Jim Chanos Is Not a Fan of IBM

Kynikos Associates has a short position in the venerable technology company

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Dec 09, 2020
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Kynikos Associates leader Jim Chanos (Trades, Portfolio) is a well-known short seller who has made a living by betting against fraudulent businesses. He is an expert in this field and teaches a class at the Yale School of Management about the history of financial fraud. It's important to note that "fraudulent" doesn't necessarily mean "illegal" - often, the businesses Chanos bets against do not engage in any criminal activity - they just take advantage of accounting regulations that allow them to misrepresent their financial information.

In a recent interview with Bloomberg, Chanos explained how the "fraud cycle" proliferates. He also explained why his firm is short International Business Machines Corp. (IBM, Financial).

The fraud cycle tracks the market cycle

Chanos has said on multiple occasions that the universe of potential short opportunities grows and shrinks with the wider market. Investor largesse inevitably leads to bad actors taking advantage of the system:

"The fraud cycle follows the financial cycle with a lag. The longer that a bull market goes, the more people's sense of disbelief erodes, and they begin to believe things that are too good to be true...The willingness of markets to buy outright frauds where the evidence is all laid out for them has never been higher. I harken back to the Wirecard (XTER:WDI, Financial) episode - for the better part of 18 months, shortsellers and journalists were pointing out a fact pattern that would almost inescapably lead you to believe that there was wholesale fraud going on."

Despite the clear evidence of wrongdoing by Wirecard, investors only soured on the German payment company when management was forced to admit to having engaged in fraudulent activities. This episode underscores an important (and often overlooked) fact about markets: It is possible for the stock of a fraudulent company to trade higher and higher, even as more and more damning evidence comes out. The driving force behind this phenomenon is a suspension of disbelief by investors who are willing to ignore corporate wrongdoing until businesses themselves admit to them. Indeed, this is one of the reasons why short selling can be so frustrating, and why there are relatively few successful short sellers.

Not hot on IBM

Chanos believes IBM has been taking advantage of accounting conventions to put itself in a more favorable financial light, which can be discerned by looking through publicly available financial documents. He points out that simply adding together the company's operating earnings and its intellectual property royalties, then subtracting interest payments and the usual 21% corporate tax rate from the figure demonstrates the real earnings for the tech company in 2020 will be $6 a share. Compare this with the venerable technology giant's stated earnings of $9 a share - Chanos is suggesting IBM is overstating its earnings by 50%.

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The divergence between Kynikos' estimates for IBM's earnings and the company's official forecasts only increases in 2021 and 2022. The company's revenue has been steadily falling over the last 10 years, so Chanos doesn't believe this is a recipe for increasing per-share earnings.

Disclosure: The author owns no stocks mentioned.

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