Jim Chanos (Trades, Portfolio) is probably one of the most well-known short sellers in the business. In the course of his career, he has become an expert in the key skill that all investors on his side of the market need to have: the ability to spot fraud. He recently appeared on a Bloomberg podcast to give advice on the art and science of shortselling
Don’t try to be faster, try to be smarter
Chanos’s Kynikos makes its money by constructing short portfolios for clients who want to hedge their market exposure by targeting fraudulent or simply overvalued companies. He refers to himself (somewhat jokingly) as being in the insurance business; his goal is to minimize downside risk for long side clients, and to do so more efficiently than by simply selling futures.
As everyone knows, markets have gotten immeasurably faster over the last few decades. It used to be the case that investors and traders could get public information faster than their peers, but now everyone with a Reuters terminal gets the data at the same time. Automated investing and trading strategies have made it basically impossible for humans to move faster. For instance, there are programs that will scan regulatory filings as soon as they become public and will buy or sell based on particular word choices.
However, there is one drawback to such a system, and that is that the machines have no way of knowing whether the information being acted on is factually correct. This is where short sellers like Chanos find their edge. They look for information that is intentionally misleading, where machine-powered buying or selling can create good opportunities.
Chanos says that a big problem for shortsellers is the threat of retaliation by the companies that they are betting against, which is why many (but not all) of them don’t like to publicize their positions:
“There’s lots of asymmetries on the short side, and one of them is that corporate managements don’t like to be held to account by shortsellers - by and large - and often will use shareholder fund to harass or litigate against shortsellers under the guise of protecting the company. And number two, all things being equal, as any businessman you’d rather keep proprietary what you’d like to keep proprietary and only issue public [statements] that you have to. One of the odd paradoxes of that is that I’ve always wondered why the money management industry has not fought back against the SEC’s disclosure rules for long investors.”
So not only do most shortsellers want to avoid litigation, they also don’t like to give away their edge. The second part of Chanos’s comment is worth examining. Long investors are required by law to disclose their holdings to the public, which essentially means that they have to give up their intellectual property for free. This is an interesting take on disclosure that I hadn’t really considered before; if you are a large investor with little turnover in your portfolio, you are required by law to give others the opportunity to piggyback on your work by tracking your actions, while shortsellers do not have to give away their edge in this manner.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Stanley Druckenmiller: Risk-Reward Is Not Good Right Now
- Seth Klarman: Reducing Portfolio Risk
- Howard Marks: Why We Need Recessions and Bankruptcies
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