THE ART OF SHORT-SELLING
By Chris Mayer
James Chanos is a famous short-seller at Kynikos Associates
in New York, the firm he founded in 1985. Chanos got a lot
of press for his accurate bearish call on Enron several
years ago. There are few better at the business of betting
on stock price declines than Chanos, who has been at this a
long time.
I recently finished reading an interview with Chanos in
Value Investor Insight, and I'd like to share with you some
of his best ideas. What follows is a summary of his three
favorite situations – broad categories in which he has
found good short candidates. I think you will find this
schematic useful in your own trading and thinking. We'll
also take a look at three of his current favorite trades,
one of which I recently recommended to the subscribers of
my Crisis Point Trader.
First, the doomsday categories...
Booms That Go Bust
Chanos cited this as his most lucrative field of
operations: great booms that then go bust. But, he offered
an important caveat on which ones to play. Specifically, he
has found great success with "debt-financed asset bubbles"
as opposed to those driven strictly by investor mania. The
former are ticking time bombs, where you are betting on the
inevitable, whereas the latter are simply plays on
excessive valuation reverting to some more normal number.
"My biggest mistakes have generally been because I stayed
in things just because they were expensive," he admits,
"...valuations can be crazy and stay crazy."
The ongoing housing bubble is one example of a debt-
financed asset bubble. But Chanos is not shorting
homebuilders. They are making money and are in good shape
financially. It is the consumer, Chanos notes, who will
suffer the most when the bubble runs its course.
In today's market, this intrepid short-seller sees a debt-
financed bubble in Chinese manufacturing. "Plants are being
built with debt for which return on capital will be very
low," he says. Since economies are prone to fits and
starts, and even the brisk Chinese manufacturers will
endure periods of slowdown and excess capacity, these debts
are a threatening overhang. On the low margins Chinese
manufacturers typically earn, they have little cushion
against adversity.
Another area Chanos thinks is an asset bubble in the making
is in the steel industry. Steel capacity has grown 30-40%
over the past few years, and the soaring steel prices have
come down significantly from the $780 highs achieved in
September 2004 (for a ton of hot rolled band). Currently
around $400 (keep in mind, this industry lost money on $300
steel prices in 2003), analysts are projecting $500-600
steel prices going forward. Chanos believes the industry's
overcapacity issues will make that a hard price to sustain.
Technological Obsolescence - Victims of "Creative
Destruction"
Economist Joseph Schumpeter gave us the phrase "creative
destruction" to describe the process of new companies and
technologies destroying and replacing older or obsolete
ones. Disruptive technologies can wipe out entire
industries and render old products worthless.
This competitive process is ongoing. Chanos cites the
transformation happening now as we move from an analog to a
digital world. "While this has created great fortunes like
Google's," Chanos notes, "it's also wiping out whole
businesses."
Traditional music retailing was one of the first to start
disappearing, and now Chanos sees the same thing happening
with video rental, as movie studios sell directly to
retailers such as Wal-Mart, not to mention the rise of
video-on-demand products.
Consumer Fads That Go Flat
The last of the trio, Chanos has also found success betting
against consumer fads – the more obvious examples would be
Cabbage Patch Kids in the 1980s, NordicTrack in the early
1990s and the Foreman Grill more recently.
In these situations, Chanos is looking to capitalize on the
all-too-human error of taking the present and extrapolating
it into the future. Investors are generally overly
optimistic about the prospects of faddish products.
Today, he is short Palm, the makers of the popular PDAs.
Palm, however, loses money on their PDAs and they don't
produce the software that makes the system go. "The biggest
problem is that Palm doesn't control the Treo software –
it's just a box," Chanos says. "Boxes with chips in them
tend to be very good shorts if that's all they have."
An example of a box with software is the popular
Blackberries produced by Research In Motion. The Blackberry
runs on Research In Motion software, which could become the
standard and then you have "a monster on your hands."
More Insights From A Great Short Seller
Add any accounting irregularities to the above and you have
a potential big winner on the short side.
As to mitigating risks, Chanos says there are two basic
methods: position-sizing and stop losses. He favors the use
of position limits of no more than 5% on his portfolio and
he cuts back on ideas that move against him. As for
mechanical stop losses, Chanos is philosophically opposed
to using them: "We've never used stop losses. We feel like
having a mechanical rule that takes you out of positions
regardless of the fundamentals makes no sense."
While we prefer to buy puts on stocks that we think will
decline, there are obvious parallels between short-selling
and put-buying – they are both bets on stocks taking a
dive. Therefore, it can be useful to study the art of
short-selling to improve your ability to detect blow-ups
and collapses. (In fact, such studies will help you on the
long side as well, helping you avoid potential craters.)
For more reading on short-selling, there are few good
resources. The best is Kathryn Staley's The Art of Short
Selling. Also, Manuel Asensio's Sold Short is a good read
and let's you into the mind of another long-term successful
short seller.
Now, let's take a look at Chanos' investment ideas. First,
in the category of "Victims of Creative Destruction," we
have Eastman Kodak (EK). In Chanos' worldview, we are
moving from an analog to a digital world and the
consequences of that are being felt by a variety of
businesses. Chanos believes Kodak is another Polaroid, a
company that is slowly being eaten alive by the
competition. Their most profitable business has
traditionally been film. Now, even professionals are moving
to digital.
The business is in decline. Free cash flow was $1.5 billion
in 2002, $1 billion in 2003 and only $500 million last
year. This year, Kodak may not generate any free cash flow.
Plus, it is spending billions of dollars on acquisitions
every year in the pursuit of elusive profits in digital
products. The company is also saddled with some large
retirement-benefit costs.
Another short candidate is Fairfax Financial Holdings
(FFH). "We think this is a zero," Chanos said. Basically,
this Canadian property & casualty company grew aggressively
with acquisitions in the 1990s. Today, it runs a chronic
underwriting deficit. It is also one of the biggest players
in finite reinsurance – the stuff that Spitzer is on a
rampage about. Fairfax is highly leveraged and heavily
under-reserved. The earnings quality, Chanos believes, is
poor.
Unfortunately, Fairfax Financial is a relatively illiquid
stock with a very illiquid option market. So that makes the
stock even more dangerous than the average short-sale
candidate. Nevertheless, Kodak and Fairfax are both very
interesting ideas. But I found Chanos' third idea to be the
most compelling, which is why I recently recommended a
bearish position on the stock to the subscribers of my
CrisisPoint Trader. I'd love to tell you the whys and
wherefores of this idea, as well as the exact strategy we
are using, but that information is for subscribers only.
[Ed. Note: Chris Mayer was chomping at the bit to divulge
this play, such is his excitement about it. After much
debate it was taken out in fairness to his many loyal
subscribers. Some savvy investors will be checking out
Chris's newsletter here:
agora-inc.com |
