Jim Chanos: The Power of Negative Thinking
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.
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:
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.
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.
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).
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