Jim Chanos

“The Power of Negative Thinking”

At the CFA Institute’s Annual Conference, 5/18/10

Many companies practice short selling - Airlines sell a seat before they deliver the
service, Insurance companies collect premiums before they pay claims, farmers sell
the harvest before it’s harvested, etc.

Short Selling is essential for Hedging – estimated that 95-97% of all short interest is
due to hedging.

In the past 25 years, every fraud has been uncovered by either 1.) a whistle blower
or 2.) someone with an economic interest (short seller, journalist)

Short Selling is not just the opposite of going long since short sellers need to 1.)
borrow shares (possibly pay a rebate), 2.) face different regulatory rules, 3.) deal with
negative reinforcement and 4.) face outright bans (such as the German one, however
that will not affect him since he always has the shares, it’s more of an issue for
traders than fundamental shorts since they often buy it back before they secure
delivery).

People say that when you’re long, stocks can only go to zero if you’re wrong but they
can go to infinity if you’re right. “I’ve seen a lot more go to zero than infinity.”

Good short sellers are born, not trained.

Short selling bans come in near the bottom of the market, which is good news. The
bad news is that it’s the bottom in time, not in price. Market often goes lower after a
ban, but the bottom is at least close by (showed 1932 and 2008 examples).

Opportunity for short sellers is very good – Large alpha of 10-20%/year, over past 30
years has been 15+% annualized alpha with negative correlation to the market (Holy
Grail of finance theory). However the alpha if often lumpy. So you have many
periods of zero returns and then a big year.

Short selling is essential to CAPM – in Sharpe’s Nobel Price Acceptance speech he

says that it assumed frictionless short selling. Gave the example of PALM/3COM, he
said the only reason that palm was worth 3x 3com even though 3com owned 80% of
Palm was because short sellers couldn’t get shares to borrow. When his broker
finally found shares at 2:30pm the day of the IPO, the stock started sliding as you
could finally short. But it took months to get back to a normal ratio, it was an
inefficiency created by retail investors chasing the hot stock.

Research process has good and bad news: Numbers are obfuscated, short sellers
have no access to management, and the sell side hates you. Those are both good
and bad. Recommends not getting close to management because they either 1.)
don’t know what’s going on or 2.) are telling you a lie. According to S&P and CFO
magazine studies, 2/3 of CFOs have been asked to cook the books by the CEO, while
55% of all respondents did not, 12% did (those add up to 67%).

Sources of Ideas. 1.) experience; 2.) Accounting related 3rd party research; 3.)
screens (although no longer a good source since management knows how to trick
screens now); 4.) other managers (not necessarily short sellers) – “there are very few
original ideas in investing”; 5.) partners/investors in the fund.

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Regarding point 5, told the story about how one investor is a restaurant franchisor
who told them that Boston Chicken would never work since they were selling
“homemade meal” replacement. Since mom/dad bought the meal and took it home,
they never bought drinks and drinks are where all the profit is made. This got them
looking at BC with more scrutiny and then noticed that management didn’t want to
open any company owned stores since they weren’t profitable and had to loan the
money to franchisees to open stores.

Some recurring themes in Short Selling:

1.) Booms that go bust – define boom as anything fueled by debt in which the
cash flows produced by the asset do not cover the cost of the debt. The
Internet is not a boom since they didn’t have debt. The Telecom Bubble that
went along with it was.
2.) Consumer Fads – investors like to extrapolate strong growth well further into
the future then they should. It’s also a great source of decoration for your
office, he’s got a Cabbage Patch Kid next to a George Forman Grill next to a
Nordic Trak.
3.) Technological Obsolescence – Everyone thinks the old product will last longer
than it actually does. Examples were Wang Word Processors (replaced by
PCs), Record Stores (replaced by digital downloads). He says the internet is
the cheapest way to distribute anything. However people are still renting
DVDs by mail, which surprises him (Hint: likely short Netflix!). These
businesses always look cheap but the cash flow goes down just as fast as the
share price (think Kodak and film).
4.) Structurally-Flawed Accounting – beware serial acquirers, they often write
down the assets of the acquired firm in the stub period that no one sees. Ask
management what the net assets of the firm were on their latest end of
quarter and what they were when they were acquired. Most management
won’t tell you this, some will, however. But by writing down inventory and A/R
they can “spring load” results once the company is acquired. They’re
supposed to adjust the purchase price but most don’t.

Enron was “1 stop shopping” for all short selling red flags. They marked to model
(only they knew what effect the weather in Seattle would have on their power
contract with MSFT), they had off balance sheet transactions, foul language
conference calls, etc. When all was said and done, they had a $65billion hole,
meaning they were more than just a little optimistic in their model’s assumptions!

He said Lehman also marked to model and had optimistic assumptions. They had a
$600b balance sheet, of which $300b was marked to market. So they had $300b
marked to model, and they had a $150b hole. So on average, their mark to model
portfolio was mis-marked by 50% (or 100% too high)!

Regarding China, he’s not calling for an impending crash, but… there’s a credit
driven property bubble with global implications. It’s a classic boom that goes bust.
There are 30Billion square feet of class A real estate under development in Tier 1, 2,
and 3 cities in China. That’s a 5x5 cubicle for every man, woman, and child in China.
Once that is done being constructed they’ll need to build more in order to keep GDP
growing…

Q&A (I/We refer to Chanos/Kynikos)

Q: what was your biggest mistake?
A: AOL. It was a short due to accounting, we thought they were masking higher
churn then they reported. We thought the value of a subscriber would turn out less
than they thought. We started shorting at $2-$4, covered as it went up, and covered

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the last at $80. We kept it to a 1%-1.5% position. We knew we were in the midst of a
bubble, so we kept it small, but it still cost us 10% over 2 years.

There are 2 ways short sellers handle risk. 1.) Stop Loss orders. We do not believe
price alone should tell if you’re right or wrong, fundamentals should. 2.) % of capital
at risk. We size our positions between 5% max and min ½% (or it’s not worth doing
the research and going through the trouble to short.) Whenever a position gets too
big, we reduce it to keep it inline with the intended % of capital amount.

Q: Do you use Options or Derivatives?

A: No. They’re used to either manage risk or gain leverage. We can do these
cheaper on our own than in the options market. We stayed away from CDS since we
didn’t get comfortable with the counterparty risk, you had to get 2 decisions right in
order to make money.

Q: Do you have any trouble borrowing?

A: We have a 70 year old partner who’s never allowed to retire since he does such a
great job finding the borrow. He monitors rebates and knows when a short squeeze
is coming or ending. It shows up as a change in the rebate.

Q: How can Short Sellers be flat in an up 30% market?

A: It depends on the breadth of the 30%. In 1999 only 2 sectors went up, so it was
easy to find stocks that went down. Conversely, if you weren’t long tech you did fine
in 2001/2002. So a Narrow advance is fine, a broad advance is not.

Q: Thoughts on Regulation?
A: I am the head of the Coalition of Private Investment Companies and we’ve been
calling for registration since 04/05. Back then Washington did not understand the
industry, they still don’t, but they really didn’t then. HFs didn’t take any money from
the government, so it’s a little easier for them to hear our side now. I believe the
short selling in financials in 08 were by other financial institutions who were hedging
their counterparty risk.

Q: How to short China?

A: Obvious is the land development companies and I’ll let you figure out which ones.
But we also short the derivative plays. There was a dramatic increase in
commodities, specifically Iron Ore, in 2005. It went from $30-$40 up to $160. I
expect that will mean revert when China stops building.

Taken by Cameron Wright

Cameron@wrightmgt.com