Chapter 4 The Boom Goes Bust

One can imagine Marco Polo, back in the thirteenth century, uttering the prescient phrase, “China is the future.” In the twenty-first century, it has become the nearly universal mantra repeated by savvy investors and the general public, uttered with increasing frequency and conviction. Certainly in the first decade of this century, had you asked just about anyone in the United States or western Europe, especially if they were sitting around a conference table at a forum on global economics, where to put your money for future growth, that is what they would have answered: China. China was seen as the world’s new economic power, replacing the West. It was where the new wealth would be made.

To some, this made China the world’s savior, since China was the fastest growing economy on earth by galloping leaps and bounds and, as of this writing, remains the second largest economy on the planet. It seemed well positioned to do the heavy lifting that would eventually haul the rest of the world up and out of global recession. If the once-dominant economic powers of the West were to decline a bit in the rankings as a result, that was okay by them. Everyone has a price, and increasing prosperity is never a bad price to pay.

To others, the China phenomenon seemed scary. They viewed China’s growth as the key competitive threat to Western hegemony, and particularly to U.S. hegemony, not just economically but in every other sphere—political, cultural, even military. Some of these folks—like bombastic billionaire Donald Trump—saw the competition with China as a war, to be fought on every front. For others—most notably for mega-investor Jim Rogers (who will be featured in Chapter 8), China was the opportunity he urged his children to embrace. It was not just talk on Rogers’s part. He sold all his U.S. assets and moved his family lock, stock, and barrel to Singapore to enable his daughters to embrace the opportunity now—his personal commitment to giving them a stake in the kind of future every parent wishes for his or her children.

And so it went. Among the talking heads on the financial chat shows, in newspapers and popular publications, even as a punch line among late-night comics, just about everyone concurred: China’s economy was the one on an upward spiral, and the baton of economic power would soon be passed from west to east. Pretty soon now, we would all be working for the Chinese. This became the conventional wisdom, and it was accepted and advanced with virtual unanimity.¹ Keep this thought in mind for now—there will be more on China later; it isn’t going away.

There was the odd naysayer, however. A handful of doubters. A few analysts skeptical of the conclusions being drawn so blithely from the known facts about China’s economic activity. One of the most prominent among them was Jim Chanos, the short seller. But then, saying nay is Chanos’s stock in trade; a disinclination to accept conventional wisdom without questioning it up, down, and sideways, comes naturally. It is what short sellers do—they bet against a stock with the aim of profiting from its falling price—and Chanos runs the biggest short selling fund in the business, Kynikos Associates.

A Fan of the Facts

Thinking about the markets comes naturally to him as well. As a boy in Milwaukee, Jim Chanos heard repeatedly from his father that “you’ll never get rich working for somebody else.” Instead, he was told, you must run your own enterprise or get rich through the markets. Jim would eventually do both.

He started by reading about the markets—not unusual, except that Chanos was in the third grade at the time. Markets and money were a frequent topic of conversation in the Chanos household—Chanos’s father owned a chain of dry-cleaning stores, and his mother worked in a steel company’s administrative office. At Yale, where he eventually majored in economics, he wrote his senior thesis on presidential election cycles, monetary policy, and stock market returns. Chanos loved researching.

Investing was certainly the business he wanted to be in, but Chanos had no interest in going to New York after Yale. Instead, upon graduating in 1980, he sent out resumes to firms in Chicago and took an analyst position offered by what had just become, via merger, Blythe Eastman Paine Webber. The merger joined two white-shoe firms, as they were then known—the phrase denotes a WASP stereotype, with conservative dominance—that were by that time anachronisms in an industry in which aggressive trading desks were becoming de rigueur. Moreover, the merger left the resulting firm somewhat Balkanized, with different partners carving out separate fiefdoms. When two former Blythe partners left to found their own private investment firm, Gilford Securities, they asked Chanos to come along as a financial analyst, and as he was far more interested in researching the stock market than in doing-the-deal books to which he had been assigned, he said yes.

Shorting Defined: A Brief Primer for Those Who Have Never Traveled to the Dark Side

“Short” a stock and you are betting that the price declines; this is the opposite of being “long” a stock, when your wager is that the stock price will move higher. But the mechanics of these two types of transactions are very different.

Buying a stock is easy; just be willing to pay a price per share that someone is willing to accept in return for selling you his/her shares.

