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Commentary

Jim Chanos on Shorting

This is a prepared statement Jim Chanos gave to the SEC back in 2003. It is interesting because it shines a little light on his methodology for successfully shorting as he goes through an in-depth case study on his short of Enron. Before I dig into his Enron short, I want to mention this quote he uses in his testimony as it is quite interesting.

“If you own shares in a company that declares war on short sellers, there is only one thing to do: sell your stake. That’s the message in a new study by Owen A. Lamont, associate professor of finance at the University of Chicago’s graduate school of business. The study, which covers 1977 to 2002, shows not only that the stocks of companies who try to thwart short sellers are generally overpriced, but also that short sellers are often dead right.”

We touched on this in How Eric Sprott got Solar Burn. Warning sign number six was “The company lashed out against its critics”.   The Wall Street Journal coined the term “Being Einhorned” today, but if I remember correctly, some of Einhorn’s best shorts have been the ones where the company most vigorously lashed back out at him. Lehman, Allied and Green Mountain come to mind.

Some takeaways from Chanos’s short of Enron:

Sometimes the best ideas are hiding in plain sight

“In October of 2000, a friend asked me if I had seen an interesting article in The Texas Wall Street Journal, which is a regional edition, about accounting practices at large energy trading firms. The article, written by Jonathan Weil, pointed out that many of these firms, including Enron, employed the so-called “gain-on-sale” accounting method for their long-term energy trades. Basically, “gain-on-sale” accounting allows a company to estimate the future profitability of a trade made today and book a profit today based on the present value of those estimated future profits.”

Even though Enron was incredibly complex, Chanos started with just the annual report

“The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the SEC. “

The major red flags were visible right away if you understood the accounting and had a sense for what the returns should look like

“What immediately struck us was that despite using the “gain-on- sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7 percent before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm, a 7 percent return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7 percent and probably closer to 9 percent, which meant from an economic point of view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000 for our clients.”

“We were also troubled by Enron’s cryptic disclosure regarding various “related party transactions” described in its 1999 Form 10-K, as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for its March, June and September quarters. We read the footnotes in Enron’s financial statements about these transactions over and over again and we could not decipher what impact they had on Enron’s overall financial condition. It did seem strange to us, however, that Enron had organized these entities for the apparent purpose of trading with their parent company, and that they were run by an Enron executive. Another disturbing factor in our review of Enron’s situation was what we perceived to be the large amount of insider selling of Enron stock by Enron’s senior executives. While not damning by itself, such selling in conjunction with our other financial concerns added to our conviction.”

Enron defenders sounded a lot like those who have invested in ponzi schemes.

Beginning in January 2001, we spoke with a number of analysts at various Wall Street firms to discuss Enron and its valuation. We were struck by how many of them conceded that there was no way to analyze Enron, but that investing in Enron was instead a “trust me” story. One analyst, while admitting that Enron was a “black box” regarding profits, said that, as long as Enron delivered, who was he to argue.

It is clear he was doing some digging beyond just looking at the filings (bolding mine)

“In the spring of 2001, we heard reports, later confirmed by Enron, that a number of senior executives were departing from the company.”

And finally, Chanos divulges what in his opinion is the biggest red flag

To us, however, the most important story in August of 2001 was the abrupt resignation of Enron’s CEO, Jeff Skilling, for “personal reasons.” In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what “official” reason is given. Because we viewed Skilling as the architect of the present Enron, his abrupt departure was the most ominous development yet. Kynikos Associates increased its portfolio’s short position in Enron shares following this disclosure.