Short selling is a tough business. The upside is 100% at most whereas the downside is infinite. Jim Chanos is among the most successful and longest lasting short sellers in the world. He launched his fund in 1985. According to Institutional Investor between 1985 and 2017, Chanos' short stock portfolio lost 0.7% annually. That means if you invested $1 million in Chanos' short portfolio in 1985 (keep in mind that Chanos is one of the most successful short sellers ever), your investment would have shrank to $725 thousand by the end of 2017. So, how is this an accomplishment? Why is Jim Chanos considered to be so successful? How did he become a billionaire by losing money shorting stocks?
The answer is relative performance. A short seller is successful if his short stock picks return less than the market. If the S&P 500 Index returns 15% in one year and a short seller's stock picks gain 10%, professional investors still consider this short seller "successful" even though he loses 10% of this capital. Why? Because short sellers don't just short sell. That's what Chanos did. His Kynikos Capital Partners is actually 190% long and 90% short. His net market exposure is really around 100%. Even though Chanos lost 0.7% annually on the short side of his portfolio, these short positions allowed him to lever up on the long side of his portfolio. Overall, Kynikos Capital Partners returned 28.6% annually between 1985 and 2017, thanks to its 190% long exposure which was enabled by its 90% short exposure.
Labeled as one of Wall Street's best-known stock pickers on the short side, Kynikos Founder and President, Jim Chanos sees a 'Golden Age of Fraud' in the speculative market. In an interview with Bloomberg, he said, "They begin to believe things that are too good to be true," talking about the willingness of the public to 'buy' even if there is evidence of fraud laid out.
Jim Chanos puppeteer
Aside from being Kynikos' Founder and President, Jim S. Chanos is an American Investment Manager and a Certified Investment advisor who is an expert in short selling and specializes in looking for legal frauds. Kynikos Associates on the other hand is an investment advisory firm that he founded in 1985.
"The longer a bull market goes, the more sense of disbelief erodes". Chanos, like the other investors, assumed that 2020 will be a write-off. It certainly is easier to find good shorts in 2020 but for him, they're just not working. He said that there are companies that have large problems and are 'mind-numbingly' expensive but the market just 'does not' care about the facts. According to Jim Chanos, the 'zero-interest-rate' made it worse for the short sellers to make a profit. But he warned the bullish investors to not feel so 'relaxed' about the Fed's effort to help raise the economy. "That's a very dangerous sort of place to be because you're completely counting on the Government to always make a you whole."
Jim's short portfolio is intended to serve as an insurance policy for clients who want to hedge their own long positions. "They're looking at the Fed as their insurance policy, not the marketplace. People are quite interested in fundamental shorts but then they shrug their shoulders and say, 'I don't really need it because the Government got my back". For him, this kind of thinking is a very dangerous assumption for market participants to have.
"Normally, we're right about 2/3 of our positions and sometimes as high as 70% and I would say that the opposite has happened now." He shared that just recently, they've been right on about 1/3 of their positions and wrong on the 2/3. For Chanos, the valuations in 2021 or even in 2022 would make no sense if we will value these businesses based on where they were in 2019.
According to Jim, there are people who believe in non-sense things for a very long time and he 'emphasized' that you must want to play with these people. "You want to be in a marketplace and bet against people doing really dumb things with their money...Right now, people are doing dumb things with their money". He marked that if you're playing properly, then you're going to come out ahead of other people.
Talking about tech stocks, Jim Chanos has nothing to say but purely positive reviews. He stated that a lot of bigger big cap tech stocks are 'pretty good' businesses. Jim Chanos mentioned Facebook (NASDAQ: FB), Google (NASDAQ: GOOGL), and Apple (NASDAQ:AAPL) as examples of tech stocks that get a very high return on capital and have high positive cash flow. He said that he would 'not' probably short some of those big tech names even if there's a possible regulation in place with the new administration.
"I think that the incoming administration is not going to be anti-market. I do think they probably will be tougher on bad actors in the market." Jim Chanos thoroughly dubbed the current market environment as the "Golden Age of Fraud". He hopes that the new administration will toughen the cops on the beat and that will be a good thing for everyone.
