Jim Chanos — Rooting out Fraud
Spring 2012
Jim Chanos
Mr. Chanos is the founder and Managing Partner of Kynikos Associates, a firm he founded in 1985. Throughout his career, Mr. Chanos has identified and sold short the shares of numerous well-known corporate financial disasters; among them, Baldwin-United, Boston Chicken, Sunbeam, Conseco and Tyco International. His most celebrated short-sale of Enron shares was dubbed by Barron’s as “the market call of the decade, if not the past fifty years.” He is a Visiting Lecturer in Finance at the Yale University School of Management and a graduate of Yale University.
G&D: Mr. Chanos, you studied economics and political science at Yale. At what point did you get interested in the stock market?
JC: My father had been a stock market investor since the 1950s, in addition to running the family business. He drilled into me the notion that to be financially independent, I would have to work for myself, work hard, save my money and invest wisely. He began teaching me about the stock market when I think I was in third or fourth grade. From this point onward, I became fascinated by investing. I was fascinated by the math and the numbers and the fact that you could invest and, unlike with a savings account, you might be able to double your money. This was my first introduction to investing and it occurred in the late ’60s. I continued to read about investing and took the only two undergraduate accounting classes while at Yale.
After I graduated I decided that I wanted to pursue an investment career. I didn’t get a job offer from any of the big New York banks, which in 1980 were the source of most of the employment offers. I joined one of the first investment banking analyst programs with Blyth Eastman Dillon’s regional office in Chicago. I put in 16 hour days six days a week working on deals for senior bankers. This was a good introduction into the numbers of investing.
There was a defining moment, however, when I realized investment banking wasn’t for me. A year into my stint at Blyth, we were working on a recommendation for McDonald’s to issue a bond. At that point in its history, McDonald’s was generating a lot of cash and reinvesting it back into its restaurants, each of which generated high returns. But the stock market was valuing McDonald’s at only 8 or 9x earnings despite the company growing at 20–25% a year pretty consistently with real cash earnings.
Around this time, I read that Teledyne and Radio Shack were growing earnings rapidly by buying back stock, as the management of these firms believed that their companies were undervalued in the stock market.
This was at a time when interest rates were at double-digits. I ran some numbers independent of the blue book that the associate, the senior banker and I were compiling, and determined that instead of the debt deal, we should recommend that McDonald’s buy back stock with some of its cash flow and cut back its expansion slightly. This could lead to a larger EPS increase relative to the bond issuance and they wouldn’t have to add leverage to the balance sheet.
Given where rates were, the impact on EPS from buying back stock rather than issuing debt was dramatic. When I made this case to the associate, he turned white and said he wanted no part of presenting this idea to the senior banker. Being pretty naïve and not realizing the political implications of such a recommendation, I handed out a two page memo to the senior banker discussing the impact of buying back stock. The senior banker looked at me with an icy stare and stated that we were not in the business of recommending share buy- backs to our clients; we were in the business of selling debt. This was my first douse of cold water regarding Wall Street and I became pretty disillusioned after that episode. I had learned that Wall Street wasn’t necessarily doing things in their clients’ best interest but was instead focused on maximizing fees.
G&D: So was it this incident that led to your transition to the buy-side?
JC: Around this time, I had been talking stocks with the head of retail client brokerage at the Chicago office, Bob Holmes, during my lunch hour. That’s what I really enjoyed; going over to his office and checking the market and punching tickers into the Quotron machine to see what was up and what was down. I would look forward to that part of my day more than any other. I had a little money saved and was trading like a lunatic in my own brokerage account, not making any money. Finally one day, Bob called me into his office, shut the door, and told me that he was leaving to start a retail brokerage firm with a couple of partners. He asked me if I wanted to join their new firm as an analyst. I could barely contain my excitement.
One of the first stocks they had me look at was insurance holding company called Baldwin-United. Baldwin was growing very rapidly by selling annuities that were uneconomic. To plug the hole that was developing within their insurance subsidiaries, the holding company was closing acquisitions. In exchange for the insurance companies’ cash, the holding company was providing the subsidiaries with overvalued securities. However, the regulators of the insurance subsidiaries were becoming wise to the development as Baldwin-United’s stock shot up. We acquired a copy of the insurance department public files and we were able to see from regulators’ letters that they were becoming increasingly concerned about the valuation of those affiliated assets held by the insurance company. They went as far as to imply that if Baldwin-United didn’t downstream additional capital to its insurance subsidiaries, they would have to declare the subsidiaries insolvent. While this was occurring, every brokerage house was recommending the stock. Although the company was rapidly growing earnings, those were all non-cash earnings because Baldwin-United was using gain on sale accounting when it sold annuities. This fictitious “gain” was based on the expected persistency of the policies and the present value of the estimated spread generated by their returns on investment in excess of the annuity pay- outs. The problem was that they were paying 14% on the annuities and were far too optimistic on their investment return estimates. My first research report was published in August of 1982. I recommended a short position in Baldwin-United at $24 based on language in the 10-K and 10-Qs, uneconomic annuities, leverage issues and a host of other concerns. The stock promptly doubled on me.
