Famous short seller Jim Chanos, founder of Kynikos Associates, is short certain components of the energy sector and finds his best short opportunities are found in the US with firms playing accounting games.
As global stock markets buzzed to stunning heights in 2013, the short selling strategy Chanos deploys expectantly found difficulty, down 13% for the year. But the hedge fund manager says that his day will come. “Anytime the market gets buoyant its tough to be short; it’s tough to be a skeptic,” he said in a recent interview from the Reuters investment summit. “But that’s the time when investors should be on their guard. Markets have a funny way of swinging back and forth.”
Short energy with bullish energy sentiment all around
Most notably Chanos is short select components of the energy sector, in particular integrated oil and coal companies.
Noting that the core business model of old line integrated oil companies has demonstratively gotten worse, Chanos also remarked that costs have gotten much higher, particularly the cost of finding new reserves has gone up. Pointing to Exxon Mobil Corporation (NYSE:XOM) as an example, he notes that “revenues are down year over year, yet capital they deploy in the business continues to grow. Cash flow has dropped dramatically.”
Chanos notes that in the past Exxon Mobil Corporation (NYSE:XOM) has been able to finance its dividends and buybacks on free cash flow, a sign of health, it now finances half its dividends and buybacks, a financial engineering yellow flag. Exxon is “not a value stock, it’s a value trap,” he said.
“Exxon used to have returns on capital near 30% and was amazingly profitable,” Chanos said, noting that now return on capital is just 20%. This should be telling investors “these companies are increasingly finding it difficult to replace their oil reserves. They are ‘liquidating trusts.’ They are not the values they used to be. They have to borrow to finance the financial engineering they do to keep their share prices up.”
Short coal companies because cycle is over
Chanos is also bearish on coal mining companies due to a significant spike in coal mining capital spending and, speaking like a quantitative trader, expects to see as a reversion to the mean.
Chanos conducted statistical analysis of capital spending in the coal mining sector going back 20 years and found a significant long term trend he believes is on the verge of reversing. In the early 1990s coal mining capital spending was roughly $5 billion per year, then it grew to $15 billion per year at the turn of the century. But in 2012 it exploded to $145 billion, which Chanos considers the “peak,” noting the 24% compounded annual growth. “What was an arithmetic growth function in mining capital spending became a geometric function,” he said. Framing the issue, he said many analysis he has seen are only looking back 5 or 10 years, and “they don’t see how dramatic the expansion of the global mining industry has been,” which he attributes in large part to China. “We believe reversion to the mean is a powerful phenomenon and mining cap X has a long way to fall to get to normalized levels,” he said.
Suspect of “old school” technology companies
“Old school technology companies are in slow decline,” Chanos said, they are just “masking it in a number of different ways” from financial engineering to aggressive buybacks and even their purchases of new companies. Chanos noted firms are purchasing their R&D, it’s not happening internally. By purchasing they are allowed to capitalize the cost on their books, making the profit picture look stronger than it is.
“Firms that invent new technologies in-house can only expense the cost of R&D,” he said, “but once you purchase a company that already has the technology you can capitalize the cost on your books,” which is much better treatment on the balance sheet. Most of the old school tech companies are showing flat or declining revenue despite these acquisitions, he said, without naming specific names. He also had a message to investors: “be careful in the accounting, make sure to compare apples to apples if the tech company is a rapid acquirer.”