Shorting is much more complex. First, your broker must locate a “borrow”*— that is, find a shareholder willing to lend his/her shares to you with the promise that you will return them at some indeterminate point in the future. In return, the lending shareholder receives what is tantamount to an interest payment. This common transaction, “selling short,” means that you are selling shares that you do not actually own (but have borrowed) with the promise of ultimately buying those shares in the open market at a point in the future to “cover” your short. Your hope, of course, is that you will be returning the shares at a lower price, capturing the difference as a gain on the short sale. The lending shareholder, of course, hopes you are making a bad bet. Here is an illustration:

You have been watching a company, which we will call MovieStream. The stock price is $100 per share, and the price-to-earnings ratio—in shorthand, the P/E—is nosebleed high at a 50 multiple. In the course of your continuing research on the company, you come across a trade publication that mentions that a few companies are poised to launch competing services. Justifiably, you determine that MovieStream stock will come under pressure, so you decide to initiate a short position. Your research proves correct; the share price declines to $50 per share. At this point, you cover the short by purchasing the shares in the market, returning them to the shareholder. You have a nice gain of $50 per share. What was an original liability of $100 per share is now a profit of $50. And of course, the person who has loaned you the shares has suffered a loss in the same amount.

Now let’s look at the other possibility. The trade publication was wrong; there is no competing service coming onto the market, and it is unlikely there will ever be. The stock ultimately trades to $150 per share, translating into a $50 loss on your short position and a corresponding increase in the liability you owe on the shares you borrowed. When a short goes against you, the position gets bigger; when a long goes against you, the position size shrinks. If your total portfolio were valued at $1,000 and you were short $100 in MovieStream stock, it would be 10 percent of your portfolio; if it trades at $150 and the short goes against you, it’s 15 percent of your portfolio.

And then there are the “crowded” shorts, where a large percentage of the share float has been borrowed by short sellers. Occasionally, these trades do work out but often cause a lot of pain to the short seller. Short interest is regarded as significant if it reaches more than 10 percent of the float, but it is not uncommon to see stocks with a 20 to 25 percent short interest. Crowded shorts can be extremely volatile because any hint of good news in the underlying fundamentals may create significant upward pressure in the stock price as weak short sellers scramble to cover, often in spite of the overall negative case still being intact. Broad market rallies can also pressure shorts just as broad market sell-offs cut a wide swath in depressing stock prices. In fact, a strategy employed by some traders is to scan the market for stocks with large short positions and buy shares, hoping to “squeeze” short sellers by forcing them to cover as they seek to limit their losses from a rising share price. Keep in mind that the potential loss for a short seller is infinite since the stock price can always move higher while the potential loss for a long holder is limited to loss of capital should the stock trade to zero.

*Most shareholders do not even know they are lending their shares out. The way it often works is this: A large index fund has many billons under management. In return for a fee, they provide the stock loan inventory to your brokerage firm, or your brokerage firm has its own large inventory, which could be its customers’ stocks that are held in Street name. They get a call for a “locate” of shares to borrow, and then they lend the shares to the short seller.

The Baldwin-United Short

The first company Chanos researched was an oddball creation called Baldwin-United, a former piano company that had, in Chanos’s words, “morphed into a high-flying financial services company.” Its biggest product was the single premium deferred annuity,² sold through Wall Street brokerage firms, and it was this product above all that made Baldwin-United the absolute darling of Wall Street equity analysts. It constituted a new paradigm, was a fresh and different way of doing business, and always beat earnings.

Chanos was not as sanguine as other analysts, especially when he got a tip from a disgruntled insurance analyst who had questioned Baldwin-United’s management and had then been effectively muzzled through concern about job security.

Chanos pored over the company’s required disclosure statements and found that they failed what he calls his Rule of Three—namely, “If you read a financial disclosure three times and cannot understand it, it is intentional.” Following the insurance analyst’s tip, he also plowed through a batch of letters from the relevant state insurance commissioner—the company was headquartered in Arkansas—to Baldwin-United management. In the letters, which had been requested under the Freedom of Information Act and were available to the public, the commissioner had asked a number of questions about the firm’s solvency.

In fact, all the research Chanos did was in readily available documentation—a central lesson he imparts early to students at the Yale School of Management, where he lectures on finance. It meant that everything damning about Baldwin-United, as he says, “was hiding in plain sight.”