This was a good introduction to the fact that in in vesting, you can be really right but temporarily quite wrong. I put another report out in early December of 1982 with the stock at $50 and reiterated my thesis while pointing to additional evidence that had come out in the interim. I went home to visit my parents for Christmas and received a phone call from Bob Holmes telling me that I was getting a great Christmas present — the state insurance regulator had seized Baldwin-United’s insurance subsidiaries. Baldwin filed for bankruptcy shortly thereafter.
That’s the idea that sort of put me on the map. After that, big New York hedge funds to which we had been trying to pitch the Baldwin short started calling us to see what other companies were short candidates. I had no predisposition to be a short seller but I thought that there could be a business niche in that arena. Maybe I could, as a young analyst, carve out a good business by being an institutional skeptic and come out with two or three really good short ideas that were thoroughly researched with the evidence clearly presented and documented. This would then be expected to lead to some nice commissions for the firm.
A lot of what happens in your life is merely serendipitous and really just luck. In a lot of ways, that’s the lens through which I look at my own career. If the McDonald’s share buyback episode hadn’t occurred, maybe I wouldn’t have left Blyth and I’d probably still be doing deals and be miserable. To join a new firm and to have the first company I look at turn out to be an enormous financial fraud was equally good luck.
G&D: For a brief period, you also worked for Deutsche Bank. How did that come about?
JC: In late1983, Deutsche Bank came knocking and asked me to move to New York to be an analyst in their new boutique investment research operation. In the summer of 1985, I began looking at the Drexel Burnham companies which Michael Milken was putting together through junk bonds. I was particularly focused on a real estate syndicator called Integrated Resources which was playing unbelievable accounting games and financing itself with junk debt issued at 14%. The company would overpay for office buildings and then syndicate their ownership interest to wealthy individuals via tax sheltered partnerships in uneconomic deals. Since there wasn’t enough cash to pay their fees, Integrated was taking their fees via overvalued third mortgages on the syndicated properties. The company’s earnings were not only overstated but were also heavily negative cash flow. I started to ruffle some feathers, and Integrated put a lot of pressure on Deutsche Bank and others to muzzle me. Later that summer, there was a Wall Street Journal front page article by Dean Rotbart describing an evil cabal of short-sellers who were saying terrible things about nine or ten great companies including Integrated Resources. According to an illustration on the inside of that Journal issue, the person orchestrating this short- selling pressure across all categories of investors was me. Within a day or two, I was summoned to a superior’s office and told that my employment contract which expired in October of 1985 would not be renewed.
Luckily, for a year or so I had been talking to a couple of investors who wanted me to run a portfolio of fundamental short ideas for them. Though my bargaining power had declined a bit since I was going to be out of a job in a few months, they agreed to set up Kynikos Associates with me. The fund was capitalized with $16 million, $1 million of which was my own, and we started on October 1st, 1985.
G&D: What were the early days like?
JC: From 1985 to 1990 was a golden era for short sellers because it was a highly idiosyncratic, uncorrelated market. Although the market was slowing, it was dominated by institutions. If you could make a case that a company was playing games with its numbers or had some other serious problem and the company then admitted wrongdoing, the stock would go down quite a bit. Meanwhile, the broader stock market had a few periods of run-up following some crashes leading up to 1990. The so-called alpha was off the charts in this time period. It was probably in the 20% area. Money flooded into any hedge fund that said they had short- selling skills. By 1990 we were running $660 million and were one of the top ten largest hedge funds in the world. Then it all came crashing down from ’91 to ’95. After the Gulf War, the Fed eased and the market took off for a good three years until ’94 and then began to take off again in ’95. I believe the NASDAQ or the Russell doubled in 1991. There was no place to hide on the short side. Everything became correlated on the way up. The worse the news a company reported, the more its stock price appreciated. It was a tear-your- hair-out market if you were a short-seller. With client withdrawals by ’93 and in ’95, we were down to $150 million and I was wondering if I was going to stay in business. I didn’t want to do what a lot of people have done in that situation — close up shop and start again two years later — because I didn’t think that was fair to my investors for whom I had lost money and who had high water marks. We agreed to soldier on and I paid most of the employees out of my pocket for a few years because there were no performance fees. I had a core group of people who were very loyal and stayed with me through this period. Then in 1995, two large clients came forward and said they believed we were still adding value to their portfolio and that they were willing to invest additional money. They agreed to lock up some additional capital for a slight cut on the fees. So, in effect, those two clients saved the business in ’95. We never really looked back.
Their timing was exquisite because although the market kept going up between 1996 and early 2000 during the dot-com era, it was again bifurcated and uncorrelated much like in 1985. If you had a good short idea, it could still go down; for example, Boston Chicken, Oxford Health, and Sunbeam were all collapses. So we had some great years despite the bull market.
