The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (31 page)

Throughout, Enron was violating the matching principle of generally accepted accounting principles (GAAP), which requires that expenses be matched exactly when revenues are incurred. Enron would sell its energy assets at a loss and then stick them into discontinued operations first—for a while. Proof, Chanos says, of the tremendous leeway GAAP allows dishonest management to mislead investors far more than inform them. (It is a point he’d made in an op-ed in the
Wall Street Journal
in 2006, writing that “I can think of no major financial fraud in 25 years I’ve been on Wall Street that did not have audited financials that confirmed to GAAP!”)

About a year later, the company would sell the assets so it could put them below the line. The crux of it was when it was selling them for a profit; it would keep them in the merchant banking division and report it as an operating profit. “The winners were always being put in operating profits and the losers were being placed in discontinued operations. So within a few weeks, it was pretty clear something was wrong but it wasn’t clear this was such an extensive fraud,” Chanos recalls. He tells his analysts to follow this general rule: if you can’t figure out what a company does after three readings of their annual financial statements, open a file on it. For long-biased value investors, he suggests something else: run the other way.

The Kynikos chief remembers concluding, at first, that Enron was just overstating earnings, which was a more typical ruse. And for 16 quarters since the first quarter 1998, Enron never failed to meet or just beat analysts’ estimates. That was one red flag. Another, of many others, was the sharp increase in sales revenue between 1995 and 2000 while growth in profits was anemic at best.

It wasn’t until Jeffrey Skilling, president of Enron, unexpectedly left on August 14, 2001, citing “personal reasons,” that Chanos knew something was very wrong. For Skilling, the architect of the whole operation, to leave so abruptly was the real red flag. A few paragraphs into a
Wall Street Journal
article, Chanos read that Skilling admitted the declining stock price had a big bearing on his decision to leave. Chanos wondered why a high-flying CEO would hit the parachutes because of a declining stock price. “Most CEOs dig in their heels when that happens,” Chanos says.

At that point, Kynikos increased its position. “We found out six weeks later they were using the stock price as the insurance mechanism for all the offshore funds that were doing business with the Raptor fund.” Enron had told investors that if they lost money in the deals they bought into from the company, they would be issued more stock to make up the difference. But the company didn’t tell anyone else. Enron’s own shareholders didn’t know that they were on the hook for issuing billions of dollars’ worth of shares. “So that’s when I realized,” recalls Chanos, “just as the whole world did—this company was going to collapse.”

On October 16, 2001, in the first major public sign of trouble, Enron announced a huge third-quarter loss of $618 million. From there, it was a sharp, rapid descent as one revelation after another showed the scale and complexity of Enron’s deceptions.

Enron was not the only company Chanos was investigating in 2001 for possible accounting fraud. Tyco, the Bermuda-based conglomerate that operated in more than 100 countries and manufactured everything from health care products to electronic components, had also caught his eye. At one time worth more than AT&T or Morgan Stanley, compensation deals and related-party transactions had turned Tyco into a piggy bank for its executives. Internal investigation would later reveal the excess of former CEO L. Dennis Kozlowski and other senior executives, from the forgiveness of tens of millions of dollars in loans to a $15,000 dog umbrella stand, a $6,000 shower curtain, and a $2 million birthday party on Sardinia. Tyco manipulated earnings and cash flow through many stratagems, booking bogus revenue, gaming cash flow through acquisitions and disposals, and hiding losses and expenses. Tyco was a serial acquirer, buying more than 700 companies between 1999 and 2002. It would ask its target companies to hold down results before the takeover date; after ownership was secured, those takeovers’ revenues would explode.

