Lessons from a short seller

Ask any student of the stockmarket what they deem to be the 'biggest disasters' in corporate history and most people will settle for Enron, WorldCom, HIH and A.B.C. Learning Centres. These multibillion-dollar corporations at least appeared to go bankrupt overnight, taking with them billions from the portfolios of some of the world's smartest investors.

Many dismissed these spectacular failures as 'black-swan-type' events—completely unforeseeable. Not Jim Chanos, founder of Kynikos Associates. He not only predicted their demise, he profited from them. Just as he did when he 'shorted' Macquarie Bank in 2007 (see Steve Johnson's Bristlemouth blog post, Chanos was right, I was wrong).

Chanos started Kynikos (Greek for 'cynic') funds to profit from a practice known as 'short-selling' (see our Investor's College article on the subject, Short selling, short change). The mechanics of short selling seem technical but the main thing to remember is that short-sellers profit when stock prices of companies go down.

This isn't the same as profiting when stock prices go up. When we buy a stock, especially if it pays a reasonable dividend, we can hang on as long as we need to for the market to recognise the stock's real value. Shorting is different. Like buying, it requires lots of research, but it has to be married with precise timing.

You pay interest to short a stock, and have to cover dividends if they're paid, too. And if the stock price rises rather than falls, then the problems really start to mount. So successfully shorting a stock is a rare and highly specialised skill. The fact that Jim Chanos has earned returns well in excess of the indices and his other hedge fund counterparts by only short selling is a testament to his expertise.

The question for mere mortals like us, then, is what we can learn from him.

You may never short a stock in your life but if you understand what Jim Chanos is looking for in a good short, then you'll know what shares to avoid. Chanos calls these 'value-traps'. He offers three basic lessons:

1. Avoid debt-fuelled asset bubbles

Questionable accounting is the foundation to everything Jim Chanos shorts. Perhaps the scariest fact of any corporate collapse is that they all had audited financial statements that complied with accounting standards.

But you don't need to be an accountant to pick up the frauds. Pay attention to the footnotes of the annual reports and compare these to the company's competitors, closely examining different assumptions that different managements use. Then ask, 'which manager is more conservative?'

Chanos finds the accounting for companies that serially conduct mergers to be extremely murky, often because managements grant themselves enormous leeway in making assumptions about newly acquired subsidiaries.

When debt is added to the mix, it often signals that all is not well; the company may have resorted to chasing new streams of revenue just to maintain the illusion of earnings growth. Tyco was a large American conglomerate that found a clever but legal accounting gimmick to hide money-losing divisions when acquiring other companies using leverage.

Many Australian investors are still haunted by the ghosts of A.B.C. Learning. It acquired child-care assets through large rights-issues and even larger bank borrowings. Many of our country's smartest investors were duped into the allure of its 'aggregation model'. But a glance over ABC's 2005 annual report footnotes should have raised a few questions: 

ABC's largest asset was an item entitled 'childcare licenses', the measurement of which sounded worryingly precise. In fact the footnote (pictured above) reveals that the 'asset's' valuation was left entirely up to ABC's management, the details of which were never properly disclosed.

This fact, coupled with ABC's large capital expenditures, negligible cash flow and growing leverage should have steered investors clear of this debt-fuelled asset binge three years before the stock fell into administration.  

2. Avoid industry obsolescence

Some of Jim Chanos' most profitable shorts have been Eastman Kodak, Blockbuster and, more recently, Hewlett-Packard. Other notable value investors, including Seth Klarman, were buying in at the time Chanos was shorting. These companies appeared cheap, often selling for single digit price-to-earnings ratios. But all operated in sunset industries, victims of technological change that drove their earnings down year after year.

'Value investors have been drawn to these companies like moths to the flame', said Chanos. 'We've seen time and time again where the cash flows do not gradually decline. Nor do managements seem very willing to pay out cash flows when they are in a declining business', he concludes. By paying 10 times earnings for a declining business today, investors may actually be paying 20 times near future earnings because profits can quickly halve.

Some of Australia's great and good, including Gina Rinehart, Mark Carnegie and John Singleton have moved into the 'old media' sector by grabbing fistfuls of 'quantitatively cheap' stocks in Ten Network, Fairfax and even Qantas. It's quite possible these investments will suffer the same fate.

Betting on an ailing business is like backing a bleeding horse; the payoff is high but the odds are stacked against you.

3. Avoid the 'one trick pony'

These are companies that rely on one factor for its earnings, perhaps a single 'fad product', government protections via easily-repealed legislation or an isolated discovery, as in the case of mining and biopharmaceutical companies.

Chanos' most successful shorts have included companies that manufacture Cabbagepatch dolls, George Foreman Grills and Martha Stewart (the products, not the person). These are household names even to us, but in the case of the first two at least, they have a huge fad element to their success. As we know, fads don't last.  

A different but local example is salary-packaging company McMillan Shakespeare. It relies on a single tax loophole for public health sector employees to earn a major part of its revenues. Selling on a PER of 20 and more than 40x operating cash flows, it would take one swipe of the legislative pen for those profits to disappear.

Buffett's right-hand man Charlie Munger once said, 'All I ever want to know is where I'm going to die, so I never go there'. That encapsulates the essence of sound investing; avoiding losers as much as betting on winners. The Jim Chanos approach will help you avoid the losers.