Something else that we did was to change our compensation formula for our managed accounts so that compensation was determined based on an inverse benchmark basis. For example, if the S&P was up 20% and we were up 10%, we would be paid as if we were up 30% but alternatively, if the S&P was down 20% and we were up 20%, we would be paid nothing because we created no excess return, or alpha. That arrangement saved the business as well. We generated a lot of alpha in the late ’90s so those were some of our best years financially and performance-wise. We still have that compensation structure today. Most of our dollar assets are paid on an alpha basis, so the clients like it and we think it’s fair.
G&D: At what point did you open your long-short fund in addition to the short-only fund?
JC: In 2003, we launched our first long-short fund — Kynikos Opportunity Fund because we realized that through our research process, we were coming across a lot of good long ideas upon which we couldn’t act. This ability to go long acted as an adjunct to our short research. A stock might collapse and the bonds might fall in price but based on the work we have already done we might think there is some value in the firm and that the bonds are money good. The Opportunity Fund allowed us to capitalize on these types of opportunities. We might also utilize a pair-trade strategy in this fund. For example, for a number of years we were long Honda and Toyota and short Ford and GM. Right now in the Opportunity Fund, we’re short Chinese property companies and long Macau casinos.
In 2005, one of the clients that saved us in ’95, inquired about our interest in running a fundamental short portfolio in Europe with a fund based in London. They were willing to finance it in exchange for a five year exclusive limited partner stake. Having been in business with this client for many years, we were certainly interested in the opportunity and we wanted to see if we could apply our process globally. We opened an office in London for non-US ideas and that too proved to be successful. We found that our approach to company and security analysis could be ported over to non-US situations. We had a great run. The exclusivity arrangement expired last year and so we now have a global short fund which we offer to clients, in addition to the domestic short fund and the long-short fund.
G&D: Could you describe your process in a bit more detail for our readers?
JC: I used to think that good short-sellers could be trained like long-focused value investors because it should be the same skill set; you’re tearing into the numbers, you’re valuing the businesses, you’re assigning a consolidated value, and hopefully you’re seeing something the market doesn’t see. But now I’ve learned that there’s a big difference between a long- focused value investor and a good short-seller. That difference is psychological and I think it falls into the realm of behavioral finance. The best way I can describe it is as follows: almost all of your readers, and I suspect you as well, are beneficiaries of positive reinforcement. That is, you’re told early in life to work hard, study hard, to get good grades and get into a good school, and then to do well there and to get a good job and so on. All of that is a virtuous circle.
On the other hand, numerous studies have shown that most rational people’s decision-making breaks down in an environment of negative reinforcement. If you think about it, Wall Street is a giant positive reinforcement machine. When I turn on my Bloomberg at home at night, I’m going to see that about 20%+ of our ideas have some sort of positive analyst report out or the CEO is on CNBC or there’s a takeover rumor. Almost all of this is noise; there’s just not a lot of informational content in this stuff. But this is the music of the investment business. It’s like a (more often than not) comfortable river that every investor floats down on. If you’re a short-seller, that’s a cacophony of negative reinforcement. You’re basically told that you’re wrong in every way imaginable every day. It takes a certain type of individual to drown that noise and negative reinforcement out and to remind oneself that their work is accurate and what they’re hearing is not. Most people are in the “life’s too short to put up with this stuff” camp.
The other problem is that there’s an asymmetry on the return patterns of short ideas. Because markets tend to go up over time and you need discrete news to affect a short idea, you tend to have weeks and months and even years when you’re not making money in your ideas. Then when you do make money with a short idea, it happens all at once. Here once again, most people are just not hard wired to find that asymmetry comfortable but good short sellers are. Though I listen to the noise to make sure there’s no new information that I need to know, I don’t worry about most of it. You need to be able to drown out what the Street is saying. I’ve come around to the view that to be a good short seller, in addition to having the important skill set, one must have the right mindset. I believe this is why a lot of great value investors aren’t particularly good short sellers. Part of what weighs on value investors is the view that any given stock can appreciate an infinite amount but can only depreciate in the worst case to $0. They always have this nagging concern that one bad short idea could bankrupt their firm. I continue to respond to this argument by stating that I’ve seen a lot more stocks go to $0 than infinity. In general, the short side can come with a more unpleasant feeling than the long side and I think that’s why there are so few short-sellers out there.
G&D: Is there anything in particular that you look for to determine if a company is a good short candidate? How do you distinguish between a stock that is truly overvalued and one that might grow into its valuation?
JC: We try not to short on valuation, though at some price even reasonably good businesses will be good shorts due to limitations of growth. We try to focus on businesses where something is going wrong. Better yet, we look for companies that are trying — often legally but aggressively — to hide the fact that things are going wrong through their accounting, acquisition policy or other means. Those are our bread-and-butter ideas. In fact, I’ve given some lectures on the concept of value traps. Probably our best ideas over the past ten or 12 years have been ideas that looked cheap and which actually ensnared a lot of value investors. The investors didn’t realize that these businesses were deteriorating faster than their ability to generate cash. Eastman Kodak was a great example of that. A few famous value investors were buying it all the way down because they assumed that the decline in the business would be a slow glide that would allow the company to harvest cash flows for the benefit of shareholders.
