A Dozen Things I’ve Learned about Investing from Jim Chanos.

I have written about the challenges associated with being short a stock before. It has been my expedience that shorting is something lots of people like to talk about, but few people actually do. Here is Jim Chanos describing what his firm does (“fundamental shorting”) with some of the best quotes coming from an excellent interview with Barry Ritholtz:

“We select a portfolio of securities – mostly stocks – that are fundamentally overvalued no matter what the market does. Our clients are primarily institutions who use us as a hedge to their core equity portfolio. It allows them to be a little more aggressive in their equity exposures, knowing that they have part of the portfolio in a small group of companies that will go down over time.”

“We are benchmarked versus the market inversely. We are an insurance policy [for our clients] that pays slight premiums.” “We are in the insurance business.”

“A short is a hedge that should produce positive alpha.”

“I view macro and short selling as skill-based or alpha businesses, whereas equity long/short hedge funds tend to be more of a “marketing of beta” business. I am always amazed that investors will pay 2 and 20 for a manager that is always net long. I have been saying that for 20 years. It is interesting because I run an alpha-based business and I am more sensitive to it than others. I sit on investment committees and I see it as an investor who advises these funds. When I ask why a lot of hedge fund compensation is simply embedded market risk, I get very uncomfortable, squirming, dodgy answers. Or no answers at all. Look at 2013. It is crazy to see managers who were up 15 percent command huge checks, when the S&P was up 30 percent. Particularly since they were not balanced completely. They were 90 percent long and 30 percent short, or something like that. Not much alpha has been created by hedge funds, and what was created has been taken by fees. This has been the case for a long time. In a way, short sellers might still be one of your great bargains out there, at 1 and 20 percent of the alpha. That is the closest I will get to a marketing pitch.”

“The two ways to handle risk on the short side are stop losses and position limits. Stop losses don’t work for us both for emotional and trading reasons. Once you exit a position it is hard to re-enter it.”

“[The ability to do what I do] is personality based. A lot of it is rooted in behavioral finance. We are the product of positive reinforcement cycles. Most people’s rational decision making breaks down in an environment of negative reinforcement.”

“If you are a short seller you are being told constantly that you are wrong. Not everyone has the ability to drown that out.”

“There is a big difference between a long focused value investor and a good short seller.” “The psychology is completely different.”

“The market won’t necessarily immediately see what you see, and in fact often doesn’t. Fundamental short sellers are often early. You also have to borrow the shares. The ability to effect a short position in reasonable size, once everything is clear, may not be given to you.”

“Most human beings perform best in an environment of positive reinforcement. We like to be told we are smart, we’re on the right track, we’re doing the right thing, and that the stocks we bought are cheap and are going up and that their earnings are going up as well… almost everything is positive. ‘Wall Street is a giant positive reinforcement machine. That’s why it exists. If you’re a short seller, you’re coming in every day, and out of fifty names in your portfolio, you can count on ten names where there will be some noise. Stocks recommended, re-recommended, earnings estimates raised, CEO on CNBC; whatever it is, you’d be facing that noise. And, a lot of very good value managers completely break down when confronted with the fact they have to invest against the grain in front of all that noise. The best short sellers I know have an innate ability to drown out the noise – to not let it affect them. They use the noise to their advantage; they don’t let it get to them. I tell managers, find out who you are first and then you’ll find out whether or not you’ll like the short side. Some of the very best value managers, with terrific long-term records, are the worst short sellers I have ever seen. Again, it comes back to investment psychology.”

The S&P is up over 2,000 percent since his firm was founded in 1985, but Chanos says the Alpha delivered to clients “is in the mid-teens.” Think about how hard it is to win as a short seller in a market that is up over 2,000%. The short seller is, in effect, swimming upstream against a significant current. What Chanos does for a living is hard. It is not something to do in your pajamas on Saturday morning. It is a full time job. And when he does short it is done via a portfolio and with a goal of providing insurance to clients who have long positions.