Chanos plunged into Tyco in 1999 but had to wait three years before being vindicated. He questioned, for example, how Tyco accounted for goodwill charges, minimizing the charge-offs taken after mergers by stretching them out for decades so they didn’t devour profits. Chanos charged that it was a classic case of “spring loading.” Before the acquisition closed, the purchased company was made to look worse than it was. After the deal was completed, the new unit’s “growth, profitability, and cash flow are stronger than would otherwise be the case,” as Chanos said at the time. In other words, Tyco would mark down the value of tangible assets but inflate “goodwill,” the premium above the fair value of net assets. An acquirer can recognize goodwill as an asset, albeit an intangible one, in its financial statements. In Tyco’s case, they allocated nearly the entire purchase price to goodwill, spending $30 billion on acquisitions between 2002 and 2005 and creating the same amount of goodwill. The company then wrote down that goodwill, as accounting rules require, to boost earnings by sweeping expenses away. And to pump up profits, Tyco would sell those assets marked down during the acquisition. Tongue in cheek, Chanos told
New York Times
columnist Floyd Norris in 2002, “The fact that these guys are alleged to have looted the company on that scale does not mean they would have overstated earnings or cash flow or done anything else nefarious to the company’s financial statements.”

“Tyco had many more moving parts than Enron,” he remembers. “The accounting games were much more ingenious and much more creative.” Chanos took a big position in the company and felt it played beautifully into author Malcolm Gladwell’s point about “financial puzzles” versus “financial mysteries.” “In mysteries, the clues aren’t there for you to find. In puzzles, they are,” says Chanos. “In the case of both Enron and Tyco, there was missing information. The smoking gun with Enron was the stock issuance scheme. With Tyco, you could see that the balance sheet was going crazy and the footnotes held all the interesting information. Tyco wasn’t showing the financial statements for the target companies in the months prior to acquisition and the consolidated balance sheets on the day of acquisition. But still, there was no smoking gun until Kozlowski left and the acquisition strategy backfired. Then the whole company imploded.”

Cause for Cynicism

Chanos founded Kynikos, who were the cynics in ancient Greece, in 1985, just five years after he graduated from Yale University with a degree in economics. Chanos had grown up wanting to be a doctor but destiny had other plans. He stumbled into short-selling by accident when, while working for Gilford Securities as an analyst in Chicago, he issued his first stock report in the summer of 1982. The company was Baldwin-United Corporation, the piano maker turned financial services company. Chanos found that the company had a hefty debt load and what he called “liberal accounting practices,” a red flag that would come up throughout his search for investment opportunities time and time again. The stock kept climbing from $24, when Chanos first wrote the report, to about $50, before the inevitable tumble in early 1983, as Chanos’s thesis proved correct down to the T. The stock was trading at $3 by September 1983.

Eventually, industry legends Michael Steinhardt and George Soros wanted to know what other ideas Chanos had to short. He could see where the opportunities were and had the stamina to stand by his convictions. “I knew the problems inherent in being on the short side, but even when a stock was running up, it didn’t bother me much. I knew I was right,” says Chanos. It was a trade that few analysts could master so Chanos decided to strike while the iron was hot. If he could do institutional research—well documented and well researched—on flawed Fortune 500 companies, he realized, “people will pay me for this.” So he moved to New York to broaden his exposure at Atlantic Capital, a unit of Deutsche Bank. He quickly attracted clients like Fidelity Investments and Dreyfus Corporation. Chanos left Atlantic Capital after a “ridiculous” article in the
Wall Street Journal
, in which he had naively agreed to be quoted, had angered his bosses in Germany. The article painted short-sellers as evil speculators “specializing in sinking vulnerable stocks with barrages of bad-mouthing,” wrote Dean Rotbart, then a reporter for the newspaper. “They use facts when available, but some aren’t above innuendo, fabrications, and deceit to batter down a stock.”