The fact of the matter is that, for most declining businesses, management tends to redeploy cash flow into things outside of their core competencies in a desperate attempt to save their jobs. In the case of Kodak, they took some of their patent proceeds and cash flow and invested in a printer business, which is another declining business model.
They ended up being decimated by their own invention of digital photography. When analyzing Kodak as a short candidate, valuation was almost the last aspect that we considered because, as I said, some of the best short ideas can look cheap from a valuation standpoint.
G&D: Can you talk about your valuation framework?
JC: We look at the same things everyone else does, but with the idea that these are moving targets. Balance sheets should give you some sense of intrinsic value on the downside. On the up- side, we have to worry about the unlimited potential. We look at things like market sizes and the law of large numbers, as to whether companies can grow their way out of a bad accounting situation or a leveraged situation. On the short side, the financials are often misleading. What might appear to be value sometimes is not. A book value that is comprised of goodwill and soft assets sometimes might not provide downside support if a company is troubled. Valuation itself is probably the last thing we factor into our decision. Some of our very best shorts have been cheap or value stocks. We look more at the business to see if there is something structurally wrong or about to go wrong, and enter the valuation last.
G&D: Some investors believe in the life cycle of investing in that a company can go from a growth stock to a value stock to a value trap — do you look at companies that way?
JC: I try not to. Companies can certainly go through life cycles. I think people who put themselves in a category of being a growth investor or a value investor limit themselves. A “growth” stock can be a great investment at the right price and sometimes “value” stocks are too expensive. On the short side, we’ve been generalists globally for six or seven years. The further you look for ideas the greater the chance you will see a unique idea.
G&D: It seems like you’ve initiated short ideas in practically every industry. Are there any industries that you gravitate to more than others for ideas?
JC: We’ve historically been drawn to financial services, where companies can really boost earnings by generating bad loans for a while. We’ve also been in consumer products, certain parts of the natural resource situations (which effectively become accounting plays) and generally companies that grow rapidly by acquisition. Where we see the juxtaposition of a bad business combined with bad numbers, that’s really in our wheel house.
G&D: Do you find more examples of fraud in smaller companies?
JC: There is probably more evidence in smaller companies, but we usually don’t short many small cap companies due to the restraints on borrowing and our size. So it was hard to short some of those Chinese reverse merger opportunities last year, though we did have a couple. Most of our positions are mid cap or large cap companies.
G&D: Could you talk about some characteristics that would make for an enticing yet, in reality, risky short candidate?
JC: Open-ended growth stories tend to have a life of their own. Our celebrated disaster was America Online. We shorted it in ’96 at $8 a share and covered our last share at $80 two years later. It was never a big position so it didn’t kill us but it was very painful for two years because people were able to make open-ended growth forecasts. We try to avoid those to some extent or we get involved further along the growth curve.
G&D: With short-selling, the timing of your idea can be particularly important. How do you address this somewhat unique challenge?
JC: That is certainly one of the unique aspects of short- selling. It is possible that when you see something developing, others are seeing it as well so at that point you may be unable to borrow the shares. This is why sometimes short-sellers borrow the shares when they can get their hands on them, even if they are early on the thesis playing out. In the ’80s and ’90s, when interest rates were high, you were effectively paid to wait out your short thesis because you could earn interest on the proceeds received from the short sale. However, in a rate environment like the one we’re experiencing today, initiating on a short too early can be somewhat more painful relative to those prior decades.
G&D: How is your firm different from other hedge funds with respect to sourcing new ideas?
JC: From an approach point of view, one of the things that distinguish other hedge funds from us is that a typical hedge fund has the intellectual ownership of an idea separate from the economic ownership of that idea. By that I mean you have the partners and the portfolio managers at the top and you generally have the analysts, who are more junior at the firm, at the bottom. The way the model works at most firms is that the guys at the top command the people at the bottom to come up with good ideas from which the portfolio managers ultimately select the additions to the portfolio. The problem with this model is that the profits go disproportionately to the people at the top of the pyramid but the risk — or the intellectual ownership of the idea as I like to call it — resides at the base of the organization with the most junior, inexperienced people. Consequently, if things go right, everyone makes money, but if things go wrong, the person at the bottom dis-proportionally shares the blame and the risk. This is why turnover is so high in the hedge fund industry. People try to do carve-outs, which I think are very bad policy.
This model puts all of the power of the idea generation, and therefore the alpha generation, with the most junior people in the firm, whereas the senior people are just doing portfolio allocation. We’ve always viewed it the opposite way. We have six partners at Kynikos who have 150 years of experience in the securities business among us and we have been together 100 years in aggregate. For example, my number two has been with me for 20 years. Because of our experience, we generate ideas up at the top. We are looking for the new ideas and we’ll do the first read-through of a company’s 10-K and other research in addition to talking to people in the industry.