Jim Chanos stated that the fraud cycle follows the financial cycle with a lag. People start to believe things that are too good to be true even if short-sellers and journalists are pointing out a fact pattern that would lead others to believe that there was a wholesale fraud going on. "It's absolutely remarkable to me as to how many instances of outright fraud are sort of hiding in plain sight and investors continue to buy the shares of these companies because the companies themselves haven't admitted it yet." He also said that these fraud companies 'outperform' the market until they admit their wrongdoing. "That's one of the reasons why I think that risks in this market are much higher than people think.". For him, if people are willing to believe criminals until the criminals themselves admit the crime, then we have a very speculative market in place.
The prime example of legal fraud according to Jim Chanos is Enron, where everything they did was legal. "It just depends on the magnitude of what the company is trying to pass off as legal under the accounting or regulatory rules." He also mentioned that the recent poster child of fraud was Valeant Pharmaceuticals which went from $10 to $260 then back to $10 because it was able to convince investors that its earnings per share were $12 when in fact, they were actually losing money but still, everything they did was legal.
Jim Chanos marked that 30% of their portfolio is composed of companies they suspect to have legal or illegal frauds because they found something wrong with their financial statements. He explained that most shorts are caused by business model issues or business environment issues and not actual fraud. "But now, we are actually seeing instances of fraud." he proclaimed.
Speaking of Tech stocks, Tesla's EV is certainly the market leader right now but according to Jim Chanos, Tesla (NASDAQ:TSLA), 'also has a problem'. "It's really a business model and valuation issue with Tesla.". Tesla is trading at half a trillion dollars at the time of the interview and it had a revenue of $30 billion but he said that there is something they do not want in their accounting. Despite what everyone says, Tesla will still be an automobile company that competes with other companies that make cars. Chanos said that 'Tesla is the stock where people pin their hopes and dreams'. "For some holders, it's an EV company. For other holders its a clean energy company. For other holders it's an autonomous vehicle company... It's whatever people want to believe." Jim then pointed out that, "For the trailing 12 months, Tesla 'has not made' any money selling cars. Whatever profit they've shown, it's been very very low and it's from selling tax credits." So despite the market leadership and the selling of 50,000 cars on average, they're still 'not'
making any money and if Jim will be able to meet Elon Musk someday, he'll say "Job well done, so far".
Tesla
"It's been painfully clearly but I will say for the first 4 years of those 5 years, it was actually not a bad short," Jim said that he still holds a position in Tesla. Despite these things that happened to Tesla, he mentioned that they were able to found lots of other things that are maybe even crazier than Tesla.
Jim Chanos also explained that in shorting, they use a percent of capital approach for risk management because if they use stop losses, they could have been stopped out from every single great position they ever had. "Calibrating positions on a percent of capital basis for us has worked better," he admitted.
He was then questioned if Tesla is a good thing for the S&P 500 Index. "A lot of people have bought the stock recently because its going into the S&P 500. I would want to point out to them that one of the ways to beat the S&P was to own Tesla over the past couple of years.".
Chanos said that 'they still like Tesla' but there are so many better stocks for them to trade now. "Probably my highest conviction is an idea that will surprise the viewers. It's a company that nobody's heard of called IBM (NYSE:IBM)." He said that IBM is a 'value trap' and they had a lot of success through the years in companies that looked cheap but have had structural fundamental problems. "The company (IBM) we think, is still engaging in basically accounting high jinx. And it's hiding all in plain sight if you take a look at their numbers." Jim added that IBM was supposed to earn $9 pro forma in 2020 but the actual number was just $6. He thinks that it's going to be only $5 dollars this year and $4 in 2022. "IBM increasingly has engaged in lots of games to do this and the latest one is they're going to do a spin-off and now take a lot of charges, that they're going to ask you to add back as part of the adjusted earnings so that the actual gap earnings don't look so bad". Jim Chanos said that IBM tried to do this thing about 5 years ago and they can only do this sort of 'illusion' for a short period of time. For him, we're in a period where IBM will sooner or later announce that "we're not really earning $9, $12 or $13. We're actually earning $6, $5 and $4. And it's going to be the next reset.".
