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John Emerson
John Emerson
Articles (106) 

Montier and Chanos on the Portrait of a Short Candidate

August 12, 2011 | About:
"They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and enforcement agencies don’t seem able to prevent." — Seth Klarman on short-sellers

Outside a limited circle of value investors, short-sellers are almost universally reviled. They are the classic scapegoats of the market, frequently portrayed as greedy purveyors of false information who operate without a code of ethics. In most cases, nothing is further from the truth; the possible exception would be "shorts" who make their living by falsely undermining the credit-worthiness of key financial institutions.

In most cases successful shorts are the smartest and the gutsiest people in the room. They have to be sharper and more diligent than the average investor since their upward losses are not capped. They help keep investing bubbles in check as well as policing the market with much more effectiveness than the SEC. Despite that fact a typical investor will generally side with "crooked management" to the bitter end, even if a preponderance of evidence exists which clearly reveals their fraudulent activities.

The systemic fraud which has been recently uncovered in Chinese RTOs is a perfect example. The shorts served as the "market detectives" who exposed the fact that countless Chinese companies, created by reverse mergers, were defrauding US investors out of billions of dollars on an ongoing basis. The "shorts" that unveiled the situation are still detested by the majority of the shareholders even though they provided evidence of deceit long before the stocks were halted and ultimately delisted. The Muddy Waters and the Citrons of the world should be lauded for their actions in uncovering the deceit; the fact that they profited handsomely is not material.

Today's article will focus on the suggestions and observations of Jim Chanos and James Montier in regard to selecting short candidates. Even if one never shorts a stock, their analysis is helpful in identifying stocks which have no place in one's portfolio.

Montier's Unholy Trinity

If you have been reading my articles you are probably aware of the fact that I am a huge fan of James Montier. I consider him to be one of the most under-appreciated members of the value community. His writing style is not only entertaining but also extremely educational, sort of like listening to a high quality sports analyst who dazzles his listeners with statistics and observations which are pertinent to the game without resorting to standard cliches. His gift lies not only in his insight but also in his ability to communicate his message in an amusing manner.

In Chapter 24 of the investment classic, "Value Investing — Tools and Techniques for Intelligent Investment," Montier points out what he refers to as the "Unholy Trinity" of short selection:

1) A high price to sales ratio, greater than one

2) A low Piotroski score, lower than three

3) High total asset growth, greater than 10%

The idea was to create a stock screen which identified companies that were overpriced, fundamentally flawed, and exhibited a lack of capital discipline. Montier cites extensive research conducted over various markets with differing time frames which indicates that these specific factors result in significant market under performance.

In essence, Montier has created a short screen which projects the portrait of an undesirable company in terms of its valuation metrics, operating efficiencies and a management which lacks capital discipline.

The screen was back tested using European stocks which were rebalanced annually from a period spanning from 1985 to 2007. The body of stocks identified declined by an average of approximately 6% per annum while the market appreciated at a rate of 13% per annum. Montier claims that when he tested the screen on US stocks it produced similar numbers.

Suprisingly, the screen identified some stocks which produced outstanding results on the positive side. To counteract that tendency Montier retested the screen using a 20% stop loss criteria; the result was an average gain of approximately 13% per annum as opposed to 6%.

It appears that the short screen inadvertently identifies a certain amount of high flyers which dramatically drag down the long-term results of the screen. By initiating stop loss triggers at a 20% threshold, the damage to the overall short portfolio was more than cut in half. It seems that Whitney Tilson uncovered just that type of phenomenon when he shorted Netflix (NASDAQ:NFLX). He also followed the strategy of the screen by covering his position after he experienced a limited amount of damage to his portfolio.

The US screen averaged 30 qualifying stock per year. However, at certain periods the sampling was reduced to under 20 qualifying stocks. Not surprising at the end of the sampling period in 2007, a staggering total of 174 stocks qualified as short candidates. The obvious conclusion is that investors should consider enlisting a shorting strategy when the market becomes significantly overvalued. If they do not choose to short equities they might be well served to at least raise some cash.

Jim Chanos and the Power of Negative Thinking

Jim Chanos arrived on Wall St. in the early 1980s and he wasted little time in establishing his acumen for identifying short candidates. In 1982 at the tender age of 24, Chanos raised the ire of Wall St. investment houses and the chairman of the board at Baldwin-United by issuing a negative research report on the company. Although he was threatened with lawsuits by the company he held firm on his negative stance and he was vindicated when the company's stock soon dropped from over 50 to the 5-dollar range. In 1983 the company filed for Chapter 11 bankruptcy. The story is recounted in Thorton O'Glove's investment classic, "Quality of Earnings."

In 2010 Chanos delivered a speech at a CFA annual conference entitled "The Power of Negative Thinking." The following is a transcript of the entire speech: http://www.marketfolly.com/2010/06/jim-chanos-on-short-selling-power-of.html

Contrary to popular belief it appears that the guys wearing the "white hats" are frequently the short sellers. Chanos points out that every act of fraud in the last 25 years was detected by either a whistle blower or a member of the short community.

Chanos further notes that short-sellers are instrumental in keeping the market reasonably efficient. Without "frictionless" short-selling the equilibrium of markets is severely compromised; Chanos noted that CAPM theory is based upon the concept.

He further noted that 67% of CFOs reported that they were asked to "cook the books" at some time. Without the diligence of the short-selling community reviewing and reporting questionable financial data submitted by the company, such matters would generally go unreported. One has to ponder the role of auditors in light of that revelation.

Chanos reveals four recurring themes in short selling:

  1. Booms that go bust – define boom as anything fueled by debt in which the cash flows produced by the asset do not cover the cost of the debt. The Internet is not a boom since it didn’t have debt. The Telecom Bubble that went along with it was.
  2. Consumer Fads – investors like to extrapolate strong growth well further into the future than they should. It’s also a great source of decoration for your office: He’s got a Cabbage Patch Kid next to a George Foreman Grill next to a Nordic Trak.
  3. Technological Obsolescence – Everyone thinks the old product will last longer than it actually does. Examples were Wang Word Processors (replaced by PCs) and record stores (replaced by digital downloads). He says the Internet is the cheapest way to distribute anything. However, people are still renting DVDs by mail, which surprises him (Hint: likely short Netflix!). These businesses always look cheap but the cash flow goes down just as fast as the share price (think Kodak (EK) and film).
  4. Structurally-Flawed Accounting – beware serial acquirers, they often write down the assets of the acquired firm in the stub period that no one sees. Ask management what the net assets of the firm were on their latest end of quarter and what they were when they were acquired. Most management won’t tell you this; some will, however. But by writing down inventory and A/R they can “spring load” results once the company is acquired. They’re supposed to adjust the purchase price but most don’t.

Contrary to their perception, short-sellers serve a number of essential market functions which generally go unappreciated by most investors. They help to prevent market bubbles as well as scrutinize the financials of publicly traded companies. In that regard, along with whistle blowers they serve as the market detectives, a job which most investors mistakenly attribute to company auditors and to the Security and Exchange Commission.

Even if an investor never engages in short-selling they are behooved to pay attention to actions and techniques of the short community. Short analysis is highly fundamental in nature and frequently reveals deteriorating businesses and sometimes outright fraud.

When a serious short position turns up in a stock which an investor holds, the investor is well advised to scrutinize the reasons that the short position has increased. In many cases the shorts have entered for good reason and shareholders should engage in extra diligence to identify if their position is in peril.

Short sellers were almost entirely responsible for uncovering the rampant fraud in dozens of Chinese RTOs. If investors had paid heed to their warnings they would have been able to exit their positions long before their stocks were halted and ultimately delisted.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

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