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Stepan Lavrouk
Stepan Lavrouk
Articles (288) 

Jim Chanos: Investment Philosophy and the Role of Short-Sellers

The master short-seller targets 5 different types of shorts

August 23, 2019

Jim Chanos (Trades, Portfolio) is one of the most well-known short sellers on Wall Street. He is the president and founder of Kynikos Associates, a short-focused hedge fund. At an interview at the Prime Quadrant Investment Conference in 2016, Chanos took the time to give his perspective on a range of topics, from the role of short-sellers in the financial marketplace to his overarching investment philosophy.

Like the free press

Short-sellers have somewhat of a mixed reputation. They are frequently accused of market manipulation and the spreading of false negative news. Chanos said that this is not a fair representation:

“The part of short-selling that gets short-shrifted, if you will, is that short-sellers are the real-time financial detectives. I’ve always said that the regulators and law enforcement, in the financial sense, are financial archeologists. They’ll always tell you five or ten years later what happened - with some degree of clarity - but that doesn’t help the people in the room, doesn’t help investors.

There’s an awful lot of bad stuff going on in the financial markets, has been for 400 years. That’s not gonna change. And having an active, skeptical short selling community in the marketplace is like having the free press. I think it’s essential to the way markets operate.”

Company managements naturally want to present their results in the best possible light. They face pressure from the market, from shareholders and from their own bosses. Most of the time, there is nothing really wrong with this, provided everyone is acting in good faith. However, this is not always the case. Chanos said that investors should remember business is not that easy, and if something sounds too good to be true, then it probably is.

Investment philosophy

Chanos outlined several types of situation that Kynikos likes to target.

Booms that go bust. Chanos defines this as “any credit-driven asset inflation where the cash flow of the asset being purchased with debt does not service the debt.” So in the late nineties, he was less interested in the dot-com bubble per se, and is more interested in the debt-financed telecoms buildout of the same period. Similarly, he likes targeting real estate bubbles, as they are typically debt-financed toward the end.

Technological obsolescence. Seemingly invincible businesses like Kodak or Blockbuster who fail to anticipate the impact of technological development fall by the wayside. Here Chanos looks for companies that are not “depreciating their capital bases fast enough to offset the technological risks to their business and find themselves in deep trouble.”

Companies that grow by acquisition. “One of the last great legal areas of fraud.” Companies that use M&A activity to either line the pockets of executives or conceal accounting irregularities.

Consumer fads. Consumers and the media become obsessed with a particular product and forecast exponential growth. The problem is that at a certain point the market for these products becomes saturated and the stocks come crashing back down.

Classic arbitrage. “Any time we can sell a dollar for two dollars.” Special situations where tightly correlated securities trade at widely divergent prices. For instance, when the Berlin Wall fell, Japanese investors became heavy buyers of European closed-end country funds on the assumption that Europe would enter a bull market. The buying was so frenzied that the price of these funds far outstripped the price of the underlying securities.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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