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Jim Chanos is the founder and Managing Partner of Kynikos Associates LP, the largest investment firm devoted exclusively to short selling. Throughout his investment career, Jim Chanos has identified and sold short the shares of numerous well-known corporate financial disasters; among them, Baldwin-United, Commodore International, Coleco, Integrated Resources, Boston Chicken, Sunbeam, Conseco, and Tyco International. His celebrated short-sale of Enron shares was dubbed by Barron’sas “the market call of the decade, if not the past fifty years.” He was the first person to predict the collapse the Chinese bubble.
I am going to focus on value traps, which is especially important for long only investors. We have noticed this in certain stocks in the past.
Classic short selling themes:
Booms that go bust. Debt driven, asset inflation; such as Real Estate, Tele-com in the late 90s, CRE in 80s, and RE bubble in China.
A couple of points about value STOCKS: predictable FCF, defensive business, reasonable valuations, margin of safety, transparent financial statements.
What about value traps?
Cyclical and overdependent products
Hindsight drives expectations
Uses non-Gaap metrics
Management explains away accounting issues
Reliance on a super national put, such as dependence on the Government; such as too big to fail.
Cycles can become secular such as auto and steel industry, some might argue airlines.
Fads that have one off hot items- Salton-the George Foreman grill, Renewable energy-solar wind.
Quasi-legal businesses such as online poker. The UK poker companies had some of the silliest financial statements. One of the executives was a former fugitive.
Hindsight driving-This is very important-technological obsolescence. This has killed value investors more than anything in the past 10-20 years. Value investors will think the stock is cheap enough to compensate for decreasing cash flow. Blockbuster had FCF go from $2b to ($500m) in just 18 months. Eastman-Kodak is another good example.
Famous management or investors-A lot of great institutional investors have been involved in Worldcoms and other stocks. Dont let your work stop because someone is on the opposite side of the trade. I drill this into my analysts when they come to my firm.
We are not Warren Buffett acolytes- but I love his quote, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Keep looking to see that incentives are aligned and keep doing your work. Sometimes their incentive is to trash the stock to buy at a cheaper price later.
Dont just buy something because it is just cheap on EBITDA basis, such as Cable TV or Blockbuster. Or cheap based on FCF-Tyco. Eastman-Kodak-ignore restructuring charges every year at your own risk. Management kept having restructuring costs every single year. If management is so good why would you need to keep restructuring?
I remember Tyco-run by accounts (that is always a red flag!). Tyco kept ignoring all questions by pointing analysts to their free cash flow. ADT was paying $1,000 routinely, and despite over-paying was showing immediate profits.
Even the published financial statements need to scrutinized, especially if management points you to a specific item repeatedly.
If the accounting issues are confusing stay away. If after three readings of the K, if I cannot understand how the company makes money, I walk away. I couldn’t understand how Bally made money and still can’t.
Dont trust the auditors, if GAAP doesn’t make sense dont buy it. The lenders in 96-97 would sell mortgages to Wall Street, loosing cash, and booking a profit. Because they were allowed to take the present value of certain provisions.
Growth by acquisitions, such as Tyco. When companies use their high PE stock to buy low PE stocks and talk about synergies be careful. If you see write down of assets or write ups of liabilities, and management talks about being conservative, you should be careful. Management will try to do this to fudge earnings.
Tyco in its last year bought $20 billion of companies and put $21 billion of goodwill on their books. They basically said that the companies never made money.
FAS 157 and value of level III assets something to look at.
XOM is not in good shape. The company has gone from net cash to net debt. Oil is getting harder to find. You see it with petrobras and with Exxon making deals with the Russian Government.
Gamestop is cheap and will continue to be cheap, because as files become more complex and easy to download, brick and mortars will be hit hard.
For profit education is going to get cheaper. There is no business that is more predatory than the for-profit industry. I think it is a national shame and they are like used car-salesman. 90% of the loans are federal so we are paying for it.
ITT have an off balance sheet entity, look at their default rate [Michael Price is very bullish on ITT]. They do not have cover from the GOP house, especially as Gen. Petraeus has lead a campaign against the for profits.
Iron Ore demand is driven by China. The commodity looks cheap, until you look at 50 year inflation adjusted chart. The giant commodity entities think this boom will never end.
Vale is an interesting companies. It does business in Brazil, and if you look at Petrobras, it does not view such companies favorably.
Value is building a navy, but it doesnt even expect to earn a return on it.
I would be remiss if I did not talk more about China. The Chinese SWF is buying banks on the open market.
The Chinese banks are there to implement shareholder policy. The Chinese banks have been recapitalized twice in the past twelve years. Both times, 40% of loans became non performing. Dont think that China will bail out the shareholders. Last time the Chinese set up asset managers who issued debt to shareholders in place of their equity holdings. The debt was recently rolled over, and the debt is still on their books. For Agricultural Bank of China we think this represents half of their capital.
We can’t even get into how leveraged the Chinese banks are. The credit creation in China is unprecedented. Most of the debt is at the four large banks, not the shadow lenders.
The Government might stand behind a lot of the lenders but dont think they will back up the shareholders. The only Western lenders who ever got a penny out of China, had the Royal Navy behind them, which would make it not a value stock.
Indian demographics might support mining boom? China is not moving the lever much and India is self sufficient in most of these commodities. The head of the mining companies will admit that the Chinese is the 800 pound Gorilla.
I was in Dubai in 08 and was there for a ribbon cutting for a band new monument. I could sense the financial madness, and I see that