Keep the Casinos Open

Thought we’d share a few other tidbits from Boston as we muse over CFA Institute’s 2010 Annual Conference, and before we return to our work on Inflation and Monetary Regimes.  This year’s conference had a heavy macro bent with terrific presentations from Ken Rogoff to Richard Koo to Naill Ferguson, who we discussed in our last post.  But there was plenty for the individual stock picker as well.  We’ve seen a lot of coverage on Seth Klarman’s session since then, so we won’t duplicate the words of wisdom from Baupost, but thought we’d offer up our notes from one of the industry’s most highly regarded short seller, Jim Chanos of Kynikos Associates. 

Unfortunately, we were unable to track down Jim’s presentation on The Power of Negative Thinking but we did come across some very thorough notes here for those not satisfied with our choppy outline below.  Perhaps our favorite Chanos Quote: “Short Sellers serve a non-regulatory watch dog function.  In the past 25 years, not a single fraud was discovered by regulators . . . Regulators are financial archaeologists; short sellers are financial detectives.” 

Cliff Asness, Founder of AQR Capital Management, offered up similar views in a paper he published back in April titled, Keep the Casinos Open.  We strongly encourage our friends to take the time to read this brief piece, as it clarifies many of the common misperceptions amplified by Washington’s political posturing and search for blame.  Cliff suggests that, “giving investors incentive to root out companies whose credit is worse than it appears, by allowing them to profit, or lose if they are wrong, from this bet is a worthwhile economic activity.  If the short-sellers are right, the problems really exist, and it’s always better to discover problems now, not later . . . nowadays the popular narrative is that this economic crisis was caused by Wall Street and derivatives.  It was not.  It was a real estate bubble caused by government.”  Thanks for setting the record straight, Cliff.  We won’t hold anything against the ex-Goldman executive, or the Big Red Dog.  The full article can be accessed below our notes from Jim Chanos’ recent presentation in Boston.

Jim Chanos: The Power of Negative Thinking

  • Shorting is not the opposite of going long.  It is a source of alpha.
  • Short sellers serve a non-regulatory watch dog function
    • In the past 25 years, not a single fraud was discovered by regulators
    • Regulators are financial archaeologists; short sellers are financial detectives
  • Short sellers exist in an environment of negative reinforcement while conventional investors are surrounded by the “Wall Street Musak”
    • Not many can cope with this pressure; short sellers are born, not trained
    • Come under fire every day
  • It is true that risks are asymmetric, but Chanos has seen more stocks go to zero than infinity
  • Generates ideas through a combination of experience, third-party research, screens, and other investors
  • Never get close to management
    • Often they don’t know and often they don’t tell you
  • Recurrent themes:
    • Booms That Go Bust – debt fueled asset explosion with assets unable to service debt
    • Consumer Fads –
      • Investors extrapolate product fads with hockey stick growth trajectory
      • These make great souvenirs (i.e. cabbage patch kids),
    • Technological Obsolescence (i.e. Word Processing; Kodak, Netflix, Newspapers)
      • These always look cheap!  All the way down to five bucks!
    • Structurally Flawed Accounting
      • Beware serial acquirers
        • Write-downs pre-acquisition
        • Always find out net assets just before and just after acquisition
        • Management will always say they are being conservative, but are predictably spring-loading earnings
    • Classic Arb – Selling $1 for $2
      • 3COM/Palm Merger
        • Palm IPO was valued greater than the parent who owned 80% of the company
        • Post IPO, PALM was valued at 3x or 4x greater!!
        • Took months for this arb to close!!
        • Limits to arb are real – Spanish closed-end funds traded at 300% premiums to NAV in the late 80s
  • Issue with Enron was not mark-to-market, but mark-to-model
    • We learned nothing from this as banks Level II-III assets were overvalued by over 50%
  • China has 30 Billion sq ft of Class A office space under construction
    • Enough for 5 sq ft of office space for every single person in the country!!
    • Iron ore prices are at three times the level of a few years ago, which was stable through history prior to China Bubble
  • Lessons Learned from shorting AOL at $2 and covering at $80
    • Does not initiate a short at more than 150 bps
    • Does not like stop losses since price alone shouldn’t tell you if you’re right or wrong
    • Prefers to manage position size relative to capital base
      • Range is 50 bps to 500 bps
      • Less than 50bps is not worth the effort
    • Does not use options or leverage to implement shorts
      • Believes that risk management is cheaper over the long run managing positions directly
    • Prime Broker relationships are very important
      • Fluctuations in rebate rates can warn of an impending squeeze of indicate when a stock is about to crack

Keep the Casinos Open – Asness 4.26.2010