And a lot was damning. A professional analyst, fluent in balance sheets, accounting records, and all legally required financial documents, Chanos simply could not figure out how the company made its money. The records made it clear that it was not earning “anywhere near” enough to pay out the annuities it was selling. Worse, the state insurance agencies were allowing Baldwin-United to “front-load all its future profits”; this meant the company could show instant profits on the books, while in fact it was bleeding cash to pay the brokers for selling the annuities.

Jim Chanos was a kid in some people’s eyes—a babe in the woods, just a couple of years out of college. So maybe he just didn’t know that negative reports were not written. It simply wasn’t done, especially on a company such as Baldwin-United that was adored by Wall Street. It was everybody’s favorite growth stock, had been featured on the cover of Forbes magazine, and represented an exciting innovation in financial services. Nevertheless, when Chanos took his negative report on Baldwin-United to his seniors at Gilford, they stood by him and followed his recommendation to short Baldwin-United’s stock. They did so for the simple reason that Jim Chanos had the evidence. Beyond the required 10Q and 10K³ reports, he had the memos that company management had written, which detailed how to front-load the profits; he had the letters from the Arkansas insurance commissioner expressing concerns about solvency; he had looked at the numbers and had documented his case with references, citations, footnotes—that is, with the facts.

Chanos issued his report on August 17, 1982, a date less memorable for Chanos’s publication than for the fact that it was the exact moment the stock market experienced the “intergalactic bull market,” as Chanos calls it, that kicked off the stock market boom of the roaring 80s. “Timing,” says Chanos, “was never my forte, but I’m still proud of that report.”

It is fair to say that Gilford clients were not thrilled with the timing either, nor with the short—at least at first. But as the weeks rolled on, the facts on Baldwin-United received more attention. By October, the Wall Street Journal had picked up the story and had begun asking some of the same questions Chanos was asking. Chanos now began to feel the lash of the counterattack from analysts and other interested parties refuting his case. Unable to assail the facts, they fired on the messenger. He’s a novice, many said of Chanos. He has no insurance experience. He has never met with management. He doesn’t get it.

This was the first, but by no means the last, time Chanos would hear himself pilloried.⁴ At least he wasn’t totally alone; he continued to have the backing of Gilford’s leadership, and he had the facts. When Forbes set out to do a major piece on Baldwin-United, its editors challenged Chanos to “walk them through” his report. He did so, and while the magazine found no “smoking gun,” its article took Chanos’s case seriously.

The light bulb really went on for Chanos when a key Wall Street analyst directly refuted one of Chanos’s claims in a way that made him realize the analyst had never looked under the company’s hood at all. The realization prompted Chanos to recommend that Gilford management double down on the short—on the theory that if no one was willing to look at the truth, it was going to hurt even more when it surfaced—and management concurred. Baldwin-United’s stock soon plummeted, and the short paid off handsomely.

Retribution for Jim Chanos followed on Christmas Eve. Chanos was back home with his family when he got the phone call telling him that the state of Arkansas had stepped in and seized Baldwin-United and all its assets. It was a moment of some satisfaction.

Future decisions in life are most often dictated by prior experience—both success and failure. Win the first time at the blackjack table and you keep coming back in an attempt to replicate that experience. For Chanos, it was the positive experience he had with his first short sale, which, unlike blackjack, was steeped in skillful analysis and shaped his path. He has never looked back. The Baldwin-United short made his reputation, and the pattern he set in identifying the important facts hiding behind the distractions became his signature.

Short Seller Supreme

Lured by Deutsche Bank, Chanos finally moved to New York. He began looking into the Drexel Burnham companies run by junk-bond king Michael Milken and recommended shorting them. Milken is a genius who created an entirely new way of financing companies. Built upon a mountain of debt, when company fundamentals and the economy are strong, leveraged entities can provide great returns, but when either deteriorates, look out below. Chanos was among the first to point out the dangers of this financing mechanism and focused on some of the less creditworthy companies. Charges flew that Chanos and other short sellers indulged in slippery tactics, and Deutsche Bank senior management got nervous. Big firms, with their varied business lines and multiple constituencies—in other words, company politics—often consider other factors than pure performance. This misguided attack resulted in Jim losing his job. But he had been right about Milken’s Drexel Burnham companies, and the short was eventually profitable.