The next step is to then send the idea down the chain to our research team to process. I will never blame the analyst for a stock that goes against us. Putting the stock in the portfolio is my responsibility and the other senior partners’ responsibility. I think this leads to a better intellectual environment at the firm. So we get analysts who love working here and will stay for 10 or 15 years. It’s a much more stable model in terms of process than some other models.
G&D: What are some of the skills that are essential to succeeding in this field?
JC: I teach a class at Yale’s Business School on the history of financial fraud. One of the things I teach my students, which I also teach my analysts here, is that nothing beats starting with source documents. You have to build a case for an idea, and you can’t do that without doing the reading and the work. We’ve had a little game where we’ve been watching a company that just put out its 10K. When it came out, prominent in the disclosure was that the company had just changed its domicile to Switzerland for a variety of important reasons. I told the analyst, let’s play a game: call the sell side analysts and try to ask them some questions to see if they know that the com- pany, under the advice of their legal counsel, changed their domicile. She said that of the eight analysts that followed the company, it was the seventh analyst who had a clue of what she was talking about. None of the others had any idea, which meant they hadn’t read the document, and that 10K had been out for 10 days. This happens more than you think. It happens because Wall Street research departments are marketing departments. The people with the most experience in these departments spend much of their time marketing. The junior people are back at the shop doing models and such, but there isn’t much thought going into this. So I teach my students and analysts: start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in. They’ll hear a story, then they’ll read some research reports, then they’ll listen to some conference calls, and by that point may have already put the stock in their portfolio. It’s amazing what companies will tell you in their documents. Enron is a great example — most of the stuff was hiding in plain sight.
There was one crucial piece of missing information, which was the “make good” in the SPVs that Fastow was running. The reason people invested in those and bought crummy deals from Enron was that there was a provision that if you lost money, Enron would issue stock and make you good. So that was a key missing piece of information. But in any case, it was amazing how much information was out there. Investing is like a civil trial. You need a preponderance of evidence, not beyond a reasonable doubt.
G&D: Do you recommend investors start with reading the newer filings first?
JC: Yes, look for language changes. Read the most current ones and work your way backwards. Read the proxy statements that are often neglected and are full of great information. By doing that and by spending a night or two with those documents, you can have a remarkably comprehensive view about a company. So start there and work your way out. This way you are looking at the most unbiased sources first. People on earnings calls will try and spin things, and analyst reports will obviously have a point of view. All of that is fine, because hopefully you will have first read the unvarnished facts. Primary research is crucial and not as many people do it as you think. Because there is so much information out there, it almost behooves people to read the source documents. If you are an airline analyst, you could be reading about airplane orders, traffic trends, fuel price trends, etc. all day long, and not have a better idea of what is going on at Delta Airlines or Japan Airlines.
Start by reading the documents of Delta Airlines or Japan Airlines. Overtime, understanding what to read and how much time to spend reading various things becomes an art as much as a science. You need to become a good information editor nowadays.
G&D: When you make macro calls, what primary sources do you use?
JC: People think we make big macro calls, but the fact of the matter is we don’t. We might end up with some macro calls but that’s only a function of our calls on the micro side. China is an example. People think we made a big macro call on China. In fact, our position on China came from the mining and commodity stocks in the summer of 2009. We were scratching our heads trying to figure out how in this terrible recession the prices for industrial commodities were going up. Well, we very quickly ascertained that China, which was 8% of the world’s economy, was generating 80% of the marginal demand for iron ore, cement, and steel. It didn’t take much work from there to realize that it was because of fixed asset build-out. As we did more and more work, we focused on the Chinese property sector and couldn’t believe what we saw, and then we moved to the banks, etc. So it was our work on individual companies that led us to the view that this was a macro problem in China property market. It was similar to our work on subprime lending in the U.S. We started by looking at the Florida real estate market in 2005, which was the first to go. I have an apartment in Miami Beach and I remember counting cranes along the horizon in 2005 and 2006. They were just multiplying. At the same time, we were doing some work on the banks and property companies in Florida. We saw that the securitization business was fueling this build out, and then we looked at the rating agencies and the big banks and worked right up the chain and realized it was a system-wide problem.
The same occurred with the commercial real estate market in the 1980s. We started with Integrated Resources, the syndicator I mentioned, and then tax laws changed in 1986. The laws meant that you could no longer write off passive losses from real estate against ordinary income, and that devastated the industry as they were just leveraging up to buy buildings everywhere. So we looked at syndicators, we looked at the savings and loan industry, and worked our way up the system. We’re not macro people. Even though we have a macro call on China real estate, it really derived from our work on individual companies.
G&D: Chinese students we spoke with seem to think that although the real estate bubble in China seems to be bursting as we speak, it may heat back up if the government starts stimulating the market. What would you say to that?
