CHAPTER 8

Dedicated Short Bias

We like to have Murphy’s Law working for us.

—James Chanos

Whereas most equity investors focus on buying stocks, a small group of hedge fund managers focus on short-selling. While dedicated short bias managers go more short than long, they often rely on the same techniques as other equity investors, namely fundamental analysis.

The focus on short-selling makes these managers zoom in on all the potential problems that firms might have. Hence, dedicated short bias managers look for stocks with materially overstated earnings, aggressive accounting methods, and incomprehensible statements in SEC filings. When they find such signs of a potential “cover-up,” they try to dig deeper into what is actually going on. They also try to investigate whether firms are engaged in outright fraud.

In addition to such misbehaving firms, dedicated short bias managers also search for well-intending firms with fundamentally flawed business plans. This could be firms with an interesting technology but no sustainable way to make profits or firms based on technology that is becoming obsolete, e.g., as happened to Nokia and BlackBerry when the iPhone came out. They might also look for firms that rely on excessive use of credit and are about to get into trouble.

Short-selling is far more challenging than buying stocks for a number of reasons, as we will discuss in detail. Perhaps for this reason, the short sellers have a particular reputation:

Short sellers are odd people. Most of them are ambitious, driven, antisocial, and single minded. As individuals, they are not very likely to own a Rolex watch or a Presidential springer spaniel or any other symbolic trapping of success; they are likely to have a wry slightly twisted sense of humor. As a group, short sellers like to disagree, and they like to win against big odds. Typically, they have an axe to grind, a chip on the shoulder. As in the general population, some of them are cretins and some are not, but they are all smarter (most of them, in fact, are intellectual snobs) and more independent than most people. Contrary to popular wisdom, they do not form a cabal and bash stocks senseless. They normally are secretive and slightly paranoid. And they are frequently irreverent in their regard for business leaders and icons of Wall Street.

—Staley (1997, pp. 25–26)

8.1. HOW SHORT-SELLING WORKS AND WHY IT CAN BE DIFFICULT

Everyone knows what it means to buy 100 shares in IBM, but what does it mean to short-sell 100 shares? At an abstract level, it means to own minus 100 shares! Short-selling is the opposite of buying a stock; it is a bet that the stock price will fall. Hence, if the price of IBM goes up by 10%, investors who bought the share will earn 10% while traders who shorted it will lose 10%. Conversely, if IBM drops 10%, investors who bought the stock will lose 10% while traders who shorted it will earn 10%.

In practice, short-selling is done as follows: Suppose that Fidelity owns shares in IBM and the hedge fund Short Capital wants to sell it short. Then Short Capital borrows (via its broker) a share from Fidelity, promising to return the share the next day. Short Capital then sells the share in the market for, say, $100. The next day, the market price has dropped to $98, and Short Capital buys the share back and returns it to Fidelity. (Of course, it will not be the exact same share, but shares are fungible, so this does not matter.) In this example, Short Capital made $2, profiting from the drop in the price of IBM. Fidelity is no worse off than it would have been without lending the security, and, in fact, they are better off too as they made a small loan fee as we discuss next.

The description above leaves out a few important details. First of all, when Short Capital sells the IBM share, it does not get to pocket the $100 that the sale raises; that is, Short Capital cannot use this money for other trades. Quite to the contrary, Short Capital must leave this money with its broker and, furthermore, must leave some additional margin equity. Hence, short-selling does not free up capital; it uses capital. The reason for this is that the security lender, Fidelity in this example, needs to be ensured that it will get its share back. Therefore, when Fidelity lends its share, it receives cash collateral in exchange. If the security borrower does not return the share, Fidelity can use the cash collateral to buy the share back in the market. To be able to buy the share back even if it appreciated in value, Fidelity receives cash collateral that is higher than the initial market value of IBM—and the extra cash corresponds to a margin requirement for Short Capital.

When Short Capital returns the IBM share, Fidelity returns that cash plus interest (at a rate called the rebate rate). If the interest rate is lower than the money market interest rate, then Fidelity earns a premium because it can invest the cash at a higher rate than it pays for it. Such a low interest rate translates into an implicit cost for Short Capital, which is called a “loan fee” (and sometimes it literally is a fee). Hence, short-selling is not exactly the opposite of buying because shorting is associated with a loan fee. However, for about 90% of the stocks in the United States, the loan fee is small, typically around 0.10–0.20% annualized. For the remaining 10% of hard-to-borrow stocks, the loan fee varies from about 1% annualized, to several percent, up to 50%, which would be an enormous loan fee.1

