do not cover the cost of the debt. The Internet is not a boom since they didn’t have debt. The Telecom Bubble that went along with it was.
  2. Consumer Fads – investors like to extrapolate strong growth well further into the future then they should. It’s also a great source of decoration for your office, he’s got a Cabbage Patch Kid next to a George Forman Grill next to a Nordic Trak.
  3. Technological Obsolescence – Everyone thinks the old product will last longer than it actually does. Examples were Wang Word Processors (replaced by PCs), Record Stores (replaced by digital downloads). He says the internet is the cheapest way to distribute anything. However people are still renting DVDs by mail, which surprises him (Hint: likely short Netflix!). These businesses always look cheap but the cash flow goes down just as fast as the share price (think Kodak and film).
  4. Structurally-Flawed Accounting – beware serial acquirers, they often write down the assets of the acquired firm in the stub period that no one sees. Ask management what the net assets of the firm were on their latest end of quarter and what they were when they were acquired. Most management won’t tell you this, some will, however. But by writing down inventory and A/R they can “spring load” results once the company is acquired. They’re supposed to adjust the purchase price but most don’t.
Enron was “1 stop shopping” for all short selling red flags. They marked to model (only they knew what effect the weather in Seattle would have on their power contract with MSFT), they had off balance sheet transactions, foul language conference calls, etc. When all was said and done, they had a $65billion hole, meaning they were more than just a little optimistic in their model’s assumptions!

He said Lehman also marked to model and had optimistic assumptions. They had a $600b balance sheet, of which $300b was marked to market. So they had $300b marked to model, and they had a $150b hole. So on average, their mark to model portfolio was mis-marked by 50% (or 100% too high)!

Regarding China, he’s not calling for an impending crash, but... there’s a credit driven property bubble with global implications. It’s a classic boom that goes bust. There are 30Billion square feet of class A real estate under development in Tier 1, 2, and 3 cities in China. That’s a 5x5 cubicle for every man, woman, and child in China. Once that is done being constructed they’ll need to build more in order to keep GDP growing.

Q&A (I/We refer to Chanos/Kynikos)
Q: what was your biggest mistake?
A: AOL. It was a short due to accounting, we thought they were masking higher churn then they reported. We thought the value of a subscriber would turn out less than they thought. We started shorting at $2-$4, covered as it went up, and covered the last at $80. We kept it to a 1%-1.5% position. We knew we were in the midst of a bubble, so we kept it small, but it still cost us 10% over 2 years.

There are 2 ways short sellers handle risk. 1.) Stop Loss orders. We do not believe price alone should tell if you’re right or wrong, fundamentals should. 2.) % of capital at risk. We size our positions between 5% max and min 1⁄2% (or it’s not worth doing the research and going through the trouble to short.) Whenever a position gets too big, we reduce it to keep it inline with the intended % of capital amount.

Q: Do you use Options or Derivatives? 
A: No. They’re used to either manage risk or gain leverage. We can do these cheaper on our own than in the options market. We stayed away from CDS since we didn’t get comfortable with the counterparty risk, you had to get 2 decisions right in order to make money.

Q: Do you have any trouble borrowing? 
A: We have a 70 year old partner who’s never allowed to retire since he does such a great job finding the borrow. He monitors rebates and knows when a short squeeze is coming or ending. It shows up as a change in the rebate.

Q: How can Short Sellers be flat in an up 30% market? 
A: It depends on the breadth of the 30%. In 1999 only 2 sectors went up, so it was easy to find stocks that went down. Conversely, if you weren’t long tech you did fine in 2001/2002. So a Narrow advance is fine, a broad advance is not.

Q: Thoughts on Regulation? 
A: I am the head of the Coalition of Private Investment Companies and we’ve been calling for registration since 04/05. Back then Washington did not understand the industry, they still don’t, but they really didn’t then. HFs didn’t take any money from the government, so it’s a little easier for them to hear our side now. I believe the short selling in financials in 08 were by other financial institutions who were hedging their counterparty risk.

Q: How to short China? 
A: Obvious is the land development companies and I’ll let you figure out which ones. But we also short the derivative plays. There was a dramatic increase in commodities, specifically Iron Ore, in 2005. It went from $30-$40 up to $160. I expect that will mean revert when China stops building.

H/T Cameron Wright