He founded Kynikos Associates in 1985 as a short selling firm, suffered some serious losses, and registered some major wins. Kynikos shorted commercial real estate in 1986 through 1992, shorted real estate again in the bubble leading up to the subprime crisis, shorted Boston Chicken, Sunbeam, Conseco, Tyco International, and of course in 2000 came up with what seemed at the time one of the most stupefying shorts ever: Enron.

The parallels between Enron and Baldwin-United, says Chanos, were “eerie.” Once again, Enron was a company on the cutting edge, having found a new way of doing business, beloved by Wall Street, making money hand over fist, and becoming the name on everyone’s lips. And as with Baldwin-United, “everything was hiding in plain sight,” Chanos says. “You just had to look.” And look he did, at a time when Enron was the darling of Wall Street, generating massive fees and lulling analysts and shareholders into visions of eternal gains on their investment in the company. Enron’s Chairman, Kenneth Lay, was one of the most respected executives in corporate America; it was almost heresy to question him.

Chanos questioned, and Chanos probed. It was a big, big win, and it brought him an even more stunning level of fame as America’s preeminent short seller.

Doggedly—and Successfully—Cynical

As Jim Chanos welcomed me into the office of Kynikos—a place where books spill off the shelves—he is as sunny and charming a host as can be imagined. Easygoing, articulate to the point of eloquence, a superb storyteller, Chanos exudes goodwill, and his cheerfulness and elfin smile evidence a most contented man, not necessarily the personality one might expect from a legendary short seller.

Short sellers tend not to be the best-liked people in the room. Their presence brings the shadow of catastrophe to a stock, making them the most unwanted of guests—especially at a party that everybody else is enjoying to the hilt. They may suffer the sad solitariness of being the lone voice in the wilderness, and it is a voice an awful lot of people simply do not want to hear. Those people tend to blame the messenger. John Mack, then the CEO of Morgan Stanley, famously did it during the financial crisis of 2008. Dick Fuld, former head of Lehman Brothers, agreed.⁵ But what everyone loses sight of is that short sellers don’t make the news; that is to say, they are not the ones who create the negative fundamentals. Rather, they exist to identify and profit from the holes in an investment thesis that others overlook, either intentionally or from lack of effort.

Short sellers are cynics, questioning all they see. The word cynic derives from the Greek, Kynikos, inspiring Chanos to choose the name Kynikos Associates for his company. Roughly translated it means dog-like but its etymology is much more expansive and on point. The followers of the ancient philosophers Antisthenes and Diogenes met in a gymnasium in a place called the Kynosarges. On the outskirts of Athens, the Kynosarges had been designated for use by those who lacked pure Athenian blood, so from the start, the Cynics were seen as outsiders. It was in the gymnasium that Antisthenes, labeled the Cynic philosopher, preached to these followers. Their philosophy spurned wealth, and its adherents often made a point of rejecting conventional manners and living on the streets, adding to the perception of Cynics as dog-like—idiosyncratic, contrary, tenacious. Not coincidentally, these are the qualities, absent the austere lifestyle and aversion to wealth, a short seller must possess to profit in a world dominated by markets that are most often optimistic.

“A short is a hedge that should produce positive alpha,” says Chanos. “It’s an insurance policy that pays premiums.” Kynikos Associates’ dedicated short funds have done just that over the quarter-century plus since Jim Chanos founded his business. The fund manages $7 billion in two portfolios, one U.S.-based, the other global. Each portfolio is comprised of just 50 positions.

Risk management, so essential to a short seller, is managed through position limits. Says Chanos: “The two ways to handle risk on the short side are stop losses or position limits. Stop losses don’t work for us, both for trading and emotional reasons. Once you exit a position, it’s hard to re-enter it.” Instead, no position in the portfolio is ever at more than 5 percent. “If it hits five,” says Chanos, an automatic trigger “cuts it back to four and a half.” Sizing, he says, is as important as research “once a stock is in the portfolio.” Even the firm’s biggest disaster—its short of AOL in 1996 to 1998—“was never more than a 1 percent position.”

To be sure, the name of the game is always to look for the negative. To that end, says Chanos, “all our work is forensic.” Chanos and his small but exceptionally experienced staff, which includes some former investigative reporters, do not talk to company management. “CEOs don’t know or shouldn’t tell you their predictions for the future,” says Chanos. “Corporate management is no better and arguably worse” at outlook prognosis than anyone else.⁶ Instead, “We start with the spin,” he says, and what follows is an exercise in intellectual honesty.

