Jim Chanos is not afraid to admit that his first foray into short-selling was a kind of baptism by fire. On a Bloomberg interview conducted by Barry Ritholtz, Chanos recalls how in 1982, when he was a budding analyst, he recommended a short on Baldwin-United, a piano maker turned insurance company. Sensing that all was not well with the accounting practices surrounding the annuities that Baldwin sold, Chanos recommended selling the stock, then trading at about $25. The timing was unfortunate: it was August 17, 1982, and Kaufman had just called a market bottom.
Though the stock fell to $20 thereafter, seemingly validating Chanos’ view, it then turned around and vaulted to $55. A classic situation often faced by short-sellers, and one compounded by the fact that Wall Street loved Baldwin, not least because brokers received 5% on every policy they sold on behalf of Baldwin.
The company’s accounting and disclosure misdemeanors soon emerged from the woodwork, however, and it collapsed into a spectacular $9 billion bankruptcy – a size unheard of at the time, and launched Chanos into one of the most successful short-oriented careers in Wall Street history.
Jim Chanos runs a hedge fund named Kynikos Associates. That’s an ancient Greek word that means “dog-like,” or a person who distrusts established beliefs or people, and also thought to be the origin of the English word “cynic.” Clients of the fund are primarily institutions who use it as a hedge against their core equity portfolios. In fact, Chanos describes his organization as “an insurance policy that pays small premiums.”
Short sellers are watchdogs
“Any time you get to sit at the knee of someone like Jim Chanos, and ask questions to see where they go, you don’t want to stop the tape running,” says Ritholtz, as he launched into the interview’s recurrent theme: how does the short seller see what the rest of the world doesn’t?
“The most important function that fundamental short sellers bring to the market is that they are real time financial detectives,” says Chanos (not in the context of his hedge fund’s name, of course).
He attributes his insight into Baldwin’s true state of affairs to persistent digging, open-minded questioning and a ‘back-to-basics’ scrutiny of filings and other freely available information such as insurance forms. “A lot of the radioactive aspects of Baldwin was hiding in plain sight – you could see it if you looked at public documents,” remarks Chanos.
Up against the system
In the Baldwin episode, Chanos recognized full well that his thesis would be unpopular, particularly because most of the analysts had Buy ratings on the stock, and most of those analysts were actually employed by firms who were selling that company’s annuities at fat commissions! “So, it was also a good introduction to the concept of conflict of interest,” says Chanos wryly.
Short sellers are traditionally battling the system, which strangely, has a two-faced approach to them.
“No one has any animus toward the commodities speculator who shorts wheat or oil. The person who shorts oil is a hero in this country because he wants the price to go down. But he who shorts an oil company is a villain because he wants the oil company’s fortune to sour. He who shorts a corrupt energy company is only vindicated when that company’s smoke-and-mirrors act has come to light.” –Don’t Blame The Shorts, Robert Sloan.
Animus? There’s plenty of that coming from errant companies put on the defensive by nosy and usually right short sellers – Enron is a case in point, and another of Chanos’ success stories:
“In 2001, when questioned about his company’s unusual accounting procedures, then-Enron COO Jeffrey Skilling famously replied to a noted short seller, “Well, thank you very much, we appreciate that. . . a****le.”
What’s striking isn’t Skilling’s lack of compunction, but the fact that he had no reaction to investors who owned Enron stock and decided to sell it. In the end, of course, the short was right to suspect that Enron’s books were a sham and considerably misleading.” – Don’t Blame The Shorts, Robert Sloan.
“Jim has the combination of an accountant’s ability to dive into the numbers and a detective’s ability to sniff out nonsense, and he has done it throughout his whole career,” says Ritholtz. “He has been crucial to investors in ferreting out fraud and using his skill sets for making money for his investors by basically identifying short selling opportunities where there has been bad behavior and fraud.”
Creative accounting at Enron was very similar to that employed at Baldwin, and both companies had very charismatic leaders that managed to keep their ‘stories’ alive in the public eye. Chanos says of Enron that filings revealed a high level of both insider selling and a number of high level executive departures. These clues, as well as a number of questions arising from Enron’s public filings helped Chanos piece together the reality at the energy company.
Enron was nothing but a leveraged hedge fund sitting on top of a pipeline, remarks Chanos, quoting a colleague’s description, after they scrutinized Enron’s financials. What’s more, entities floated by company management were trading against the company in a peculiar structure that apparently had the blessings of McKinsey!
Chanos on regulators: Wilful blindness and poor scorecard
Ritholtz asked a pointed question: Hadn’t short sellers precipitated the financial crisis in 2008?
Not so, says Chanos. In fact, he along with Paul Singer, had delivered presentations to an august gathering of G7 leaders and functionaries in Washington in April 2007. Paul Singer had presented on the looming credit crisis, and Chanos had highlighted his concerns with banks’ balance sheets. The response at the meeting: “Polite applause and stifled yawns.”
So the powers-that-be had ample warning, and chose instead to ignore them. “Wilful blindness,” says Chanos.
Chanos also clarified that regulators were singularly ineffective in policing errant companies – virtually all major frauds over the past 20-30 years had been exposed by internal whistle-blowers, journalists or short sellers – not regulators.
What buybacks are telling us about corporate earnings
In a telling observation on the corporate finance function in American companies, Chanos wonders why corporations are intent on buying back stock considering stock market returns, on average, are half that of company earnings (which are claimed to be in the mid to high teens). Calling buybacks just so much ‘financial engineering,’ Chanos claims this could indicate that the quality of reported earnings is suspect.
Couple this aspect with the fact that C-Suite executives normally time their buybacks poorly (at market tops generally) and you have a recipe for corporate underperformance down the line, he says.
Chanos is also concerned with the rising trend in insider selling seemingly going hand in hand with buybacks, indicating that company internals may be worse than what is apparent – and disturbing when viewed in the context of the increasingly short tenures of C-Suite executives.
How do you stand up against those vicious rallies just when you thought the short bet was going in the right direction, asked Ritholtz.
The answer is more rooted in behavioral finance rather than research, clarifies Chanos. You have to withstand the ‘cacophony of negative reinforcement,’ or in other words the ‘noise’ the market throws at you to make you lose faith in your short bet.
Not everybody has the ability to drown that noise out.