The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (32 page)

Chanos says the portfolio manager and the partners make the decisions over how money in Kynikos’s funds is invested; in this way, intellectual ownership and economic ownership are married. Kynikos analysts are compensated on a staff basis, or on the firm’s profitability, instead of on their ideas alone. That’s why Chanos believes they can feel comfortable telling it like it is. “It’s a much more rigorous and intellectually honest model,” says Chanos. “And, consequently, no one’s screaming at the analysts when a stock blows up. That’s our responsibility. We take the heat because we are the ones who made the investment decision.” That doesn’t mean the analysts aren’t held responsible for their end, though. “We expect our analysts to do as thorough a job as possible in getting us all the information, positive or negative, as the idea develops so that we can constantly make those decisions to trim a position for capital reasons, or add to it because the information flow makes the case for doing so,” says Chanos. He thinks it’s a much more stable format for the firm than the traditional model, where there’s more turnover and the least experienced people are initiating the firm’s ideas as opposed to deepening their expertise in processing the partners’ ideas. Because he’s up front about its model, the firm’s turnover isn’t very high. In a year or two he may lose one or two people on a team of 20 analysts. “Our analysts are analysts through and through,” he says. “We’re looking for people that love to do research.”

The Secret Sauce of Short-Selling

First, some basics about short-selling. It’s a tough business. In bull markets, where a rising tide lifts even the weakest performers to high valuation levels, shorts must be right more often than they are wrong. The stocks may be hard to borrow. Governments have been imposing restraints and bans on certain short-selling activity, using short-sellers as scapegoats for the implosion of investment banks and sovereign debt woes.

While a percentage of short-selling is directional, meaning the investor has an adverse view of a company’s valuation based on an analysis of its financial statements or a sector outlook and hopes to profit when the stock falls or the sector weakens, hedging is another reason. Investors may be long in a sector but believe one or two companies will underperform; taking short positions may boost overall performance. Market and options makers may take short positions to balance order flow or hedge their long exposures. For convertible bonds, investors may boost yields through shorting the underlying security. In both cases, these strategies are “market neutral.”

Academics, by and large, are on the short-sellers’ side. Their research shows short-selling to improve markets to the benefit of investors by enriching price discovery, deepening liquidity, and acting as a pressure valve to deflate investors’ irrational exuberance. For analysts willing to do the work, digging for skeletons in companies’ closets is a very important part of the equation. And for that, Chanos believes you cannot beat financial statements. “It’s still far and away the best predictor of future corporate performance. There’s nothing better than analyzing the company’s numbers themselves to find the anomalies because modern GAAP is as much of an art as a science, as any good accountant will tell you.”

A company’s profitability is not a concrete number, but one that involves estimates, guesses, and accruals. And, therefore, what Chanos and his team are looking for is a real discrepancy between economic reality and the reported numbers and, furthermore, where an unscrupulous management team is pushing the accounting envelope, most of the time, legally. The difference, Chanos points out, is that the economic reality is very different from what the companies are saying, and that will only become apparent after some rigorous financial analysis. “As an analyst, you have to be very comfortable with the balance sheet, flow of funds statement, and very comfortable reading the footnotes. That’s blocking and tackling 101.”

So when business school students or undergraduates ask Chanos what they should study, he doesn’t hesitate: accounting. “Take practical courses in financial and corporate accounting. Because, at the end of the day, the language of business is numbers,” he says. “And 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.”

Beyond knowing your financials backwards and forwards, there is a certain attitude required to being a good short seller. When Chanos started in the business, he thought the skill set for an analyst on the long side is the same as that on the short side. He also thought it was a learnable skill. He quickly realized that all of the ancillary headaches associated with being a short-seller throw a lot of behavioral finance roadblocks in your way, which is challenging for many. “There’s this constant drumbeat of bullish spin every single day. And a lot of people don’t handle that well. They like positive reinforcement.” Now he believes short-sellers are born, not made, and that most people don’t function well in an environment of negative reinforcement. That is why, in part, he doesn’t expect his analysts to go on the line with short call positions. “That’s why I rely on those who have gone through the bull markets and manias and bubbles,” says Chanos. “And still, they, too, sometimes get caught up in the positive hype.”

So where does he find people with this inborn talent? Analysts at Kynikos have different backgrounds than analysts at other hedge funds, where a rigorous completion of a two- to three-year investment banking analyst program is required after graduating from a top school. While there are some of those, undeniably, one of the best analysts in the firm’s history was an art history major who worked for a wealthy family in the art department but was intellectually curious. Kynikos has also had some good success with journalists. “Young journalists are just always very good at training and asking good questions,” says Chanos. “First and foremost, you need to be facile with numbers but the second most important quality for our analysts is intellectual curiosity.”

Chanos stresses the importance of not taking anyone else’s word. He expects his analysts to come forward when they have hit a wall, too. “I love it when my analysts say ‘I don’t get this. Why is this number doing this?’ and ‘Is this normal?’ Those are the questions we love.” Chanos recalls with a chuckle the results of a 1998
Business Week
survey that asked Standard & Poor’s (S&P) 500 CFOs if they have ever been asked to materially falsify financial results by their superior. Fifty-five percent said they had been asked and never did it. Twelve percent said they had been asked and had done it. And 33 percent said they’ve never been asked. “What that told me was that two-thirds of the S&P 500 had asked their CFOs to materially falsify financial results at some point,” he says switching to a very serious tone. “So there’s a lot of agency risk in financial statements and relying on what somebody else is saying is very fraught with danger.”