Loan fees are usually close to zero because the number of lendable shares is in principle infinite, as the same share can be re-used many times. As a result, the short interest can in principle be larger than the number of shares outstanding, although such a large short interest almost never arises in equity markets (but it regularly happens for U.S. Treasury bonds). To understand this, consider the example of Short Capital borrowing the share from Fidelity and selling it in the market. Suppose that a mutual fund run by Vanguard buys the share. Then Vanguard might lend the share to another hedge fund, which sells it short again. The share is then bought by another investor, who might in turn lend it, and so on. Regardless of how many times a share has been lent, it is always held by someone who could lend it again, so if everybody wants to earn a positive loan fee by lending and if there were no frictions in this process, the loan fee would be driven to zero. However, not all investors lend their shares, and there can be significant search frictions in this process, leading to positive loan fees sometimes.²

Shorting is not always possible. First of all, short-selling of shares is banned in some countries or banned for some stocks for some periods in others. For instance, many countries banned short-selling of financial stocks during the global financial crisis. Even if short-selling is legal, it requires that one can find a share to borrow. While this is usually the case, it isn’t always possible—and it is usually particularly difficult when short sellers really want to do it. Indeed, the securities lending market is driven by its own supply and demand issues, so when the demand for borrowing shares is high relative to the supply of lendable shares, the loan fee rises and it becomes more difficult to locate the shares.

The potential difficulty in locating a share also means that short-selling is subject to a risk called “recall risk.” Indeed, short sellers often want to keep their short position on for several days, weeks, or months. To do this, they often borrow the share for just one day and then “roll over” the securities loan each day, meaning that they keep extending the contract with the lender for another day after making mark-to-market adjustments. In some cases, they make a “term loan,” meaning that they immediately agree to borrow the share for a longer period, say a week. In any event, the short seller often wants to keep her position on when the securities loan is due (e.g., because the stock price still has not gone down or has even gone up). The short seller then risks that the lender will not extend the stock loan and that it is difficult to find another share. In this case, the securities lender recalls the share—and, hence, the short seller faces recall risk. If the short seller does not send back the share that has been recalled, the lender can enforce a “buy in” by buying the share itself using the cash collateral.

When short sellers are forced to close their short positions, they are forced to buy the share back and, when many short sellers do this simultaneously, the stock price can be driven up—a “short squeeze.” A short squeeze feeds on itself: As the buying drives the price up, more short sellers may be forced to close their positions as they cannot make their margin calls, leading to further buying, higher prices, and more margin calls.

There are two reasons why short sellers face margin calls when stock prices rise. First, their positions are marked to market each day, so if a stock price increases from $100 to $105, then short sellers must pay $5 per share shorted. Second, when prices move against a short seller, the dollar value of the position increases, leading to higher margin requirements (since margins are typically a fixed percentage of value). For instance, if the margin requirement is 20%, then margin requirement goes from $20 per share to $21 per share in the above example. In contrast, when prices move against an investor with a leveraged long position—i.e., prices drop—then the position size decreases. Hence, such a long investor faces a mark-to-market payment but a reduction in the margin requirement.

In addition to these “technical” reasons why short-selling can be difficult, short-selling is also difficult simply because it is less intuitive for most people and because it is up against the general headwind that stocks go up more often than they go down on average (i.e., the equity premium is positive). For instance, shorting a stock that goes up by less than the overall market is in principle a successful trade, but it may not feel that way. In other words, such a trade has positive alpha to the market and makes money if it is hedged, but it loses money if seen in isolation.

In summary, short-selling can be difficult as it requires locating a lendable share, it requires posting margin collateral, it is associated with a loan fee, and it evolves recall risk and funding liquidity risk (the risk that you run out of capital before the trade converges).

8.2. SHORT SALE FRICTIONS MEAN THAT COMPANIES CAN BE OVERVALUED

Dedicated short bias managers sell short to profit from stocks being overvalued. If short sellers could do so without all the costs and risks discussed above, the market clearing price would incorporate both the views of pessimists and optimists, thus reflecting more information. The difficulties in shorting, however, make it harder to express negative views, opening the potential for stocks to be overvalued in an efficiently inefficient way.

To understand the effect of short sale frictions, suppose that people have different opinions about a stock: Some are very optimistic, and others are skeptical. If short-selling is difficult, the skeptics will simply have a zero position in the stock, focusing their investments on other stocks. The optimists will naturally buy the stock, pushing up the price (especially if they ignore that there might be skeptics with negative views that are not being reflected in the price). Hence, the market price could end up being too high relative to the average view of the company’s fundamentals. Furthermore, a too-high current price means that future returns will be low.