At 27, Chanos decided to strike out on his own, getting backing from two venture capitalists, who wanted him to run a short portfolio for a wealthy family. Because it was relatively virgin territory, the playing field was very lucrative. “There wasn’t a lot of capital in the strategy,” Chanos recalls. The majority of the investors at Kynikos were wealthy individuals. Pension funds found it too risky even though the strategy was perfect for tax-exempt investors because profits from short-selling are treated as ordinary income. Short exposure also allowed clients to mitigate risk by giving them investments that weren’t correlated to the stock market. Kynikos’s Ursus Partners fund returned 35 percent before fees in 1986, compared with 18.6 for the S&P 500 Index. In 1987, it rose 26.7 percent while the benchmark index rose 5.1 percent.

The Contrarian Investor

Chanos’s view of the world has always been against the grain, and he runs his firm the same way. First and foremost, he identifies himself as a securities analyst, second as a portfolio manager, meaning, with Chanos, everything is bottom up. Despite what people might think when they see Kynikos making macro calls, all of it derives from work it does in companies. “That’s how we train our analysts and how we think about the portfolio. At the end of the day, we’re financial statement junkies. And we really enjoy digging into the numbers and looking at what makes the companies tick.”

Kynikos differentiates itself from other shops on the Street in many ways. Besides uncovering great ideas on the short side, Kynikos looks at its ideas with a longer time frame than many short portfolios. In one way, you could say Kynikos is a “value investor,” as Maggie Mahar suggests in her book
Bull!
Kynikos relies on its research in the fundamentals; he says the best bears are “financial detectives.”

But there’s a big difference: value investors profit from buying low and selling high, but short-sellers sell high and borrow low. The fund has been consistent over its 25 years, turning the portfolio over about once a year, which is slow by hedge fund standards. Chanos sees them as intermediate-term investments as opposed to short-term trades. But, Chanos explains, “there’s really a difference. In addition, we tend not to pursue small-cap ideas—and never have. We tend to always be in large and midcap ideas, which gives us liquidity in the short side that a lot of funds don’t have.” When Kynikos is long in its opportunity fund, it can be as hedges. For example, when the firm went short Chinese property stocks, it went long Macao casinos. “It could either be hedges or pair trades,” explains Chanos. “It could be where we’re long one auto company and short another. Or it could be intercapital arbitrages where we’re long the debt of a company and short the stock.” In other words, these kinds of hedges allow Kynikos to manage risks effectively.

On the management side, Kynikos stands apart from the pack as well by the way it has set up its research process for idea origination and processing. The typical hedge fund has a portfolio manager or several managers at the top. At the bottom are the junior analysts, the firm’s least experienced people, whose job is to find ideas for the portfolio managers.

According to Chanos, there are two types of ownership of an idea in an organization. There’s the intellectual ownership, which resides with the person who brought the idea to you, and then there’s economic ownership, which resides with the partners. When things go badly, you have a problem because the person with the intellectual ownership of the idea and the person with the economic ownership of the idea are in conflict. And there may be information flows that stop because the analyst doesn’t want to give any more bad news to the partners who had invested in the idea. So, there’s disproportionate risk and disproportionate reward. Chanos says: “We have a different approach, one in which the partners generate ideas—an investment theme, let’s say—and the analysts help to validate, build upon, or disprove those ideas. Our approach encourages intellectual curiosity, collaboration, and an openness.”

Chanos thinks pattern recognition is important and something that simply takes experience, which is one reason why he tasks the firm’s partners with originating the ideas. The partners have extensive experience in seeing patterns in odd-looking financial or press statements, for example. Through their mosaic of experience and wisdom, they are in the strongest position to decide what strategies to explore and not get distracted by the markets’ daily vagaries. Once a partner identifies an idea to pursue, the analysts process the idea, compiling the research to validate or disprove the thesis. Being financial detectives, Chanos says, is what short-sellers do. The analysts produce an idea memo and make a recommendation, either suggesting that the idea demands more research—or should be abandoned. “They may come back to me with an explanation for bad numbers,” Chanos explains, “or tell me the company has some great products coming down the line. They are never held accountable for price performance on a stock, but they are held accountable if they don’t provide the information needed. Our research team works very hard; they are key to the firm’s success.”