“In the last 30 years,” Jim Chanos asserted, “every major financial fraud has been uncovered by an internal whistleblower, a journalist, and/or a short seller—or some combination thereof. Not by the SEC. Not by law enforcement. Not by internal auditors or counsel.” It is why he believes short sellers are essential to keeping the world of finance honest; they are, in Chanos’s phrase, “a market-incentivized group that can root out fraud.” That emotions run high around shorting and short sellers is surprising to Chanos only in the sense that the practice itself is so quintessentially rational—and that is all to the good. “Short sellers arguably are the ultimate capitalists,” says Chanos. “Without us pointing out failures, the capital markets won’t function as well.”

The China Short

There is no lack of irony in Kynikos’s canine association and the firm’s legendary short of China since, as is widely known, dog is still a menu item in some parts of the People’s Republic. Yet this is a case where the diner may end up being swallowed; that, at any rate, is the big bet Jim Chanos embarked upon in the fall of 2009.

The path to Chanos’s China short was indirect. The firm had been exploring the abnormal returns of some producers of iron ore and other commodities. The returns were “so far above historical norms,” Chanos says, that he decided to investigate further. It turned out that “80 percent of the marginal demand came from China, despite its being only 10 percent of the world economy.”

Chanos directed his staff to uncover the reasons for this, and they found the answer in the number of square meters of class A office space—that is, high-design, top-quality, high-profile office space—under construction or in development. The number was 2.8 billion square meters. “You must have transposed the decimal point,” Chanos said, interrupting the analyst making the presentation. “That’s what I thought at first too,” the analyst replied. The number was correct.

Chanos did some quick mental figuring: 2.8 billion square meters is roughly 30 billion square feet, he quickly calculated, and 30 billion square feet, given the population of China, means a five-foot by five-foot office cubicle for every man, woman, and child in China—a totally absurd proposition. “That’s when the enormity of this unprecedented building wave struck me,” says Chanos. “This was building stuff for the sake of building it.”

True to form, he investigated further. What numbers might the Kynikos analysts have missed? Which numbers weren’t real? The research was fast but thorough and uncovered two standard “myths” about China, as Chanos calls them, that needed “to be addressed and refuted.”

One myth is the migration argument—that is, the idea that with 20 to 30 million rural Chinese peasants moving to the cities, housing is desperately needed. The need for such housing is indeed desperate, although Chanos suspects that the number of temporary workers moving from villages to cities is actually higher than the 20 to 30 million figure given, but the point is that what is being built is not affordable housing; rather, it is high-rise, high-priced condos that can be afforded by only the top 2 to 3 percent of the population. The construction boom, Chanos concluded, was “all speculation.”

Chanos is somewhat sympathetic to the speculators. The real estate market in China, he recalls, only got started in the late 1990s; it isn’t very old, and it has only gone up. The market has “no experience with empty construction, no sense that it depreciates,” says Chanos; moreover, “there is no secondary market.” For reasons of both cultural legacy and future profitability, everyone wants to own a new condo, and there are plenty of them to buy. But, asks Chanos, “to whom will they sell the ones they’ve bought?”

Meanwhile, the speculative boom “is doing nothing to alleviate the housing problem for the low-wage laborers” still pouring into the cities.

The second myth, says Chanos, “is that nobody is leveraged.” Again, partly due to cultural legacy and partly to credit controls—at least theoretically—by the central government, there is the assumption that everyone in China pays cash. The truth, Chanos found, is that “credit growth is exploding in China.” Since municipalities may not issue debt, local officials partner with a developer and set up a local government financing vehicle that can borrow the money for marquee development projects. Small businesses, to which big banks may not extend loans, find credit in an active, if hidden, black-market environment for down payments and small loans. Chanos found that even large corporations had begun to use corporate cash to speculate in the real estate boom, setting up property subsidiaries to do so.

Kynikos’s research estimated that credit as a percentage of GDP in China has averaged 20 to 25 percent per year as far back as 2003; some estimates put total private credit in China at 200 percent of GDP. In fact, no one knows how many loans are outstanding. The government has made repeated efforts to tighten the credit markets, making it more difficult for banks to lend and for people and corporations to borrow, but both the lender and the borrower have done end runs around those government efforts. The shadow banking system in China is estimated to be near $1.5 trillion, an astoundingly large amount of credit to be sloshing around. But the bulls on China don’t seem to care, as Chanos asserts, since any debt that goes bad is backed by the central government; at least that is the escape hatch the China-is-the-future boosters count on. Still, backing that kind of outstanding debt could be an awfully big pill for the nine-member Politburo in Beijing to swallow, especially since the local governments have every incentive to keep the speculation going.