This process of stock price overvaluation can be significantly amplified when investors start to speculate in the future forecasts of other investors, rather than focusing on the company’s fundamentals. The phenomenon of investors focusing on forecasting the forecast of others is called the “Keynesian Beauty Contest” because of the following quote:

… professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

—John Maynard Keynes (1936)

The idea is that investors focus on what the stock price will be tomorrow—driven by the average opinion of buyers tomorrow—rather than the long-term intrinsic value of the stock. Focusing on the opinions of future buyers could still lead to an efficient market since the future buyers should also care about the fundamentals (as should the buyers even further into the future to whom they will eventually sell). However, Keynes’s point is that the process can go off track when investors ignore fundamentals and buy a stock simply based on the view that others will drive the price higher. This process could be self-fulfilling as long as every fool can sell to a greater fool, but eventually this process must come to an end as stock prices revert to fundamentals. Let us see how in a specific example.

Speculative Bubbles: An Example

Consider the market for stock A, a cyclical firm that depends on the macro environment. All investors agree that, next year, it is equally likely to be a boom or a recession. There exist two types of investors, type 1 and type 2, who differ in their views on how cyclical the stock really is. Type 1 investors believe that the company will be worth 80 in a recession and 120 in a boom. Given that these are equally likely, they value the stock at 100 (ignoring risk premiums).

Type 2 investors believe that the stock is more cyclical. They think that the value in a recession will be only 60, but the value in boom will reach 140. Given that these scenarios are equally likely, type 2 investors also value the stock at 100.

Suppose that short-selling is impossible and that the price is always set by the most optimistic investors. What is the current price? Given that all investors agree that the intrinsic value is 100, this would seem the obvious guess. However, let’s first consider what the price will be next year.

In a recession, type 1 investors will be most optimistic about the firm; they will buy the stock and drive the price to 80. In a boom, type 2 investors are the most optimistic and the price will be 140. Given that a recession and boom are equally likely, the current price will be (80 + 140)/2 = 110. Hence, all investors are willing to pay 110, more than the 100 that everyone agrees the stock is worth! For instance, type 1 investors might think that in a recession the stock is worth 80 and, in a boom, I can sell the stock to the type 2 investors, who will overvalue it at 140. Both types of investors expect to sell to a greater fool in some scenario. The resulting speculative bubble of 10% in this example could be significantly higher if we considered the dynamics over many time periods, not just 1 year, so that investors would forecast higher degrees of others’ forecasts.3

Loan Fees and Stock Valuation in an Efficiently Inefficient Market

The overvaluation in the example above was driven by the combination of short sales being impossible and speculative behavior. In practice, short-selling is in fact possible in most countries, but there are costs and frictions associated with short-selling, as we have discussed. Limited short-selling creates an extra supply of shares that can reduce bubbles, mitigating the bubble effects discussed earlier.

However, the short-selling cost also has a surprising effect: The short seller’s cost of borrowing a share is a source of income for the optimistic owner of the stock who lends it out. The owner may therefore be willing to pay more for the stock in reflection of this securities-lending income than he would have if everything else were equal. In other words, capitalizing the loan fee can contribute to the higher stock prices—and the high stock price contributes to short sellers’ willingness to pay a loan fee. Hence, as short interest builds up in stocks with significant divergence of opinions, prices and loan fees may suddenly become very high, but eventually loan fees come down as shorting demand has been satisfied and prices revert toward fundamentals.4

Evidence on the Return of Highly Shorted Stocks

There exists significant evidence that stocks can become overvalued and that a high demand for short-selling is associated with low subsequent returns for the stock. Stocks with high short interest (i.e., with a high number of shares currently being shorted) have low subsequent return.⁵ Furthermore, stocks with high lending fees have low future returns—both the gross returns that abstract from the loan fee and even the return net of the loan fee. This is especially so when the high loan fee is driven by an increase in the demand for shorting. Cohen, Diether, and Malloy (2007) find that an increase in shorting demand is associated with a 3% negative abnormal return for the stock in the following month, consistent with the idea that short sellers can identify overvalued stocks, which subsequently fall in price.⁶

There is also evidence that short sellers can identify misbehavior by firms, for instance, the short interest rises around negative fundamental events, such as SEC enforcement actions for earnings manipulation and earnings restatements that lead to shareholder lawsuits.⁷

8.3. FIRMS VS. SHORT SELLERS: IS SHORT-SELLING GOOD OR BAD FOR SOCIETY?

Management in many companies does not like to have their shares shorted. They feel that it is a vote of no confidence, and they are afraid that short sellers will drive down the stock price. Managers sometimes try to fight short sellers in various ways. For instance, they may take actions to make shorting difficult such as stock splits or distributions specifically designed to disrupt short-selling or try to coordinate with shareholders to withdraw shares from the stock lending market. Sometimes managers even accuse short sellers of crimes, suing them or requesting that the authorities investigate their activities.

