We had the rare opportunity to sit down with the world-renowned, President and Founder of Kynikos Associates, Jim Chanos. Read our full interview with him in the latest edition of the Capitalize for Kids Investor Series.

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2016 Hedge Fund Letters

Investment Insights from Jim Chanos of Kynikos Associates

CAPITALIZE FOR KIDS: When you look at the current makeup of Kynikos, how does that compare to what you originally envisioned when you started the firm?

JIM CHANOS: Well I mean the original ethos of the firm hasn’t changed, it’s basically through a portfolio of good fundamental short ideas that we provide a hedge for our clients which enables them to basically stay long or be more long secure than they otherwise would be comfortable with. So, I joked way back in ‘85 and to this day, that I’m in the insurance business, and so that hasn’t changed. What has changed of course is the actual make up the firm in terms of number of partners, capital employed, you know the size of the operation. But what we do and how we do it hasn’t changed since it was just me and a secretary in 1986. So, I think that’s the one nice thing about the firm, its continuity. The other aspect that I’m very proud of is the fact that the core group of partners, as well as several employees, have been here a very, very long time. So, I have 7 partners and we have over 150 years on Wall Street but 100 of it under this roof, combined. My oldest partner, Chuck Hobbs, has been with me since 1992.

CAPITALIZE FOR KIDS: That’s incredible.

JIM CHANOS: And the head of trading, they’ve been with us since 1993, and the next group kind of all came around 2000. So, that’s unheard of in our industry, really, to see people stay at one shop for so long.

CAPITALIZE FOR KIDS: You must be very proud of the loyal culture you’ve been able to build.

JIM CHANOS: Well I think it gets back to what we do and it’s not a business model for everybody. So, I think that that’s another thing that sort of sets it apart.

CAPITALIZE FOR KIDS: When you founded Kynikos, you mentioned it was just you and a secretary. Since then, your resources have grown meaningfully. How has your ability to detect frauds or bad actors in the financial community changed as a result?

JIM CHANOS: Well, it’s always better when you get a little bit more support than when you’re the only person doing it. So, I think that certainly has made a difference. I like to tell people, my analysts and my students, that back in 1985 really for a good 10 + years the problem was getting the information. So, I used to spend a lot of time in the SEC micro-feed rooms in New York, just looking at 10-Qs. Today, it’s completely different. Today it’s filtering the information that comes at you in a firehose. Everybody has instant information in their pocket. The question is what do you do with it?

So, I think that the core problem for a research-oriented shop has changed from obtaining the information that gave you an edge to now being a better analyst of said information. So, we really have begun to change our focus, it’s really not about going out and going to the collegial factory up in Albany to check on their out of home computer production. Or, going to some parking lot and counting cars. You can do that by satellite today right. Again, there’s no shortage of things like Glassdoor or whatever that will get you inside a company in public forums.

So, those sorts of things that short sellers were known for in the 80’s and 90’s are much much less important today than actually understanding the way that businesses work, understanding how the numbers are flowing and when bad actors are playing games with you.

Jim Chanos

CAPITALIZE FOR KIDS: You spoke at length about information becoming more ubiquitous. How has the past experience of your team allowed you to see what could potentially unfold?

JIM CHANOS: I’ll give you great Canadian example from a little company called Valeant Pharmaceuticals. I’ve been on record saying I believe it might be the largest single stock loss in the hedge fund industry and greater than Lehman, Enron, and a number of others because the hedge fund concentration was so high. When we first discussed the idea in late 2013 in this room, our pharma analyst, who was a CPA, brought up the idea. Two of the partners who’d been here a long time and were here in 2000 looked at me and we all basically said the same words at the same time, Tyco International. Tyco was an aggressive roll up run by two guys who ended up going to prison, Dennis Kozlowski and Mark Swartz. They were playing some of the most aggressive roll-up type accounting games.
The situation was different but they were still employing some of the same stuff that Mike Pearson was doing at Valeant.

When we said ‘Tyco International’ every other person in the room looked at us blankly. They were too young to go through that with the firm and it was great having some institutional memory for pattern recognition. The ability to see a story, have it put out for you on a whiteboard and suddenly say, “Wait a minute I’ve seen this before.”

It’s not always exactly the same of course, but there were enough clues that I felt it was worth doing a deep dive on the idea. Now, as a follow-up on that regarding the information issues that we were talking about – the challenges of either getting it or processing it. In 2015, I saw on a website called FiercePharma, which is a daily website for the pharmaceutical industry that shows up in my
inbox every day. There was a story about an aggressive pharmacy called Philidor and someone had pointed me to the link. I looked at the link and  under the comment section, of all places, was a series of comments by people saying Philidor fills Valeant Pharmaceuticals orders. Well, then there were a couple of comments that said no, Philidor is Valeant. That set off alarm bells in my head. This was April of ‘15. Now Roddy Boyd and others wrote about it in late September, early October of ‘15. We had already sent our analyst in the summer of ‘15 to go check out Philidor. We drove out to Pennsylvania, and we expected to find a mail drop, we expected to find just some sort of paper thing that Valeant was using as a pharmacy of convenience. Instead we were actually stunned. We saw a big operation – warehouses, drops, the whole nine yards and it was enormous. And that’s when we began looking back. Where was the disclosure of this thing? Obviously, this is a huge operation. It wasn’t disclosed properly. So we started asking ourselves, ‘what else don’t we know here?’.

That was right around the stock’s peak, around $240 or $260. Now that was sitting out there in the public domain from April

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