ibm, building, business, sign, wall, uk, laptop, tech fair, corporation, office automation, worldwide, international business, international fair, innovation, hardware, london,
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As for commercial real estate, the reopening will be beneficial for things like hospitality and retail. Jim Chanos marked that commercial real estate peaked in 2018 and rents have been 'declining' ever since while the department store sales peaked in the year 2000. He said there have been real pressures that were happening in real estate even before the pandemic. "The reason we're negative on real estate is due to interest rates and that cap rates in which people capitalize cash flows in the real estate business are back at all-time lows, meaning valuations on a dollar cash flow are at all-time highs.". He mentioned that this one is caused by the Fed's zero-interest-rate and because of people's belief that interest rates will never go up again. Jim cited SL Green Realty (NYSE:SLG) and Vornado Realty Trust (NYSE:VNO) as examples of REIT's that backed down to the lows we saw in 2018-2019. "The reason why some of these REITs are still lower is that the cash flows are down 30% YOY. And it's fascinating to us that people have sort of disregarded the cash flows were dropping before the pandemic and are going to stay under pressure because of oversupply of office space or retail space.". Jim thinks that the oversupply brought multiples back from all-time high to all-time low cap rates and it's the risk that investors have to take in commercial real estate. He is also certain that cash flows are going to continually decline even after the pandemic. According to Jim Chanos, there's going to be a 'very interesting opportunity' in the public markets versus the private markets in the commercial real estate since the need for office and retail space is going to be challenged as more retailers go out of business and landlords will be forced to cut rents due to the fact that the 'work from home' set up is now a trend.
Let’s now start to look at short selling legend Jim Chanos' top 10 stock picks:
10. WisdomTree Europe Hedged Equity Fund (HEDJ)
Chanos had $972 thousand invested in HEDJ at the end of September. During the third quarter he boosted his stake in HEDJ by 113%.
"WisdomTree Europe Hedged Equity Fund seeks to provide exposure to the European equity market while hedging exposure to fluctuations between the U.S. dollar and the euro," according to WisdomTree.
HEDJ invests in Eurozone stocks that pay dividends. It is hedged to neutralize the exchange rate fluctuations between USD and EUR. They were able to achieve a decent return of 6.5% annually over the last 5 years. The top three stock holdings of this hedged European ETF are Sanofi SA(NASDAQ: SNY), Unilever(NYSE: UL), and LVMH.
9. iShares MSCI Emerging Markets ETF (EEM)
Chanos had $1.1 million invested in EEM according to the latest 13F filing. EEM has an objective that seeks to monitor the overall quality performance of a market index that is a build-up of rising mid to large capitalizations market equities using a representative sampling indexing strategy.
They also offer effortless access to a variety of 800+ emerging market stocks. The funds' purpose is to be used as a segment of wider asset allocation strategies per se.
iShares focus more on the future term in order to achieve its goal to diversify globally and to seek long term growth. Alibaba (NYSE: BABA) and Tencent are among the funds' top three holdings as they try to beat their own annual return performance of 12.14% for the last 5 years.
8. Health Care Select Sector SPDR Fund (XLV)
Jim Chanos had $1.1 million in XLV at the end of September. The funds' primary focus is to impart itself to be exposed to health-related industries, whether it be in biotechnology, pharmaceuticals, or even in health care providers and services.
XLV aims to produce outstanding results through their specific choice of health-related stocks that can be found in the S&P 500 Index. They have $26,332.70 million in Assets Under Management as of January 7, 2021.
Health Care Select Sector SPDR Fund has achieved an overwhelming annual return of 11.43% for the last five years. The holdings in XLV are composed of pacesetter companies that work on the Coronavirus vaccine. Their top three stocks are Johnson & Johnson(NYSE: JNJ), UnitedHealth Group, and Merck & Co. Inc.(NYSE: MRK)
7. iShares Core S&P 500 ETF (IVV)
Chanos had $1.5 million in IVV at the end of September. IVV's mission is to primarily be intact with large-cap American companies, where they provide cheap and tax-efficient access to these equities in their search for long-term growth.
This market index fund's top three holdings are, as expected, Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), and Amazon (NASDAQ: AMZN). IVV was able to accumulate a huge 15.18% annual return for the last five years. As you can see Chanos isn't trying to fight the market, he is just trying to enhance his returns by shorting the overvalued stocks and reinvesting the proceeds indirectly into the biggest names in the market.
6. Technology Select Sector SPDR Fund (XLK)
Chanos had $2.2 million invested in XLK at the end of September. According to XLK, "The Technology Select Sector SPDR Fund seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Technology Select Sector Index".
Known to be one of the most popular ETF that invests in large-cap equities, XLK focuses mainly to be part of the different technology-related companies in a more prudent strategy rather than the conventional way of investing.
XLK has achieved a milestone consistency of 26.72% annual return for the last 5 years, with Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), and Visa (NYSE: V) as their top 3 holdings.