The best personal commentary I can provide on shorting is perhaps to tell a story about an actual short that I put in place that is most similar to what Chanos does for his clients. It is not precisely the same but the intent was similar (to put a hedge in place). The events in the story took place in the 1990s. Peter Thiel described the period well when he wrote in his excellent book Zero to One: “The 1990s have a good image… but many of those years were not as cheerful as our nostalgia holds.” Thiel points out that the early 1990s were not particularly remarkable. The mobile phone business was doing well then which was a good thing for me. But the overall business climate for new technology ventures didn’t really start to get unusually positive until the Mosiac browser was released in November of 1993. After Netscape went public in August of 1995 the business and investing climate in the technology world started to get bit euphoric. By the fall of 1998 things in the technology stock sector were getting nutty. By 1999 valuations were skyrocketing daily and the climate was full on bonkers.

It was in the still bonkers year 2000 that I took the working vacation on a boat that I describe in my book on Charlie Munger. During that trip I read and re-read the writings and speeches of Warren Buffett and Munger. I spent that vacation trying to discover whether what was happening in the technology investing world was real and what was likely to happen to valuations. When I returned from that working vacation in late August of 2000 I decided that some of the Internet businesses I had been following were fundamentally broken. For example I knew that the Internet was not doubling as fast as people like John Sidgemore claimed and more capacity was not good for valuations as George Gilder claimed. Reading Munger in particular helped give me the courage to act. So at a very advantageous time I sold some shares that could be sold and created a proxy hedge for certain shares that could not be sold by shorting a basket of Internet and telecom stocks. This type of short sale is not the sort of thing I do often, but it was a reasonable thing to do at the time since it balanced non liquid positions that I could not sell except at a significant discount in private markets. I was taking a risk that someone would announce a takeover of one of the firms I had shorted, but since I shorted a basket of stocks I felt that risk was reasonable. The proxy hedge I put in pace provided me with insurance similar to what Chanos provides to his clients. The short positions in the portfolio hedged some long positions I had in other stocks.

Chanos says in the Barry Ritholtz interview that I link to in the Notes below that he does not like to have any one position in his portfolio be above 5%, with an average of 2% per position. “Our portfolio turns over about once a year,” says Chanos. “Doing this as a professional with a portfolio approach makes much more sense.” “Don’t try this at home kids.” Using the success of Jim Chanos as an example to short one or two stocks is unwise since he invests via a portfolio approach. If someone announces a takeover at a premium of a stock you shorted and you do not have a portfolio of shorts and are instead concentrated, you can be financial toast.

Chanos also said: “If you are a fundamental short seller you have no problem finding out what the bull case is.” “If you are long a stock, knowing what the bear case is takes work.” He is saying the ease of knowing the long case can create a favorable asymmetric benefit for the short seller, who does the hard work to know the short case.

You will see below that Chanos believes the only reason to short a stock is if the business is fundamentally broken. Shorting a stock just based on valuation alone if the stock is not broken in some fundamental way, is dangerous since markets can remain irrational longer than you can remain solvent.

Before getting to the usual quotes from Chanos here are a few quotes from other investors on shorting stocks.

Monish Pabrai:

“When you are long on a stock, as it goes down in price, the position is going against you and it becomes a smaller portion of your portfolio. In shorting, it is the other way around: if the short goes against you, it is going to become a larger position of your portfolio. When you short a stock, your loss potential is infinite; the maximum you can gain is double your value. So why will you take a bet where the maximum upside is a double and the maximum downside bankruptcy?”

Bruce Berkowitz:

“I am not genetically engineered for shorting. If you are long and you are wrong, you go to zero. If you are short and you are wrong, you may face death. The mania of markets can last quite a long time, and when you take into account mark to market and the collateral needed, it doesn’t appeal to me.”

