Good Places to Short

We hope we 've dissuaded you from shorting, but if we haven 't, we 'd like to share some advice that Jim Chanos gave when we interviewed him in 2005 about the categories for his best short ideas:4

What are the broad categories your ideas tend to fall into?

JC: The first and most lucrative are the booms that go bust. We've had our most success with debt-financed asset bubbles— as opposed to just plain asset bubbles—where there are ticking time bombs in terms of debt needing to be repaid, and where there are people ahead of the shareholders in the bankruptcy or workout process. The "debt-financed" distinction is important. It kept us from shorting the Internet in the 90s—that was a valuation bubble more than anything else.

A classic example here was the commercial real estate bubble in the late 1980s. More recently was the bursting of the telecom bubble. We made a lot of money on that—much more than on Enron, for which we get so much credit. We looked at a company like Lucent and discovered to our amazement that they were essentially financing their whole business through venture-capital investing in start-ups. They'd invest in a start-up, which would then take the equity money it got from Lucent to use it as a down payment for Lucent equipment. So Lucent would book a 10-year revenue commitment, backed by a very non-credit-worthy set of receivables, when no net new money had changed hands.

Speaking of potential asset bubbles, what 's your take on the residential housing market today?

JC: We've watched with amazement as this has played out, but we 're not short the homebuilders because they're getting their money out. By and large, it's the consumer who is leveraged and is going to be the patsy. When prices adjust, the effects are going to be very broad, but not as specific to companies as we 'd like to see as short sellers. Other than a pause in homebuilders ' activity levels, we don' t see most of them being in financial distress. . . .

What's the second broad category in which you've found good ideas?

JC: Technological obsolescence. Economists talk quite rightly about the benefits of "creative destruction," where new technologies and innovations advance mankind and grow GDPs. But such changes also render whole industries obsolete. Disruptive technologies have two sides and always have. You saw it in the 1980s as personal computers wiped out the word-processor and minicomputer markets.

What's playing out now is the transformation from an analog to a digital world. While that 's created great fortunes like Google 's, it 's also wiping out whole businesses. Traditional music retailing was one of the first to start going. Then came the ongoing problems in video rental. My value-investor friends buying Blockbuster are completely wrong. Studios selling DVDs directly through outlets like Wal-Mart is killing video rental, before we even talk about the rise of video-on-demand or piracy. . . .

Many of your past big winners have involved accounting irregularities. Is that still a fruitful area for you?

JC: No question. This can run the gamut from simple overstatement of earnings, often a gray area, to outright fraud. We 're trying to find cases where the economic reality is significantly divorced from the accounting presentation of the business. It's not GE managing earnings—everybody does that. We want to see something way beyond that, where management is going out of its way to mislead.

It could be the hiding of losses in offshore subsidiaries like Enron. It could be abusing mark-to-market accounting like Baldwin-United and many others. It could be Boston Chicken, a big winner for us in the 1990s, lending money to franchisees to cover losses and not reserving for the receivables.

The biggest abuse in accounting today, often legally, is in acquisition accounting. This is still wide open to management estimates for things like writing down assets, writing up liabilities and setting reserves. Often the target company, right before a purchase, is instructed to withhold sales and front-end expenses. Tyco was a master of that. Suddenly, right after the acquisition, things would look wildly accretive, but it was very misleading. When you get on that treadmill, you have to do bigger and bigger acquisitions to keep the game going.

Another general area in which there 's a real propensity for abuse is any case where companies are making long-term assumptions about the value of assets and have the ability to book them immediately into profits. We scrutinize that very carefully. . . .

Are there specific metrics you look for that signal problems with the numbers?

JC: Managements have gotten so good at playing Wall Street that I 've actually become more skeptical of the metrics they want you to focus on. For example, when people would question the earnings at Tyco, former management would say "There can't be anything wrong with earnings, just look at our cash flow."

It turns out that just about every cash-flow lever possible was being gamed at Tyco. Capital spending never seemed to grow, until you looked at the footnotes on future contingencies and saw they were calling everything operating leases that never showed up in the capital spending.

Any other broad categories where you find good ideas?

JC: The last big one would be consumer fads. This is when investors—typically retail investors—use recent experience to extrapolate ad infinitum into the future what is clearly a onetime growth ramp of a product. People are consistently way too optimistic and underestimate just how competitive the U.S. economy is in these types of things: Cabbage Patch Kids in the 1980s, NordicTrack in the early 1990s and, more recently, Salton with the George Foreman grills.

We're short Palm right now, based on the Treo Smartphone. It's a nifty product, but that's all they have. They lose money on their PDAs. And you have Samsung, Nokia, Sony Ericsson and everybody looking to have their own product like the Treo. The biggest problem is that Palm doesn 't control the Treo software—it's just a box. Boxes with chips in them tend to be very good shorts if that 's all they are. . . .

Before we turn to our analysis of MBIA and Wells Fargo, we 'll again repeat that, especially in this environment, for most people, we think shorting stocks is a very bad idea.

Chapter 12

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