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My Investing Notebook: Jim Chanos: The Power ofNegative Thinking (CFA annual conference 2010)

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 its

harvested, etc.

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

In the past 25 years, every fraud has been uncovered by either 1.) a whistle blower or 2.) someonewith 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 and4.) face outright bans (such as the German one, however that will not affect him since he always has

the shares, its more of an issue for traders than fundamental shorts since they often buy it backbefore they secure delivery).

People say that when youre long, stocks can only go to zero if youre wrong but they can go toinfinity if youre right. Ive 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 thatits the bottom in time, not in price. Market often goes lower after a ban, but the bottom is at leastclose by (showed 1932 and 2008 examples).

Opportunity for short sellers is very good Large alpha of 10-20%/year, over past 30 years hasbeen 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 Sharpes Nobel Price Acceptance speech he says that itassumed frictionless short selling. Gave the example of PALM/3COM, he said the only reason thatpalm was worth 3x 3com even though 3com owned 80% of Palm was because short sellers couldntget shares to borrow. When his broker finally found shares at 2:30pm the day of the IPO, the stockstarted sliding as you could finally short. But it took months to get back to a normal ratio, it was aninefficiency created by retail investors chasing the hot stock.

Research process has good and bad news: Numbers are obfuscated, short sellers have no accessto management, and the sell side hates you. Those are both good and bad. Recommends notgetting close to management because they either 1.) dont know whats going on or 2.) are tellingyou a lie. According to S&P and CFO magazine studies, 2/3 of CFOs have been asked to cook thebooks 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 (althoughno 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/investorsin the fund.

Regarding point 5, told the story about how one investor is a restaurant franchisor who told them thatBoston Chicken would never work since they were selling homemade meal replacement. Sincemom/dad bought the meal and took it home, they never bought drinks and drinks are where all theprofit is made. This got them looking at BC with more scrutiny and then noticed that management
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didnt want to open any company owned stores since they werent profitable and had to loan themoney 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 flowsproduced by the asset do not cover the cost of the debt. The Internet is not a boom since theydidnt 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 thenthey should. Its also a great source of decoration for your office, hes got a Cabbage PatchKid next to a George Forman Grill next to a Nordic Trak.

3. Technological Obsolescence Everyone thinks the old product will last longer than it actuallydoes. Examples were Wang Word Processors (replaced by PCs), Record Stores (replacedby 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 shareprice (think Kodak and film).

4. Structurally-Flawed Accounting beware serial acquirers, they often write down the assets ofthe 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. Mostmanagement wont tell you this, some will, however. But by writing down inventory and A/Rthey can spring load results once the company is acquired. Theyre supposed to adjust thepurchase price but most dont.

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

He said Lehman also marked to model and had optimistic assumptions. They had a $600b balancesheet, 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% toohigh)!

Regarding China, hes not calling for an impending crash, but... theres a credit driven propertybubble with global implications. Its a classic boom that goes bust. There are 30Billion square feetof class A real estate under development in Tier 1, 2, and 3 cities in China. Thats a 5x5 cubicle forevery man, woman, and child in China. Once that is done being constructed theyll need to buildmore 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 theyreported. We thought the value of a subscriber would turn out less than they thought. We startedshorting at $2-$4, covered as it went up, and covered 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% over2 years.

There are 2 ways short sellers handle risk. 1.) Stop Loss orders. We do not believe price aloneshould tell if youre right or wrong, fundamentals should. 2.) % of capital at risk. We size ourpositions between 5% max and min 12% (or its 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. Theyre 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 didnt get comfortable with thecounterparty 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 whos never allowed to retire since he does such a great jobfinding the borrow. He monitors rebates and knows when a short squeeze is coming or ending. Itshows 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 findstocks that went down. Conversely, if you werent long tech you did fine in 2001/2002. So a Narrowadvance is fine, a broad advance is not.

Q: Thoughts on Regulation?A: I am the head of the Coalition of Private Investment Companies and weve been calling forregistration since 04/05. Back then Washington did not understand the industry, they still dont, butthey really didnt then. HFs didnt take any money from the government, so its a little easier for themto hear our side now. I believe the short selling in financials in 08 were by other financial institutionswho were hedging their counterparty risk.

Q: How to short China?A: Obvious is the land development companies and Ill let you figure out which ones. But we alsoshort the derivative plays. There was a dramatic increase in commodities, specifically Iron Ore, in2005. It went from $30-$40 up to $160. I expect that will mean revert when China stops building.

H/T Cameron Wright

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