Even given the haphazard nature of some of the data on China, the assumption that there is missing data, and the large grain of salt with which short sellers typically receive handed-down assumptions, any way Chanos sliced the facts and no matter how skeptically—even cynically—he looked at them, “You could see the magnitude and the direction” of the construction boom: “It was big and going up.” Kynikos eventually estimated the size of the property market at more than 60 percent, when including related activities, of China’s total GDP—absolutely unprecedented, Chanos believed. “Something unique in world history was happening,” he concluded. “A world-class bubble was being inflated right before our eyes just two years after our own bubble had burst.”

He saw it as “one giant land boom,” in Chanos’s phrase. “Land underpins all of it. It’s the basis of the municipal finance; it’s the collateral for all the loans; it’s the value-added on all the real estate. And if it goes, a big part of the Chinese economy goes.” On that basis, starting at year’s end 2009 and in the first months of 2010, Kynikos began shorting the Chinese property market. It has been, he says, “a very good short.”

Chanos takes pains to insist that his short is contained—limited only to the Chinese property bubble, although he contends that he believes the Chinese growth model overall “has problems and needs to be navigated.” His bet, however, is against the boom. Benchmarked inversely against the indices, the short focuses on developers, banks, commodity suppliers, even railway companies tied to the bubble and trading in Hong Kong or elsewhere.⁷ But Kynikos is, Chanos says, “economically long the market.” Specifically, the firm is long Macau casinos. In other words, says Chanos, whether out of cynicism or sheer irony, he is “long corruption, short property.”

As we go to publication, China’s economy is indeed showing signs of slowing. Various economic indicators are showing signs of contracting and hitting recessionary levels. Property surveys indicate that transactions are slowing and prices declining in most major cities. Demand in China’s most significant export market, Europe, is also declining. Through all this bad news the China bulls voice the mantra that the central government will not allow the country to suffer a hard landing. The United States, far more experienced than China in the ways of capitalism, could not prevent a recession, yet the U.S. market expectation is that a still communist country, much newer to capitalism, will be better at managing their slowdown.

Putting your money on the eternals of human nature rather than on the ephemera of an infatuation—especially one based on murky “facts”—may or may not be the quintessential short seller move. It is certainly quintessential Jim Chanos, especially when accompanied by the fruits of dogged research. And while he may be almost alone in saying what he is saying and investing against what everyone else is certain is the wave of the future, would you bet against him? Table 4.1 may help you answer that question.

The Takeaway

By definition, a hedge fund makes simultaneous bets on investments that its managers expect to increase in value and on positions they expect will decrease in value, hoping to profit from both. By being hedged, they hope to be in a position to make money regardless of market direction. But ask any hedge fund manager what is the most difficult aspect of investing and he or she will admit that it is “finding shorts that work.”

There is a codependency between the words “shorts” and “work.” It is not too difficult to find a company whose fundamentals are declining, but the trick is finding one whose stock price has not already been discounted for a turn in fortune. Small companies are usually more fertile ground for shorts since they are generally less well followed, but a fund the size of Kynikos requires big positions or multiple positions relying on the same theme to make an impact on its overall performance. And then of course there is the ability to be patient and to absorb losses on the way to being right so that you can ultimately book the gain. Very few hedge funds, and certainly very few individuals, have the fortitude to stick with a short position; it is certainly easier to take the path of least resistance and follow the herd. Imagine always going to a movie and rooting for the hero to lose. The world is full of optimists, thankfully, and markets tend to rise more often than decline, making Chanos’s consistent performance all the more remarkable.

All of which helps explain why short sellers are always in the minority. And like a number of minorities, they are maligned and shunned by the legion of long shareholders and their army of supporters—including Wall Street analysts and company managements and, recently, even government regulators who have occasionally banned the practice of selling short. Being a short seller is lonely and often gut-wrenching. Being good at it requires having the constitution of a competitive eater. But unlike Joey Chestnut, perennial winner of the Nathan’s July Fourth hot dog eating contest, a short seller’s holding period can extend to weeks, months, or years before claiming the win. And instead of an antacid, the medication is additional research and correct position sizing.

