Jim Chanos: The Master of Short Selling

Jim Chanos is many people’s favorite short seller. He almost singlehandedly vindicated short sellers by revealing the ongoing fraud at Enron and WorldCom. Jim Chanos is the master of short selling. The stock market is only as efficient as the amount of information analysts find about the companies that are trading. Most of the time there is little inefficiency in the market. Quantitative strategies exploit whatever inefficiencies there are and generate single digit alpha. For a given stock, there’s a certain amount of information. Some of that information is public (known), some is nonpublic (unknown). The best case scenario is that the market prices the stock on all of the public information, and if that even occurs is up for question on a stock by stock basis. In other words, an investor never really knows if the market has priced a stock on all of the known information. By doing extensive research, talented fund managers may unearth material facts (that the market has not priced in) about these companies which will lead to significantly higher abnormal returns. That’s what Chanos does.

Jim Chanos puppeteer

He blew the whistle on Enron, now he is blowing the whistle on China’s property bubble. Like David Einhorn, he grew up in Milwaukee. Chanos graduated from Yale with an economics degree. He has been in the business of short selling for more than two decades now. Kynikos, which is the Greek word for cynic, short sells stocks and his fees depend on the performance of his portfolio relative to the market. So when the market goes up by 20% and his portfolio loses 12%, he receives a portion of the 8% difference between the market and his portfolio. He has $3 Billion under management.

Chanos holds a tight control on his company. He and his partners come up with the investment ideas by reading newspapers and financial publications. They don’t believe in forcing analysts to come up with ideas because he and the partners are the ones with the experience and they get paid to do exactly this. Bloomberg’s Katherine Burton profiled Jim Chanos in her book “Hedge Hunters”. She says this is how Chanos picks the stocks he plans to short:

“The companies Chanos targets for shorting tend to fall into several broad themes. One is consumer fads; he has made money on companies associated with Cabbage Patch dolls, George Foreman grills, cigars, world wrestling, and Martha Stewart.

The second lucrative area is booms that go bust—debt-fueled asset manias in which the asset’s price keeps rising even though the asset doesn’t throw off enough cash to service the debt. That happened with real estate in the late 1980s and with telecom companies just after the turn of the century. These trends are great for short sellers because they tend to involve lots of large and liquid companies, allowing the short seller to ride the trend for a long time.

The third indicator Chanos looks for is accounting irregularities, like the kind he uncovered at Baldwin-United and later at Tyco, WorldCom, and Enron. These situations are often likely to arise at companies that expand through acquisitions. “Growth by acquisition is the last bastion of legalized accounting fraud in America,” says Chanos. When a company buys another entity, it has quite a bit of leeway to revalue assets and book them immediately as profits.”

Another area Chanos picks stocks to short is the industries that are going through innovation. Innovation creates technological obsolescence and lots of losers who invested in now obsolete technologies. He made a lot of money shorting Kodak, Blockbuster, and movie theaters such as Regal Entertainment. In 2007 Chanos predicted that Netflix will face an outcome similar to Blockbuster’s. This is what he said:

“Look at Netflix. Consider the concept of having little old ladies in warehouses stuffing envelopes with DVDs. That might be a business for the next two or three years, but then it won’t work. Why anyone would pay twenty-seven times earnings for that is beyond me.”

Considering James Chanos has around 40 short positions in his portfolio at any time, it’s very likely that he is short Netflix. We also know that Chanos is short Ford and that he lost a bundle on that one.

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