For instance, when David Einhorn (who runs the hedge fund Greenlight Capital) criticized Lehman Brothers for covering the full extent of its troubles before the failure in 2008, Lehman fought back:8

For the last several weeks, Lehman has been complaining about short sellers. When management teams do that, it is a sign that management is attempting to distract investors from serious problems.

—David Einhorn

Policy makers and the general public also sometimes want to fight short sellers:

Policymakers and the general public seem to have an instinctive reaction that short selling is morally wrong. Short selling has been characterized as inhuman, un-American, and against God (Proverbs 24:17: “Do not rejoice when your enemy falls, and do not let your heart be glad when he stumbles”). Hostility against short selling is not limited to the United States. In 1995, the Finance Ministry in Malaysia proposed mandatory caning as the punishment for short sellers.

—Lamont (2012)

Lamont (2012) further documents how the U.S. Congress held hearings in 1989 on the problems with short-selling, during which a representative described short-selling as “blatant thuggery.” During the hearings, however, an SEC official testified that

many of the complaints we receive about alleged illegal short selling come from companies and corporate officers who are themselves under investigation by the Commission or others for possible violations of the securities or other laws.

—Ketchum and Sturc (1989)

During the hearings, officials from three firms testified against short sellers, and, paradoxically, their testimony provided evidence to the general point by the SEC official. Indeed, after their testimonies, the presidents of two of these three firms were prosecuted for fraud (for the third firm, the SEC determined that the company had made materially false and misleading statements but that the evidence was insufficient to prosecute).

Many people forget that there are significant benefits of short-selling. First of all, short-selling can make a market more efficient by allowing both positive and negative opinions to be expressed in the market. When your grandmother buys a stock, who protects her from buying a worthless piece of paper marketed by a malicious firm? Who helps ensure that the price she pays corresponds to the aggregate view of what the stock is expected to be worth? Well, this is what an efficient market is supposed to ensure, but a market does not become efficient by itself—investors need to be able to trade on their insights, positive and negative.

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.

—Bernard Baruch, testimony before the Committee on Rules, House of Representatives, 1917

Furthermore, short-selling comes with other benefits. It allows hedging. It makes markets far more liquid, reducing investors’ transaction costs. Short-selling makes markets more liquid by making market prices more informative, by increasing turnover, and by allowing market makers to provide liquidity on both sides of the market while hedging their risks.

Hence, overall allowing short-selling is clearly the right decision as short-selling is for the better. Does this mean that short-selling can never be associated with misbehavior? Of course not. If short sellers are trying to manipulate the market, this is clearly wrong and illegal, but price manipulation is wrong and illegal both when traders are buying and when they are short-selling—so this is not specific to short-selling (e.g., “pump and dump” is price manipulation on the long side). A particular regulatory concern is that bears short-sell a stock in order to push the price down and that the low price itself will kill the firm—i.e., short-selling kills a firm that would otherwise be in good shape. For instance, a low stock price could make it more difficult to issue shares or borrow. This concern is particularly relevant for bank stocks where the idea is that short-selling drives down the price, and this result creates a run on the bank, eventually leading to real troubles for the bank. While this concern may occasionally have some relevance, there is little evidence for this mechanism, and, at best, it would imply a temporary short sale ban of financial stocks during severe crisis, as has been implemented in several countries. That said, such stories are often used in connection with scapegoating short sellers.

Some investors in a stock are also annoyed with short sellers and may decide not to lend their shares. This decision is often irrational. When an investor lends his share to a short seller, the share is sold in the market, which could drive down the price, but, when the share is returned to the lender, it must be bought back, which could drive up the price. Hence, for a long-term investor, the argument cannot be that shorting drives down the price, for this is at most a temporary effect. Also, the argument cannot be that the short sellers discover negative facts about the stock because this information will come out sooner or later anyway, and it should be better for the value of the stock to stop the management’s misbehavior early rather than late. If the investor thinks that the short sellers are right, maybe she should sell her shares rather than holding them without lending them out. Furthermore, not lending the shares means that the investor does not earn the loan fees.