Structurally flawed accounting is one of the four areas Chanos advises in lectures before business students, including his class at Yale’s School of Management. Another is booms that go bust. Throughout history, he shows how investors rushed into overvalued investments based on a “new” idea that “old” methods of valuation and analysis failed to understand. The Mississippi Company in the 1700s, the start of railroads in the United Kingdom and the United States in the nineteenth century, and more recently, dot-com companies—all experienced unsustainable run-ups that fraud, bubble physics, and investor guile facilitated. Consumer and corporate fads, too, drive companies to excessive valuations; remember the 1980s when leveraged buyouts (LBOs) were used frantically to acquire or expand? Investors like to extrapolate growth too far into the future than they should. And technological obsolescence can create short opportunities. Digitization of music and video overnight changed business models, for example, to take advantage of the Internet’s cost efficiencies for distribution. Everyone thinks, though, that the old product will last longer than it does.

Defending an Investment Strategy

As they have been throughout financial history, short-sellers are an easy scapegoat for government leaders when investors suffer losses. The rapidly unfolding financial crisis from 2008 onward saw the implosion of such investment banks as Bear Stearns and Lehman, and exposed the frailties of mortgage behemoths Fannie Mae and Freddie Mac. As the real estate market and mortgage business collapsed, the contagion spread to all sectors of the economy, ushering in the worst era for capital markets since the Great Depression. Private investment companies—including hedge funds—were also under fire.

Chanos was called to testify before Congress several times in 2009 as an expert witness on behalf of the Coalition of Private Investment Companies. In each appearance, he made several points. He showed how hedge funds enable qualified investors to more effectively manage risks with the potential to achieve above-average returns. He noted that hedge funds did not receive bailout funds from taxpayers as investment banks had during the financial crisis. He also endorsed the drafting of a “special ‘Private Investment Company’ statute, specifically tailored for SEC regulation of private investment funds.” This legislation, he said, “should require registration of private funds with the SEC; provide that each such fund and its investment manager be subject to SEC inspection and enforcement authority, just as mutual funds and registered investment advisers are; require custody and audit protections to prevent theft, Ponzi schemes, and fraud; should also require robust disclosures to investors, counterparties, and lenders; require that private funds provide basic census data in an online publicly available form; require that they implement anti–money laundering programs, just as broker-dealers, banks, and open-end investment companies must do; and, for larger funds, require the adoption of risk management plans to identify and control material risks, as well as plans to address orderly wind-downs. The Coalition of Private Investment Companies believes that these statutory requirements would benefit investors by putting into place a comprehensive regulatory framework that enhances the ability of regulators to monitor and address systemic risks while providing clearer authority to prevent fraud and other illegal actions. Our approach strives for the highest standards of prevention without eliminating the beneficial effects of responsible innovation.”

In the end, the SEC toughened antifraud provisions and tightened custody requirements, while Congress cleared registration requirements for investment advisers along the lines that Chanos had proposed.

As to the “un-American, unpatriotic” short-sellers, he noted how they were responsible for uncovering many infamous financial disasters during the past decade. They often are the ones wearing the white hats when it comes to looking for and identifying the bad guys. During the financial crisis, Chanos recounts a phone call from Bear Stearns’s CEO, who asked him to make calming public statements that the then nation’s fifth largest investment bank was fine and that Kynikos had funds on deposit with them. “Here they were trying to co-opt a short seller to tell the market everything was fine. Talk about misdirection,” he told the press then. Bear Stearns was one of the biggest underwriters of complex investments linked to mortgages. Investors had grown increasingly skeptical that it could continue repaying its loans or honor its counterparty obligations in complex agreements with other financial institutions.

But a groundswell of antishort initiatives emerged. Then SEC Chairman Christopher Cox imposed an unprecedented three-week ban in September 2008 on short-selling of 799 “financial” companies’ stock. Worldwide, regulators also imposed various constraints, a pattern that has continued with the euro-debt crisis. Cox later confessed to the
Washington Post
that that decision was the biggest mistake of his tenure, pointing to the pressure from Treasury Secretary Henry M. Paulson, Jr., and Fed Chairman Ben S. Bernanke.

Many academic studies bear out Cox’s regrets, showing that the bans reduced liquidity, slowed down price discovery, widened spreads, and failed to support stock prices. Another consequence: legitimate trading strategies, including long trades, were impeded.

China’s Coming Crisis

“We certainly weren’t the first on this idea,” Chanos tells me at his offices in April of 2011 about the biggest short position of his life: The People’s Republic of China. Chanos first spoke publicly about his grand stake in China over a year and a half ago on CNBC’s
Squawk Box
in December 2009. “Right now, we’re as bearish on China as we’ve ever been,” he says. He followed that with a presentation at St. Hilda’s College, Oxford in January 2010, “The China Syndrome: Warning signs ahead for the global economy.”

Chanos argued that China, fearing a sharp slowdown from the financial crisis, pumped credit into asset growth—mainly real estate but new roads and high-speed rail, too. There were “classic pockets of overheating, of overindulgence” he said in his presentation. Fixed asset investments as a percentage of China’s gross domestic product (GDP) were exceeding 50 percent—a “sh-a chén bào” (sandstorm) of money, he said. The stimulus was massive: $586 billion, or 14 percent of GDP (the U.S. package was $787 billion, or 6 percent of GDP). With state-owned enterprises controlling 50 percent of industrial assets, and not being driven by the need to make profits, and local party officials dictating the real estate development process, large-scale capital projects were growing “sillier by the day,” including rising industrial and manufacturing overcapacity. There were empty cities, such as Ordos, and lonely malls, such as the New South China Mall. News reports showed new buildings toppling from shoddy construction. It was the latest chapter in China’s history of credit-fueled booms and busts. China was “letting a thousand Dubais bloom,” he quipped. “Go to Dubai and see what happened. It was . . . what I call the ‘Edifice complex.’”