JC: That is the overall belief in China. When we first started talking about this, my critics said, well, Mr. Chanos doesn’t speak Mandarin and has never been to China. I said, that’s true, though my clients pay me for performance, not how many visas I have in my passport. Most people who go to China visit Shanghai and Beijing. That’s like saying I went to London and New York and didn’t see any problems in 2006 and 2007. Well, if you had gone out to Phoenix or Las Vegas maybe you would have seen them. So the critics, who initially in 2010 said our call was wrong, are now saying “well, there are problems, but the government can reflate and fix them.” My response to that is the government is the one that got you into that problem. People in the U.S. always said, if the U.S. gets into trouble, the Fed will just cut rates.
The problem is that the government policy has been loose in China regardless. The one restriction they have in place is the House Purchase Restrictions (HPRs), which apply for second and third homes. But people who own more than a couple homes are almost always speculators. The bulls are saying the government will loosen the HPRs, but the problem is that the government doesn’t want speculation in real estate. So I think that’s a pretty bad argument. Secondly, the flood of construction has continued apace, and the unsold inventory is piling up. What if the speculators turn into sellers as opposed to buyers when the HPRs are relaxed?
G&D: Do you think the government is seeing that?
JC: They are seeing it, and just a few weeks ago Premier Wen gave a speech saying they are going to keep the restrictions in place because they still think prices are still too high and they want to stop speculation. Anyone who is counting on the government to fix that market is, I think, counting on hope rather than analysis. This is a bubble that has a long way to go on the downside. Residential real estate prices, in aggregate in China, at construction cost, are equal to 350% of GDP. The only two economies that ever saw higher numbers at roughly 375% were Japan in 1989 and Ireland in 2007, and both had epic property collapses. So the data does not look good for China.
G&D: If a collapse occurs, will it be very damaging to the global economy?
JC: Interestingly enough, it may not impact the U.S. all that much. The U.S. might even be a beneficiary due to lower commodity costs. The commodity companies however will be hit hard. I also think the renminbi is overvalued. If there is some depreciation of the currency, that could lead to cheaper products from China, which could actually help the U.S. economy. Places like Australia and Canada and Brazil would be hit pretty hard, however, because they rely on exporting commodities to China.
G&D: You talked at the Value Investing Congress a few years back about the difficulty of investing in companies with so much of their profitability tied to commodities. How do you determine what’s a sustainable average price for a commodity-focused company?
JC: It’s difficult, and you determine the price based upon a probabilistic range. If you look at the price of iron ore in real terms since the 1920s, it basically traded between $30 and $45. Iron ore is not hard to find, it’s pretty much everywhere. The cost to extract it was around $30 per metric ton in real terms. In 2005 it suddenly took off and it got to $180 last year. It’s back down to $140 right now, and people are modeling out their profit forecasts based on a range of $120 to $160. Well, what if it gets back to $30 or $40? You might want to put your lower bound a bit lower here. Everyone’s just looking at the last four years.
The last four years was the China boom. It was a once in a lifetime build out of infrastructure in the most populous country of the world. After you have your third international airport in Hainan, China, you probably don’t need a fourth one — especially when no one is using the second one. In this case, things are really two or three standard deviations from the norm, and that’s what you need to be looking for. If iron ore prices were $50, I really wouldn’t care, but at $140-$180 with more capacity coming on and lower demand in the future, I think we’re in for a disaster.
G&D: But why do you think the government is tolerating this?
JC: It’s all about incentives. In China, everyone is incented by GDP. They are fixated on growth. In the West, we go about our economic lives, and at the end of the year the statisticians say, this year your growth was 3%. But in China, it’s still centrally planned. All state policy goes through the banking system. They decide what they want growth to be and then they try and figure out how to get there. The easiest way to do that, in an economy where consumption is only 30% of the total economy and net exports are deter- mined by the world markets, is to stick a shovel in the ground and build an- other bridge, since that contributes to GDP. So a random party chief knows they will never be sacked if they make their GDP targets.
G&D: Why are they targeting 8% instead of something like 4%?
JC: Because that’s how they’re compensated. These are not profit maximizing enterprises. China doesn’t produce GNP numbers, they don’t put out figures net of capital depreciation. If they did, the numbers would be much lower because there is so much that needs to be depreciated. The problem is that Western investors have fallen for the idea that, if there is rapid growth in this country, they must be able to make a lot of money.
Well, not necessarily. In fact, GPD growth in China is poorly correlated with stock returns. If you were a European investor in 1832 and you were looking for a great growth story, you would have invested in the U.S. The U.S. went through probably the greatest 100 year period of growth in history from 1832 to 1932, and yet, if you had invested over that period you would have probably lost all of your money five different times. Just because something’s growing over the long term doesn’t make it a great investment.
G&D: Given your Greek heritage, we’re especially curious about your observations about the situation in Greece?