In conclusion, short sellers take the difficult side of making markets efficient, going against conventions, against the upbeat pitches of firms and equity analysts, against the headwind of the equity premium, and against the loan fees. They contribute to price discovery and help society allocate capital to the most productive firms.

8.4. CASE STUDY: ENRON

Enron Corporation was an apparently highly successful energy and commodities company, which Fortune magazine named “America’s Most Innovative Company” each year from 1996 to 2000. Enron employed approximately 20,000 people, and its market capitalization reached $60 billion, about 70 times its earnings, in the beginning of 2001. On December 2, 2001, however, Enron went into bankruptcy, causing a major scandal. The scandal was not caught by Enron’s auditor, Arthur Andersen, and the scandal ultimately led to the dissolution of one of the world’s five largest accounting firms. The short seller James Chanos became famous for spotting early the issues with Enron. Here, we hear his version of the Enron story (from his statement to the U.S. Securities and Exchange Commission, May 15, 2003), and we will hear more from him in the interview in the next section.

My involvement with Enron began normally enough. In October of 2000, a friend asked me if I had seen an interesting article in the Texas Wall Street Journal, which is a regional edition, about accounting practices at large energy trading firms. The article, written by Jonathan Weil, pointed out that many of these firms, including Enron, employed the so-called “gain-on-sale” accounting method for their long-term energy trades. Basically, “gain-on-sale” accounting allows a company to estimate the future profitability of a trade made today and book a profit today based on the present value of those estimated future profits.

Our interest in Enron and other energy trading companies was piqued because our experience with companies that have used this accounting method has been that management’s temptation to be overly aggressive in making assumptions about the future was too great for them to ignore. In effect, “earnings” could be created out of thin air if management was willing to push the envelope by using highly favorable assumptions. However, if these future assumptions did not come to pass, previously booked “earnings” would have to be adjusted downward. If this happened, as it often did, companies wholly reliant on “gain-on-sale” accounting would simply do new and bigger deals—with a larger immediate “earnings” impact—to offset those downward revisions. Once a company got on such an accounting treadmill, it was hard for it to get off.

The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the SEC. What immediately struck us was that despite using the “gain-on-sale’’ model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7 percent before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm, a 7 percent return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7 percent and probably closer to 9 percent, which meant from an economic point of view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000 for our clients.

We were also troubled by Enron’s cryptic disclosure regarding various “related party transactions” described in its 1999 Form 10-K, as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for its March, June and September quarters. We read the footnotes in Enron’s financial statements about these transactions over and over again and we could not decipher what impact they had on Enron’s overall financial condition. It did seem strange to us, however, that Enron had organized these entities for the apparent purpose of trading with their parent company, and that they were run by an Enron executive. Another disturbing factor in our review of Enron’s situation was what we perceived to be the large amount of insider selling of Enron stock by Enron’s senior executives. While not damning by itself, such selling in conjunction with our other financial concerns added to our conviction.

Finally, we were puzzled by Enron’s and its supporters’ boasts in late 2000 regarding the company’s initiative in the telecommunications field, particularly in the trading of broadband capacity. Enron waxed eloquent about a huge, untapped market in such capacity and told analysts that the present value of Enron’s opportunity in that market could be $20 to $30 per share of Enron stock. These statements were troubling to us, because our portfolio already contained a number of short ideas in the telecommunications and broadband area based on the snowballing glut of capacity that was developing in that industry. By late 2000, the stocks of companies in this industry had fallen precipitously, yet Enron and its executives seemed oblivious to this fact. And, despite the obvious bear market in pricing for telecommunications capacity and services, Enron still saw huge upside in the valuation of its own assets in this very same market, an ominous portent.

Beginning in January 2001, we spoke with a number of analysts at various Wall Street firms to discuss Enron and its valuation. We were struck by how many of them conceded that there was no way to analyze Enron, but that investing in Enron was instead a “trust me” story. One analyst, while admitting that Enron was a “black box” regarding profits, said that, as long as Enron delivered, who was he to argue.

In the spring of 2001, we heard reports, later confirmed by Enron, that a number of senior executives were departing from the company. Further, the insider selling of Enron stock continued unabated. Finally, our analysis of Enron’s 2000 Form 10-K and March 2001 Form 10-Q filings continued to show low returns on capital as well as a number of one-time gains that boosted Enron’s earnings. These filings also reflected Enron’s continuing participation in various “related party transactions” that we found difficult to understand despite the more detailed disclosure Enron had provided. These observations strengthened our conviction that the market was still over-pricing Enron’s stock.