The most important aspect of Jim Chanos’s success is, in fact, research—an extensive process that provides him with the fortitude to stay with a short position even when the price action goes against him. With accounting shorts or frauds such as Enron, there is rarely a slow atrophying of the stock price as investors continue to buy into what they believe is a solid fundamental story. All the while, the fraud is working to do what it is designed to do: make the investment extremely attractive. Enron’s Ken Lay spun a web that captivated investment bankers, analysts, and investors, driving the stock price higher and higher. Investors—and of course Enron employees as well—were entranced by a fairy tale that Aesop would have been proud to write.

Much like an individual investor, dedicated short sellers don’t have access to a company’s management team to vet their thesis. Companies don’t want to speak with someone who only wins if they lose. So Chanos relies on his own grassroots research efforts, including a top-to-bottom review of all financial filings of both the company he is targeting as well as of others in the same business. If, for example, every company in a particular sector has an operating margin of 15 percent, how is it that one company, with no special products, has an operating margin of 20 percent? To those bullish on the stock, this is great news; no questions need be asked. But to Chanos, this is a yellow flag. Maybe the outsized margin is justified, maybe not, but it is in any case worth a look. He and his team of analysts will then research the thesis from the bottom up and the top down. As the last step in the process, Chanos convenes a meeting with his analysts and elicits their input, exhorting them to poke holes in his thesis, while he tries to find the weak links in theirs. Having already checked out the firm’s ability to borrow the shares, they start building the position. It is critical that they do it stealthily lest other funds compete with them for the “borrow.” Once Kynikos has a full position, they sit and wait for the story to unfold, for others to see what they see, and find out what they already know, on occasion sharing their information with others.

Sometimes, as with WorldCom and Enron, Chanos has targeted a fraud; more often, it is a story unraveling from the top down, as with China. Or it could be that a company’s business model is flawed and there is a large discrepancy between deteriorating fundamentals and the high valuation accorded to the stock price by the market. To the extent the market closes this gap, Chanos makes his money. But it does not always work out, or it doesn’t happen quickly enough and, as mentioned before, he can suffer a great deal of pain in the interim. So how does Chanos or any other short seller stay the course when the overwhelming majority is going the other way?

Shorting stocks is a tough business and not for the faint of heart. It requires independence, an appetite for risk, and deep pockets. Make a mistake in buying a stock and the downside is defined; the lowest it can go is zero. But short a stock and the loss is theoretically unlimited since the stock can continue to trade higher. The practical application of this is that when a short goes against you, it becomes a bigger part of your portfolio; when a long position doesn’t work, it becomes a smaller part of your holdings.

There are two basic types of shorts: fundamental and valuation. In the case of Enron and China’s banks and property developers, Chanos found significant flaws in the investment thesis of each. With both, he could help make other investors aware of these issues and perhaps decrease the time he would have to wait to get “paid” on his investment. After all, he was extremely confident in his work and could point to the catalysts for his negative thesis to come into play. But shorting stocks solely on the basis that their valuation is too high, that they are “too expensive,” is a dicey strategy. Valuation shorts are a different matter since there is no identifiable catalyst to drive the stock lower.

For example, let’s say you come across a stock that is trading at an egregiously high and unsustainable level based on virtually any valuation metric. Let’s suppose, for example, that this particular equity is trading at a price/earnings multiple of 75 at a time, when the average P/E of all the stocks represented in the S&P 500 market index is 15. Sure, the company is growing slightly faster and has a great balance sheet, but you determine that such a large valuation discrepancy is unwarranted. You continue digging and cannot really find any flaws in the story, but that doesn’t matter since you believe the company will eventually have a misstep and then everyone will realize that the stock price is just too expensive. Besides, how much more expensive can it get? You decide to short the stock and then you wait. And wait. And wait. The stock drifts higher, and now the pain of loss is palpable despite the stock being more overvalued than when you first put the position on. But, as previously noted more than once, here is the issue: The market can be irrational for a longer time than you can stay solvent. Valuation shorts, without any identifiable catalyst within a defined period of time, can often result in significant losses.

Back in 1999, during the Internet stock bubble, a smart hedge fund manager I knew shorted Amazon. At the time, the company was barely making a profit, and the P/E was almost incalculable. My fund manager friend could not find anything wrong with the company per se. Yes, it was a relatively new concept, and analysts’ projections for growth were mind-blowing. But this fund manager was accustomed to owning stocks that traded at a P/E of 10 to 20 times, not 100 to 200. So he shorted the stock at $100 a share, then shorted some more at $125 a share, and more at $150. Finally, after losing millions of dollars, he covered his short and learned the valuable lesson that it is very difficult to make money on valuation shorts.

