From the 2012 Financial Analysts Seminar in Chicago: A Short-Seller’s World Tour Starring Jim Chanos
In the nearly 30 years since famed short-seller Jim Chanos founded Kynikos Investments, his firm has produced a remarkable record of success betting against overvalued and overhyped stocks. For the man who called the Enron debacle (PDF), corporate chicanery, in particular, is something of a specialty. “The largest financial frauds always have marquee investors,” Chanos warned delegates yesterday at the CFA Institute Financial Analysts Seminar in Chicago. Pausing for effect, the consummate skeptic added: “There’s a lesson here. Always do your own work.”
It’s a mantra that Chanos regularly imparts on students who take his course at the Yale School of Management. Recently, his team applied this do-it-yourself analysis to their own investment track record to see what they could learn from both their successes and failures. What they discovered surprised even Chanos himself: the firm’s most successful investments turned out to be so-called “value traps,” cheap stocks that attract bargain-hunters — but that turn out to be cheap, and keep getting cheaper, for a good reason. The internal review helped Chanos articulate a framework for understanding how and why the market can get things so wrong, and how to profit from these mispricings.
Value investors, Chanos said, typically look for stocks with predictable cash flows, defensible positions, no need for superior management, a low valuation, a stock price down materially from recent highs, a margin of safety, and reliable, transparent financial statements. Unfortunately, though, when financial analysts aren’t careful these characteristics can lead them straight into value traps. Chanos and his team focus squarely on such traps by flipping value investing attributes on their head: his team seeks out companies that are more cyclical or dependent on one product and where hindsight drives expectations, marquee management and/or famous investors are in play, the stock appears cheap using management’s metric(s), and, most importantly, there are accounting issues. In addition, Chanos says that his team searches for companies that are overpriced due to credit-driven asset inflation and where cash flow generation from the asset(s) does not service the debt. Both of these factors help him avoid valuation bubbles, he said.
Using this approach as his framework, Chanos treated his audience to a tour of current short opportunities around the world. First up: thermal coal companies that are getting squeezed out of the energy market through regulation on the one hand and the shale gas revolution on the other. The short target in his sites: Consol Energy (CNX).
Next, Chanos turned his attention to the enormous difficulty of managing technology companies in an era where technology seems to undergo repeated paradigm shifts. With the advent of smartphones and tablets, personal computer manufacturer Hewlett Packard (HPQ) is struggling mightily to keep pace. In the past few years, HP has spent $37 billion in acquisitions and yet has flat revenues, Chanos said, showing how hard the company is running just to stand still. (More details on Chanos’s short call on HP can be found here.)
On the other side of the pond, Chanos focused on Banco Santander (SAN) in Spain, where the popping of that country’s massive real-estate bubble warrants huge write-downs to reflect reality — but have yet to be taken because the banks are terrified to do so.
Chanos concluded his remarks by continuing east and touching on the Chinese real estate bubble, a subject that he has been discussing for several years, and what that bubble means for the massive supply chain that feeds it. Chanos’s view is that China’s infrastructure build-out is unsustainable. Yet Australian iron ore producer Fortescue Metals Group (FSUGY) exports 99% of its product to China, he said, and is a company that has fully embraced this development as a paradigm shift. Who is right? Only time will tell.
In the meantime, as Chanos would put it, be sure to do your own work.
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