Jim Chanos Masterclass: The Fundamental Short Seller

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'I don’t believe that he deliberately set out to nail Baldwin or send them into bankruptcy, but clearly we threw weight on a sinking ship.' - H. Robert Holmes, the chairman of Gilford Securities

There was a time when Jim Chanos may not have become the world’s most famous short seller. Born in Milwaukee in 1957 to a Jewish-Greek family, Chanos studied political science and economics at Yale but originally wanted to become a doctor. At college he dabbled in options and stock trading but back then, as he told Value Walk, ‘business was pretty much a four-letter word’.

After graduation in 1980 he read The Money Masters by John Train, where he was first introduced to a famous short seller of the 1970s called Robert Wilson, and Contrarian Investment Strategies by David Dreman. Forsaking a career wearing a white coat to join one that occasionally enjoys white shoes, he became a junior investment banker in Chicago.


Defying The Experts

It wasn’t for him, however. As he told Value Investor Insight in 2005, ‘It became clear to me after that there had to be something more interesting than making wrong recommendations [to clients] with twisted facts just to generate fees’.

That’s how he came to be a junior securities analyst at Gilford Securities in Chicago. Many of Gilford’s clients owned MGIC, which at the time was subject to a takeover offer from Baldwin-United. As Chanos told Steven Drobny in The New House of Money ‘the more I looked at Baldwin, the more I could not figure out how they were making money.’

Chanos felt certain the company was using insurance funds to make acquisitions, faced the threat of regulatory action as a consequence and was heavily indebted and overpriced. As he told Value Investor Insight;

‘They were issuing annuities at 12–14 %, and I couldn’t figure out what they were investing in that was possibly earning that. Other than all their acquisitions, their portfolios were mostly bonds bought years before that were basically underwater.’

In August of 1982 and only a few years into his career, Chanos wrote an eight-page recommendation to sell Baldwin-United short at a price of US$24. The stock fell at first but then more than doubled, hitting US$50. Lawsuits were flying and there was pressure from the New York head office to dump the errant upstart.

Chanos knew he had spotted a fraud and, to wit, a huge mispricing. But no one wanted to know. Then fortune fell his way.

After a story in Forbes called Baldwin a ‘house of cards’ the company’s share price collapsed. Incredibly, on the very same day Merrill Lynch refuted major aspects of the story, including parts that even Baldwin-United had publicly admitted, it retained a buy recommendation.

Chanos said of the incident;

‘When I saw that go across the tape, it hit me: So many people had bought the stock on this analyst’s recommendation and she had not even looked at the Arkansas statements I’d written about months before. It was a real eye opener in how dissenting voices were squashed, how serious facts could be ignored for months on end, and how cozy the banker/analyst/company relationship could be.’

And then the phone started ringing. Suddenly, everyone was interested in what else Chanos didn’t like. Swimming with the tide, The Wall Street Journal, which two years later was to claim that Chanos ‘epitomizes all that is wrong with modern short-sellers’, hailed his ability to defy the experts.


Vindication had taken the reputation of Jim Chanos from zero to hero in a few short months. And that got him thinking; ‘If you can be rigorous and do the work in these kinds of situations, and you get your facts right, you might be able to make some serious money taking advantage of how things work.’

And then: ‘If nobody wanted to do this type of thing, and I was willing to take the heat, there was a real opportunity to build a business as a young person.’

Frauds, scams and high prices – The search for value

‘Whether you want to short stocks or not, you ought to take valuation into account when you buy something because it will matter at some point.’ - Jim Chanos

Shorting stocks has its problems, which is why not one Intelligent Investor Share Advisor analyst has ever engaged with the practice - something to bear in mind when reading the stocks each would short if forced to do so.

The reason is simple. For value investors, valuation and how it compares to price, is everything. Once a cheap stock has been purchased one need only wait for the market to catch up. Whether that takes months or years need not matter. With no holding costs, and sometimes a high dividend to grease the wheels, patience doesn’t have a price.

Shorting stocks doesn’t work like that. There is a cost – the cost of borrowing the stock and the payment of dividends to its owner – plus something potentially more damaging.

Always Invert

A shorted stock can only fall to zero (a 100% gain for the shorter and the maximum possible gain) but can rise by thousands of per cent. So getting out of a short position can cost far more than the most you can make from it. In ‘long’ investing you can only lose the money you’ve put in. In shorting, you can lose multiples of it.

That’s why Chanos says, ‘everybody says be careful shorting on valuation and I think that’s a good bromide.’ That’s why Chanos always has reasons in addition to valuation for shorting a stock.

Shorting does have some advantages, though. Fewer people do it, which means it’s a less competitive field. And frauds, scams and over-priced stocks are arguably easier to spot than merely cheap companies.

Chanos employs a team of analysts, including former journalists, a profession he values for its inherently sceptical nature, to wade through company accounts, examine management and calculate financial ratios. Most certainly, this is a fundamental approach.

But Chanos and his team use these skills to uncover ‘inverse’ value. Instead of seeking out ‘clean’ accounts where every transaction can be traced, they look for dirty, opaque accounts where management employs a great deal of latitude in valuing its own assets.

‘Long’ investors look for strong, well-managed, stable businesses with predictable futures. Chanos looks for companies under threat, run by blinkered managers that fail to see the elephant in the room.

And whereas every sensible long term value investor tries to avoid bubbles, Chanos loves them, famously shorting in one way or another almost every bubble that has come his way. He categorises his shorts into four areas:

1. Debt-fuelled asset bubbles

Chanos claims that bursting bubbles are the source of his most lucrative shorts, especially those that are debtfinanced rather than more conventional valuation bubbles such as the Dotcom era.

Kynikos avoided that debacle, largely due to the absence of debt and the fact that, as Chanos acknowledges, ‘we did not know how high those names could go’.

A few years earlier, Kynikos had shorted internet service provider AOL because it was experiencing a high churn rate and was capitalising marketing costs. The stock price flew from US$10 a share to US$80 and was eventually purchased by Time Warner, a painful experience that probably influenced Chanos’ thinking.

He typically finds the accounting for companies that serially conduct mergers or acquisitions to be extremely murky. When debt is added to the mix, it often signals all is not well – the company may have resorted to chasing new streams of revenue just to maintain the illusion of earnings growth.

2. Suspect accounting practices

There are always people willing to fiddle the books. Some might be aware they’re breaking the law, others that they’re pushing it a little, inhabiting the grey area that what Chanos says ‘a rule based system’ creates. In a perfect world a company’s accounts should be an accurate reflection of reality, of how it makes and accounts for money. The problem with a rules rather than standards-based system is that, as Chanos told Value Investor Insight:

‘we want every single possible transaction to have a rule. So you have armies of investment bankers and lawyers who do nothing but think about how to get around the rules. I can’t think of one major fraud where the auditors didn’t sign off on the statements. In a rules-based system it’s easier for unscrupulous people to fix the numbers and get people to sign off on them as proper.’

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