Known as the master of short selling. Jim Chanos runs Kyninkos Partners, a hedge fund with assets under management of over $6 billion. Here’s a list of lessons I’ve learned from the short seller.
- The financial statements. The first and most important lesson when it comes to investing in a company, or shorting it, is the ability to analyze and truly understand its financial statements. The numbers tell it all, and more importantly the accounting principles; how a company books receivables, accounts for sales, etc., will effect the value of the company in the long run. Looking for bad accounting practices can help investors anticipate a potential problems for the stock in the near future. Bad accounting practices can lead to overstated earnings, and that’s bad for the price.
- Flawed business models. I started in the markets as an equity trader, I would trade my own account, looking to profit from momentum swings. Recently I’ve changed my style from trading to value investing, though Jim is a short seller, he has helped me become a better long term investor by focusing on the fundamentals. Understanding the dynamics of an industry, market, economy, or company is essential to investing and on the short side being able to identify companies with flawed business models is important. An example would be the tech bubble of the 90s, many companies were selling a dream without any plans or proof of making money. Chanos was short these stocks, he believed many would never managed to achieve operating profitability. An important thought experiment would be to look at the current market and see what industries or companies are operating in a flawed matter.
- Off balance-sheet activities are also inputs to consider when valuing a company. Some companies tend to fudge their numbers, they do it to give their balance sheet the perceived value of being healthier than it actually is, which in turn, boosts the stock price. When Chanos looks at a company he’s looking for off balance sheet activities that are uneconomic in the long-run. Off balance sheet transactions can hide the true debt picture of a company and other liabilities. Here is another article I wrote regarding Off balance sheet scenarios.
- Fraud. General fraud, when a company claims to own assets it does not own, or it is subject to liabilities and debts it has not disclosed, or there is an act of corruption or embezzlement amongst employees or managers of the business. Be on the lookout for fraud.
- Executive Turnover. According to Chanos, “when you see a company with a high executive turnover rate, there’s probably something fishy going on.” This is an interesting lesson because its a red flag that investors should be looking at when they own a company or are thinking about buying some shares.
- Value Traps. This is one of the most interesting ideas I’ve learned from Jim. A value stock is a stock in which there’s predictable, consistent cash flow, reliable, transparent financial statements and that can be classified as a defensive and/or defensible business. A value trap, is a value stock with some characteristics like: cyclical and/or overly dependent on one product, hindsight drives expectations, marquis management and/or famous investor(s), and appears cheap using management’s metric. These companies may seem valuable or cheap, but the company or the entire sector is in trouble, and that stock prices may not move higher.
- Benford’s Law. I was reading an article in which Jim states that his firm uses Benford’s Law, the principle that in any large, randomly produced set of natural numbers, around 30 percent will begin with the digit 1, 18 percent with 2, and so on, with the smallest percentage beginning with 9. A data set which does not conform to Benford’s Law may well indicate that something is not right. This may be fraud, or may be mistakes or misstatements. In any event all of these leave investors operating at a disadvantage when compared to investing in a company with accurate reports. Of course Benford’s Law has a mathematical proof (here’s another), but I’ll avoid that and lean on an intuitive example from Wikipedia: [I]f a quantity doubles every year, then it will be twice its original value after one year, four times its original value after two years, eight times its original value after three years, and so on. When a quantity which doubles every year reaches a value of 100, the value will have a leading digit of 1 for a year. In the next year, the value rises from 200 to 400 and will have a leading digit of 2 for a little over seven months, and 3 for the remaining five months. In the third year, the leading digit will pass through 4, 5, 6, and 7, spending less and less time with each succeeding digit. Early in the fourth year, the leading digit will pass through 8 and 9. When the quantity’s value reaches 1000, the process starts again. From this example, it can be seen that if the value is sampled at uniformly distributed random times throughout those years, it is more likely to be measured when the leading digit is 1, and successively less likely to be measured with higher leading digits. This example makes it plausible that data tables that involve measurements of exponentially growing quantities will agree with Benford’s Law. But the law also appears to hold for many cases where an exponential growth pattern is not obvious.