In the summer of 2001, energy and power prices, specifically natural gas and electricity, began to drop. Rumors surfaced routinely on Wall Street that Enron had been caught “long” in the power market and that it was being forced to move aggressively to reduce its exposure in a declining market. It is an axiom in securities trading that no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets. We believe that the power market had entered a bear phase at just the wrong moment for Enron.

Also in the summer of 2001, stories began circulating in the marketplace about Enron’s affiliated partnerships and how Enron’s stock price itself was important to Enron’s financial well-being. In effect, traders were saying that Enron’s dropping stock price could create a cash-flow squeeze at the company because of certain provisions and agreements that it had entered into with affiliated partnerships. These stories gained some credibility as Enron disclosed more information about these partnerships in its June 2001 Form 10-Q, which it filed in August of 2001.

To us, however, the most important story in August of 2001 was the abrupt resignation of Enron’s CEO, Jeff Skilling, for “personal reasons.” In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what “official” reason is given. Because we viewed Skilling as the architect of the present Enron, his abrupt departure was the most ominous development yet. Kynikos Associates increased its portfolio’s short position in Enron shares following this disclosure.

The effort we devoted to looking behind the numbers at Enron, and the actions we ultimately took based upon our research and analysis, show how we deliver value to our investors and, ultimately, to the market as a whole. Short sellers are the professional skeptics who look past the hype to gauge the true value of a stock.

8.5. INTERVIEW WITH JAMES CHANOS OF KYNIKOS ASSOCIATES

Jim Chanos is the founder and managing partner of Kynikos Associates LP, the world’s largest exclusive short-selling investment firm. Chanos opened Kynikos Associates LP in 1985 to implement investment strategies he had uncovered while beginning his Wall Street career as a financial analyst with Paine Webber, Gilford Securities, and Deutsche Bank. His celebrated short sale of Enron shares was dubbed by Barron’s “the market call of the decade, if not the past fifty years.” Chanos received his BA in economics and political science in 1980 from Yale University.

LHP: How did you get started as a short seller?

JC: One of the first big companies I looked at as a securities analyst was Baldwin United. It was really more a matter of chance that I was asked to look at that company by my boss, and that we stumbled upon what ultimately proved to be a big fraud.

LHP: So following on this successful call, you decided to focus on the short side?

JC: Yes, because I felt that one of the lessons of that episode was that it’s very difficult to do the research on overvalued firms, so not many people do it, but there was value added. Many people contacted us after Baldwin to get our research, so I felt that there was an unserved part of the marketplace.

LHP: Can you tell me about your investment process?

JC: We have a different approach than most hedge funds. Most hedge funds have an approach where the portfolio manager is at the top and a group of junior analysts are below. The typical model is that the portfolio manager pressures the junior analysts to go get ideas, bring them in, process them, and show them to the portfolio manager, who will pick and choose. We don’t like that business model because it puts a lot of responsibility at the junior level and, if something goes wrong, the junior person does not have an incentive to pass on the relevant information.

Here, the senior partners, particularly myself and two other heads of research, are the ones who first come up with the ideas. We then send the idea down to our staff for processing and a recommendation. The recommendation could be “It looks like a good short,” but most of the time, it is “No, there is an explanation to what you thought was happening—it’s all okay.” This is a better business model because it puts the economic ownership and the intellectual ownership up at the same level—at the top.

LHP: What are the steps from an idea to knowing that you should short this?

JC: There’s a whole process. The first step is: Can we borrow the shares? Because if you can’t borrow the shares, you can’t do the trade.

Assuming we can borrow the stock, then we start with the bull case: Why do people like this company? We assign the stock to the appropriate analyst who will then begin talking to sell-side analysts, get all the research reports that are out on the company, and begin to understand the story, as much as he or she can. At the same time, we begin looking at the financials, breaking out comparable companies in the same industry. And after a week or two, we’ll prepare an internal memo that lays out why it is a good short or not.

When we have formed a hypothesis, we talk to the bulls and ask them to debunk it. We will have them in here for lunch, and sometimes we’ll have our story up on the white board. “Here’s why we’re negative on China. Where are we wrong? Where do you see that we’re wrong?” Finally, after a few weeks of the initial idea, the senior partners discuss the case and make a decision.

LHP: And are there some key numbers that you focus on?

JC: Yes, but we’re a little leery of any one number because companies can game numbers. But it’s hard to fudge return on capital, where you look at operating income to total net business assets. If a company is showing a declining return on capital, usually something is going wrong. Or a very low return on capital with high growth, like Enron was.

LHP: What about insider selling and departures?

JC: Yes, we are always looking at those, and if you see both, you’ve really got a red flag.

LHP: Are there other red flags?