JC: It’s dire for Greece. Clearly the European Union has made an example out of the country. As has been said, the problem with the EU is that it’s a currency union without a fiscal union. The incentives are all skewed. People who say that Germany suffers from having to share the EU with these Southern countries like Greece are missing the point. Germany is very happy to have those Southern countries in the EU, because it keeps the currency lower than otherwise. If Germany had its own currency, it would go through the roof, and harm German exports, which are the big driver of that economy. So in effect what’s happening is that German taxpayers are bailing out European banks, who’ve lent money to the Southern European countries, which are buying Ger- man products. The problem is that it’s a political issue and so many people just want to look at it as a financial and economic issue. There’s an interesting alignment of interests where the taxpayers in the donor countries are upset, and rightly so. In other words, the typical German taxpayer is saying, why should I pay for this? The other thing is the recipient countries are upset, too. It’s not as if the typical Greek citizen wants this money. They’re not seeing any positive results from the money — it just goes right to the European banks. It’s not financing any new growth initiatives. I’m not going to apologize for Greeks who didn’t pay their taxes or retired at 42. The stories are out there and they’re all true. But be that as it may, there are an awful lot of law abiding Greeks who are being destroyed by what is going on in Greece now. The new twist in 2011 is that the donor countries installed their technocrats in Greece’s ministries to oversee tax collections and interior policy, and that has really hit a nerve. Now Germany is basically dominating Europe. You ignore that political calculus at your peril. All of this connects to historical issues, such as how the Germans treated the Greeks in World War II. Greece lost one million people in World War II out of a population of eight million. The only country with a comparable (and higher) ratio was the Soviet Union. In the fall of 1941, after the Germans invaded Greece, they left the Greek government intact but they put Reich’s ministers in charge of all the ministries to oversee them.
One of the things they did was to loot the country of its harvest. Eight hundred thousand Greeks died in that famine of 1941. Almost every Greek family has someone who died in that famine. So this twist has opened up a 70 year old wound. Keep an eye on Spain and Portugal because they’re next. The other issue that is coming about is cutting your way to growth. Is austerity key to getting these countries back on track? So far the evidence is pretty poor that it is. We may look back and say, wow, what a policy mistake.
G&D: Where do you come down on the nature vs. nurture debate? You made a great investment in Baldwin United at 24, a time when many are barely learning about investing.
JC: I always used to say, on the short side, people are made not born. I’ve changed my view on that a bit. I do think there are enough asymmetries between the long side and the short side that it makes it difficult for people who are otherwise very bright investors, particularly people in the value world, who look at things and see great short opportunities, but can never get their mind to the point where they can become good short sellers. I do think, to some extent, the temperament of a good short seller is probably genetic. So I think the skill set is the same in terms of trying to do deep research and finding unique value in companies is the same, the mindset can be very different. You need to be able to weather being told you’re wrong all the time. Short sellers are constantly being told they’re wrong. A lot of people don’t function well in an environment of negative reinforcement and short selling is the ultimate negative reinforcement profession, as you are going against the grain of a lot of well-financed people who want to prove you wrong. It takes a certain temperament to disregard this.
G&D: How often do you see companies that are fudging the numbers able to maneuver their way out of it?
JC: If a company is very fraudulent, it is very difficult to recover. Where companies have simply fudged the numbers, such as Tyco International, they are able to come back but the shareholders and sometimes bondholders are wiped out. If we end up being right on the fundamentals, it’s very rare that a company in mid- problem can turn itself around. Usually it requires a cleansing of the old order for things to change. Generally the problems we see are deep-seated enough where they need to confront them, pay the economic price, and move on.
G&D: Could you give us an example of some current ideas?
JC: Currently we are short the natural gas industry in the U.S. for a few reasons. First, there has been a major technological innovation — fracking — that has created displacement. This has driven prices from high single digits per MCF of natural gas down to $2 per MCF. Most of the companies in the natural gas area began an exploration boom that has created this glut. These companies counted on the price to remain above $6–7 per MCF. A number of companies that had structured their balance sheets and paid up for acquisitions with this expectation of higher prices are now struggling. So they’ve got weakened balance sheets in a commodity business that is in oversupply, and on top of that, many of them are engaged in some pretty egregious accounting games, like hiding negative cash flows in various ways. I think this area will be a very fertile area on the short side for a number of years. The good news is that this happens to be an amazingly positive development for the U.S. because energy prices have dropped so much.
As an ancillary development, the other industry that gets killed by this is coal. Natural gas prices are now half the price of coal. Coal used to be one of the cheapest sources of energy, but it was the dirtiest. Now it’s becoming one of the most expensive fuels and is still the dirtiest. Utilities and others are rapidly transforming from burning coal to burning natural gas, which I do not think bodes well for the coal industry.
G&D: Haven’t some of the stocks of companies in these industries been hit hard already?
JC: You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock price only wipes out 5% of the total capitalization. You have to look at the total capitalization. In some of these cases the total capitalization is only down a little while cash flow has been cut by 75%. This is the reason that some investors get killed in value traps. They look at the stock and they don’t look at the total capitalization. They don’t realize that the debt burden is forever, meaning it’s not shrinking, whereas the equity capitalization may fluctuate in the market. If the cash flows have diminished dramatically the company’s ability to service the debt, then the stock going down by half doesn’t mean anything. You could still be at risk of losing all you capital.