The conclusion reached by many is that shorting stocks is the bastion of hedge fund professionals. In fact, for the most part, I agree. But if you still want to engage in the practice of short selling because you are absolutely convinced that a particular stock is overpriced, there are two strategies you may want to consider. The first is buying puts where the potential loss is defined by the cost of the options. The second strategy is to wait for the stock to “break.” Tops and bottoms in stocks and markets are virtually impossible to predict with any certainty or consistency. But once a company’s fundamentals turn, once that unidentified catalyst actually becomes visible, the momentum is broken, and the price often begins its precipitous decline. Once the emperor is shown to have no clothes, his most loyal subjects—that is, the shareholders—desert the investment in droves, driving the price lower. At this point, the biggest risk, albeit uncommon in application, is that another company acquires the entity you have shorted.

The final takeaway: Shorting may not be the riskiest form of investing, but it can be the costliest. It is a science, not an art, and very few investors are successful at it. Most professional money managers don’t short stocks because of the inherent risks. But if you are a completely independent, non-consensus thinker who has the wherewithal to perform in-depth research and maintain strong risk controls, have at it.

1. Author’s comment: I believe that China will be a growth opportunity for many years to come and holds unbridled economic promise. However, managing the transition to a more capitalistic society will be bumpy and expectations of the transition will periodically exceed reality. I do not believe anyone doubts the growth story, Chanos included; the skepticism relates to what an investor should pay for it at a point in time.

2. A single premium deferred annuity is a contract between an individual and an insurance company in which the individual provides funds that are invested and later used as the basis for lifelong distributions to the annuity holder.

3. The Securities and Exchange Commission requires public traded companies to file a quarterly (10-Q) and annual (10-K) financial reports.

4. Short sellers are often targets but never more so than during the financial crisis of 2008–2009 when Congress took up the cry against them. Short selling of financial stocks was banned for a period of time.

5. John Mack and Dick Fuld blamed short sellers for bringing on their issues of solvency, never owning up to the fact that it was likely a lack of proper risk management that nearly bankrupted their firms. What neither Mack nor Fuld pointed out was the significant amount of revenue their companies earned from facilitating the activities of short selling firms.

6. As Chuck Royce will mention in Chapter 6, he feels no need to speak with management prior to initiating a position, preferring not to be biased before doing his analysis.

7. Within days of completing this interview, China’s major sovereign wealth fund bought shares in four Chinese banks in an effort to shore up their capitalization, the result of a deteriorating financial position as loan losses increased.

Classic Short Selling Themes Booms that go bust Consumer fads Technological obsolescence Structurally flawed accounting Selling $1.00 for $2.00 Value traps	Value Stocks: Definitive Traits Predictable, consistent cash flow Defensive and/or defensible business Not dependent on superior management Low/reasonable valuation Margin of safety using many metrics Reliable, transparent financial statements
Value Traps: Some Common Characteristics Cyclical and/or overly dependent on one product Hindsight drives expectations Marquee management and/or famous investor(s) Appears cheap with management’s metric Accounting issues	Current Value Traps Liquidating Trusts Digital Distribution Destruction Miseducation Nationalistic Commodity China Bubble Fuel
Vale (NYSE: VALE): China or Bust? Cyclical peak creates impression of value Forward P/E 5.1×*, operating cash flow margin over 45% $160/ton iron ore price more than 5 × 30-year historical average Capital expenditure inflation is soaring—2011 budget of $24B; up 85% over 2010 Questionable capital allocation—VALE Navy 12 Chinamax 400 k dead weight ton very large ore carriers (“VLOCs”) “It’s not our policy to make money in freight.”—Jose Carlos Martins, Vale Executive Officer of Marketing, Sales and Strategy Enormous exposure to uncertain Chinese demand growth China accounted for 43% of Vale’s iron ore sales in 2010, up from 29% in 2008 Reliance on continued fixed asset investment growth in China Brazilian Government influence on strategic decision making Key driver of economy—iron ore exports accounted for 17% of total exports in 2010 Recent resignation of CEO Agnelli amid rumored tensions with newly elected government