JC: If you can’t understand the disclosures, usually there’s a reason for that. If you read a company’s 10-K two or three times and are still not able to figure out how they make money, there’s a reason for that. They’re trying to intentionally not tell you—keep it obfuscated. So the nature of a company’s disclosure is also important to us.

LHP: Do you rely on red flags or can you usually find a smoking gun?

JC: Well, you can’t always get a smoking gun. And that’s the problem. I mean taking a position in the market is not a criminal court of law, so it’s not based on evidence “beyond a shadow of a doubt.” The market is more like a civic court, based on the “preponderance of evidence.” Often you don’t see the smoking gun even in the best shorts, until very much at the end. To use the Enron example, we had a pattern of a lot of questionable things, but we did not think it was a fraud.

LHP: I heard that you don’t tend to visit companies, hire detectives, or talk to ex-employees.

JC: Yes. Well, first of all, we don’t tend to visit companies because we’re not going to be invited. People know who we are. But when we need information from a company, it’s not that hard to get. Companies do conference calls. We do have good relationships with the sell-side brokers, so that if we have a question about a number, we can usually get it answered. Furthermore, access to management is one of the most overrated things you have, in that if management is telling you something that they’re not telling anyone else, they’re breaking the law, under Regulation FD [Fair Disclosure]. The management is just going to tell you the same exact story they tell every other investor, which is in every bullish research report and in every presentation on their website. Further, you get a false sense of security—if the CEO is telling it to you, so therefore it must be true. That’s number one.

Number two, in terms of talking to ex-employees and hiring private detectives—we think that gets into a real grey area. Again, even ex-employees can have fiduciary responsibilities to their company. So having an ex-employee tell you corporate secrets is probably a violation of securities law. We stay as far away as possible from anything that could be material non-public information.

LHP: What about talking to competitors?

JC: Yes, we do sometimes talk to competitors and industry people to get a sense of how the businesses work and industry trends.

LHP: How do you know whether the negative information is already reflected in the price?

JC: Well, that’s a really good question. How much negative information is already out there? Is it already reflected in the stock price? Is it time to cover your short, if all the negative news is out? We don’t know; it’s a judgment call.

LHP: Can you give examples of some of the more memorable short sales that you did?

JC: Obviously Enron was a story that put us on the map, and it was an interesting short story. I think that being short a number of the Drexel Burnham stocks back in the late eighties was also an interesting situation on the short side, including the junk bond companies Integrated Resources and First Executive. More recently, some of the real estate companies.

Our biggest loser was America Online, which we shorted in 1996, I think, and basically covered in 1998, when the stock was up eightfold. We shorted it because we believed that the company was not properly accounting for its marketing costs. It then took a big bath write-off in ’96, and people said, “Okay. Everything must be fine.” We simply pointed out that the big write-off meant that they were never profitable, and our view was that they probably never would be. But we underestimated the power of the Internet and the euphoria of retail investors, who just didn’t care. And because it was an Internet stock and one of the Internet leaders, the stock just kept going up and up and up. Fortunately, it was never more than a one percent position for us. So we kept trimming it back, even as it kept doubling. But having said that, we probably lost five, six, seven percent over two years on the position. While not a disaster, certainly you never want to see a short go up eightfold against you. This trade underscores the risk of the short side, and it taught us a lesson on how to size positions in volatile stocks. You can never be too big in the volatile stocks; you need to have more names to diversify your risk.

LHP: Can you talk about the difficulties of short-selling, and how you try to overcome them?

JC: There are lots of difficulties to short-selling. I mean the market generally goes up. You have to borrow the share. You have less advantageous tax treatment. No one likes you. But all of them, I think, create the opportunity, that’s the flip side.

LHP: Do you think that the “mechanical” obstacles to short-selling or the behavioral ones are most important?

JC: It’s a great question because, when I first started doing this, I thought that being short would just be the mirror image of going long. I don’t believe that anymore. I believe that there’s a behavioral aspect of shorting that’s very difficult for most people, and this is the most important effect.

Wall Street exists to sell securities to people. So most of the stuff you’re going to hear all the time is positive. Buy recommendations. I come in every morning, and I check my BlackBerry. Of our 50 domestic stocks, probably 10 of them are going to be commented on that morning by someone, raising earnings estimates, going from “buy” to “strong buy,” the CEO is on CNBC, there’s a takeover rumor, or whatever it might be. Ninety-nine percent of the time, it’s just noise with no new information, but it’s a positive drumbeat.