G&D: Any other ideas that we can talk about?
JC: I think for-profit education business is a flawed business model. The outcomes are very poor, as I feel that these degrees are sold, not earned. Anyone that wants to sign up for these things can get in, but tuition is up there with many private schools. People are coming out of these schools with $20,000-$50,000 in debt and many don’t even graduate but incur the debt nonetheless. Some of the technical schools do good practical training, but most of the business has now shifted to online degree granting because it is more lucrative. I remember a couple of years ago, the head of human resources at Intel was quoted in a front page New York Times article saying that if someone came in from an online college, they won’t even look at them. The types of jobs these graduates get are no better than if they just had a high school degree, and yet they are incurring all of this debt.
Ultimately defaults will go so high in the student loan area that the federal government will see mounting losses and will change the student loan program guarantee to force institutions to take a bigger chunk of the risk. Once this happens, the business model is broken. The only reason these companies exist is because of the federal loan guarantee on student debt.
G&D: What are some characteristics of the best analysts that have worked for you?
JC: The thing I look for most is intellectual curiosity. One of the best analysts we ever had was an art history major from Columbia. She had no formal business school training. She was so good because she was very intellectually curious. She was never afraid to ask why and if she didn’t understand something she would go figure out everything she could about it. This is almost something that you can’t train. You either have it or you don’t.
G&D: Who are other investors that you respect?
JC: I have a lot of respect for other investors that have gone public on the short side. People like David Einhorn and Bill Ackman have been willing to go negative and be public. To the extent that they are willing to take a controversial stand, I think it is a courageous thing to do. It is also an important thing to do because for too many years short sellers have been demonized for being anonymous. We have been one of the few public figures out there. We believe that if you are willing to put an investment hypothesis out there before people with a face on it, it adds to the overall level of investment debate. All kinds of people are willing to say why they own something, but are afraid, because of retaliation by the companies, to say why they are short something.
G&D: What are some of the avoidable mistakes that you see analysts make?
JC: One of the biggest things I see quite often is getting too close to management. We never meet with management. For all of the bad asymmetries of being on the short side, one of the good asymmetries is that we don’t rely on the company. We can get information from the company if we want to, as we can go through the sell-side. Those that are long the stock and are close to the company almost never hear the negative side in any detail. The biggest mistake people make is to be co-opted by management. The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive.
A second mistake some people make is not reading all of the documents. I guide people to always start with the SEC documents, and then go to other sources for information. It’s amazing how few analysts actually read SEC filings. It blows me away. We have the greatest disclosure system in the world and people by and large don’t take advantage of it. I am a big believer in looking for changes in language in a company’s filings over time. During the year we were short Enron, each successive filing had incrementally more damning disclosure about the company’s off- balance sheet entities. It was obvious that internal lawyers were pushing management to give investors more detail on these deals that were being done, as they felt uncomfortable about them. Language changes are not accidental. They are argued over internally.
G&D: What is your view on the banking industry today?
JC: I believe that right now the banking industry is at the tail-end of its credit problem in the United States. We addressed it before everyone else. I call it the ‘pig-in-the-python’, where the python is the world credit situation. If the pig at the end of the snake is the U.S., the pig in the middle is Europe, and the pig being eaten now is China and Asia.
G&D: The investment management industry is extremely competitive. What do you recommend students do who have not be successful in getting the job of their choice?
JC: In one word, network. Go to as many lunches and dinners as you can. Try and meet as many investment management people as you can. Find out where the investment management people at your firm hang out, or join an investment ideas group. There are lots of different doors that can open throughout your career. Stay intellectually curious and meet as many people as you can.
G&D: What are some of the things that you think business school students who want to follow in your footsteps should do?
JC: If you ever have an idea and you think you need to take career risk to accomplish it, do it early in your career. Life intrudes — as when you get older you end up with more responsibilities and your ability to take risk diminishes. If you are 25 and have a great idea and you fail, no one is going to hold it against you, and future employers and investors might actually look favorably upon it. So if you really want to pursue something, do it while you’re young — you’ll have more energy and you’ll be able to take more financial and career risk. If it doesn’t work you still have your whole life ahead of you.
G&D: In the beginning of our interview, you mentioned how your father’s advice about working hard and working for yourself was important for you in your life. What kind of advice do you give to your children?
JC: Do something you really want to do. There are few feelings worse in the world than waking up every morning and not liking what you do. Whatever field it might be, you should do what you want to do. Life is too short. The people that are the most productive are those that are happiest in their jobs and find intellectual curiosity and stimulation in what they do. And when fortune smiles your way as it does in any business career a number of times, take advantage of it. That’s when people grow, that is when you see quantum leaps and step functions in career moves.
G&D: Thank you very much Mr. Chanos.