Charlie Munger:

“It’s dangerous to short stocks.” “Being short and seeing a promoter take the stock up is very irritating. It’s not worth it to have that much irritation in your life.” “It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then at have it go from X to 3X and at h the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that? We don’t like trading agony for money.”

Warren Buffett:

“It’s ruined a lot of people. You can go broke doing it.” “You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it’s not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, “Hey! Look at all that value creation!” and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas.” “Charlie and I have agreed on around 100 stocks over the years that we thought were shorts or promotions. Had we acted on them, we might have lost all of our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it’s going to pop, or how high it will go before it pops.” “I had a harrowing experience shorting a stock in 1954. I wouldn’t have been wrong over 10 years, but I was very wrong after 10 weeks, which was the relevant period. My net worth was evaporating.”

Here are more quotes from Chanos:

“Short selling is an inherently risky proposition. Profits are limited to a maximum of 100% of the proceeds on the date of sale; losses, however, can be infinite, depending on how high the stock price moves after the sale.” Chanos points out that you can take your gains from a falling stock to short more shares. He is saying you can compound your short-based profits. Chanos also says that the prime broker will sell you out before your losses are infinite and that a limited partner can lose only what they put into the limited partnership.

“As Warren Buffett has acknowledged… ‘it’s a tough way to make a living,’ because over time stock markets rise more than they fall, the transaction costs are high, and the risks great.”

“Short selling represents only a very small fraction of market activity. It is very costly and full of risk for the short seller to execute and maintain a position, waiting for the rest of the market to realize the stock is overvalued.”

“We try not to short on valuation, though at some price even reasonably good businesses will be good shorts due to limitations of growth. We try to focus on businesses where something is going wrong.” “Everybody says be careful shorting on valuation and I think that’s a good bromide.”

“The whole idea of fundamental short-selling is to select a portfolio of stocks that are fundamentally overvalued, no matter what the market does.”

“It is mechanically impossible for short sellers to drive down the price of the stock.” “At the end of the day, the language of business is numbers… If you’re not very comfortable with understanding how companies can play games with their financial statements using GAAP accounting, you’re never going to be a good short-seller. That’s just the bottom line.” “There’s nothing better than analyzing the company’s numbers themselves to find the anomalies because modern GAAP is as much an art as a science, as any good accountant will tell you.”

“In investing, you can be really right but temporarily quite wrong.”

“There’s nothing better than analyzing the company’s numbers themselves to find the anomalies because modern GAAP is as much an art as a science, as any good accountant will tell you.”

“You need to be able to weather being told you’re wrong all the time. Short sellers are constantly being told they’re wrong. A lot of people don’t function well in an environment of negative reinforcement and short selling is the ultimate negative reinforcement profession, as you’re going against the grain of a lot of well-financed people who want to prove you wrong. It takes a certain temperament to disregard this.”

“In a fundamental short position, not only are you analyzing the company or whatever it is that you’re analyzing, but in many cases you have a management team interposed that’s actively working to prove you wrong through activities that are not necessarily kosher … And so there is an added layer here of three-dimensional chess when you’re on the short side … The market won’t necessarily see what you see, and, in fact, often doesn’t, which is why most fundamental short-sellers will tell you that they’re most often early.”

“I’ve seen more stocks go to zero than infinity.”

Notes:

Barry Ritholtz Interviews Chanos: Masters in Business https://soundcloud.com/bloombergview/barry-ritholtz-interviews-6

SEC statement https://www.sec.gov/spotlight/hedgefunds/hedge-chanos.htm

The Big Win: Learning from the Legends to Become a More Successful Investor By Stephen L. Weiss http://www.amazon.com/The-Big-Win-Learning-Successful/dp/0470916109

Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets Steve Drobney http://www.amazon.com/Inside-House-Money-Traders-Profiting/dp/1118843282/ref=sr_1_1?s=books&ie=UTF8&qid=1452021295&sr=1-1&keywords=the+new+house+of+money