When you’re short, that drumbeat is negative reinforcement. You’re coming in every day and being told, “You’re wrong. You’re wrong. You’re wrong. You’re wrong. This company’s going to do well because of this, this, and this.” And most people just say, “Life’s too short. I don’t need this. I don’t want to hear this about my shorts every day. I’d rather be long and just hear the positive, happy things every day.” Human beings are human beings. Even most hedge fund managers worry much more about their short positions, and some very, very good traditional long managers are terrible short sellers.

So I think that good short sellers are born, not made, quite frankly. I never used to think that. But I do think that now, after 30 years of doing this. That is, you have to have some mental makeup that allows you to just drown out that positive noise, disregard it, and just focus on your work, your facts, and your conclusions, based on that.

LHP: So were you born in such a way that the positive hype is only making you want to short more?

JC: I don’t know about that. I mean there’s a difference between drowning out noise and being stubborn. You want to be aware of what’s being said, so that you’re not missing something important—that one percent of the time where something has changed, and you need to know it and get out of the way. So you just don’t dig in your heels.

LHP: There is also the asymmetry that stocks can only drop to zero, but there’s no limit to how far they can go up.

JC: Yes, they can go up to infinity, but I’ve always said, “I’ve seen many more go to zero than infinity.”

LHP: Do you have only short positions in your fund?

JC: We have two groups of funds. Our main institutional product is the short-only funds, and those are just pure short. We also have a small traditional long and short hedge fund, called the Kynikos Opportunity Fund.

LHP: How do you manage risk and construct your portfolio?

JC: At any given time, we have about 50 stocks, domestic or abroad. We size the positions based on volatility, based on borrow, and based on industry exposure. We construct a portfolio with an eye toward return and risk. And we have a rule that no one position can ever be more than five percent of the value of the fund. Plus, we’re never leveraged. With 50 positions, the average position is two percent, a large position for us is three percent, and a small position is one percent. Even if we love a position, if it’s going against us, we’ll trim it back, like we did with America Online.

LHP: Why do you think that people are often critical of short sellers?

JC: Part of the reason is that there are a lot of misunderstandings about it. People start with the idea: How can you sell something you don’t own? And then once you start down that path, it’s much harder to get people to think about it, in the form of the marketplace. But then I point out to them that insurance is a giant short-selling scheme. Much of agriculture is a giant short-selling scheme. You’re selling forward what you don’t have yet, with the idea that you will replace it later at a profit. When an airline sells you an advance purchase ticket, they’re short-selling you a seat. All kinds of business are done on a short sell basis, where you get money up front, and you get the goods or services later.

People often make the analogy that short-selling is like taking fire insurance out on someone else’s house, but there is an important difference. The difference is that if you imagine a person taking insurance out on someone else’s house, then you’re making the next leap of faith that the person is going to commit arson. So, the analogy implies that a short seller is going to do something criminal to make the stock price go down—and that’s the fallacy. Anybody, long or short, who knowingly spreads false stories about a company is guilty of securities fraud.

LHP: Hearing about the actual people—like you—might help demystify short-selling.

JC: That’s one of the reasons why I’ve been more public than other short sellers. When you’re anonymous, it’s easy then for people to think the worst of you and to just extrapolate. But when you actually put a human face behind the story and say, “This is why we do this, and these are the kinds of companies we’re looking for, and this is why it’s important to the marketplace to have people with a negative viewpoint, as well as a positive viewpoint, so people can make their own decisions.” I think then people understand it a lot easier. The marketplace is ultimately a reflection of information, and to limit people to only expressing positive views is crazy.

LHP: So short sellers play the role of collecting information in the financial markets?

JC: Exactly. Of the major financial frauds of the past 25 years, almost every single one of them has been uncovered by an internal whistle blower, a journalist, or a short seller. Not outside auditors. Not outside counsel. Not law enforcement. It’s almost always someone who has a vested interest or a guilt complex internally. Short sellers help uncover important information.

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1 The size of loan fees is studied by D’Avolio (2002) and Geczy, Musto, and Reed (2002).

² This process and the equilibrium loan fee are modeled by Duffie, Gârleanu, and Pedersen (2002).

³ Miller (1977) discusses how short sale frictions can lead to overvaluation, and Harrison and Kreps (1978) model the speculative dynamics.

⁴ For the equilibrium price and loan fee with speculation, see Duffie, Gârleanu, and Pedersen (2002).

⁵ Desai, Ramesh, Thiagarajan, and Balachandran (2002).

⁶ See also Jones and Lamont (2002).

⁷ Dechow, Sloan, and Sweeney (1996) and Griffin (2003).

⁸ See Mallaby (2010), p. 352.