Friday, June 25, 2010

Jim Chanos On Short Selling: The Power of Negative Thinking

Short selling and Jim Chanos go hand in hand. Whenever you see his name, you instantly think of Enron and how he unveiled the fraud there. The Kynikos Associates hedge fund manager is worth following due to his success but maybe more-so for the fact that he makes so many public appearances. If hedge funds operate behind a shroud of secrecy, then short sellers typically operate behind a shroud ten times as secret. Yet Chanos deviates from the norm and can often be found on television, doing interviews, and sharing his ideas. While talking his book might help some of his positions, it also means he's more often than not cast as a villain. Chanos argues that good short sellers are born, not trained. Many would take issue with that statement as numerous hedge funds recommend their analysts read Kathryn Staley's book, The Art of Short Selling to really gain an edge.

In late May, Chanos delivered a presentation at the CFA Institute's annual conference. You'll remember that Baupost Group's Seth Klarman also spoke at this event and we previously covered his thoughts on the markets as well. This time around we present you Chanos' speech entitled, "The Power of Negative Thinking" which focused on his bread and butter: short selling.

His talk centered on all aspects of the process including idea sourcing. When scavenging for shorts, Chanos says you focus on your experience, accounting related third party research, other investment managers, partners, investors, and various stock screens (though he admits this last technique is not as helpful as it once was). Chanos makes short selling seem like a much more simplistic process than it is. But he does bring up an excellent point that there are very few original ideas in investing. And if he and other short sellers are sourcing ideas through word of mouth and industry networking, this just goes to reiterate the hedge fund herd mentality we've discussed before.

Chanos also outlined that successful short positions often come from various recurring themes including:

- Booms that go bust
- Consumer fads
- Technological obsolescence
- Structurally-flawed accounting

On the point of technological obsolescence, we've seen that David Stemerman's hedge fund Conatus Capital has built short theses around this occurrence.

Throughout his speech, Chanos also dropped hints at various companies he could be short. He mentioned that it still amazed him people still rented DVD's by mail which could be interpreted as a short position in Netflix (NFLX). On that point, we've seen in the past that Whitney Tilson's hedge fund T2 Partners has been short NFLX. In fact, many hedgies have tried to short this stock to no avail as it continues to rip higher. Regarding China, Chanos is short the land development companies but did not name specifics. For those interested, we've previously posted up Chanos' in-depth speech about China overheating.

Lastly, regarding the process of short selling, Chanos iterated that position sizing and risk management are obviously key. Short selling involves the potential for unlimited losses so you obviously have to keep a close eye on things. He handles risk with stop loss orders and limiting positions to between 0.5% and 5% (max) of capital. If positions start to get too big, they'll trim them back down to the intended allocation. Also, Chanos revealed that he does not use options or derivatives.

Embedded below are in-depth notes courtesy of Cameron Wright regarding Jim Chanos' presentation on short selling, "The Power of Negative Thinking":

To learn how to become a better short seller, we of course would point you to a book that hedge fund Blue Ridge Capital has recommended: The Art of Short Selling. For more of our coverage of Jim Chanos, head to his thoughts on China's property bubble as well as his in-depth talk on investing in China. Lastly, remember that in addition to Chanos, investment guru Seth Klarman also spoke at the CFA Conference and his thoughts from the event are definitely worth checking out as well.

What We're Reading ~ 6/25/10

Security analysis and business valuation on Wall Street [Jeffrey Hooke]

Some recent hedge fund performance numbers [Dealbreaker]

A multi-section, in-depth analysis of National Presto Industries (NPK) [Kerrisdale Capital]

The controversy over for-profit colleges by Richard Posner [University of Chicago Law Blog]

Beaconcrest Capital opens hedge fund to investors [FINalternatives]

Hugh Hendry says the euro is finished [Pragmatic Capitalism]

The new economic gangs of New York [Reformed Broker]

Great company brands of tomorrow [Pragmatic Capitalism]

Fund manager Ken Heebner: A hot touch gone cold [Business Week]

In gold we trust, an in-depth report from Erste [zero hedge]

How to invest like Jim Rogers [TheStreet]

Thursday, June 24, 2010

Response to Steve Eisman's Short Thesis on For-Profit Education Companies

You'll recall that recently provided a summary of the Ira Sohn Investment Conference where numerous prominent hedge fund managers presented their latest ideas. Among those presenting was Steve Eisman of FrontPoint Partners. You might remember him of course as one of the successful subprime traders profiled in Michael Lewis' latest book, The Big Short.

At the conference, Eisman presented a short thesis on for-profit education companies, interestingly titled 'Subprime Goes to College'. You can view the entire presentation through that link, but he essentially laid out a bearish view on the following companies: Apollo Group (APOL), ITT Educational (ESI), Corinthian Colleges (COCO), Education Management (EDMC), as well as the Washington Post (WPO) for its test preparation business. His thesis states that the industry will be hurt by two factors: increased government involvement & regulation, as well as a rise in employment (generating a decrease in enrollment).

Eisman's crusade against for-profit education companies has obviously lit a fire under the collective asses of said companies' executives and representatives of the industry. Courtesy of our buddy StockJockey, we see that Harris Miller, President and CEO of Career College Association has even gone as far to pen a response to Eisman. Unfortunately, Miller's retort falls short (no pun intended) right from the get-go when he immediately casts Eisman as a villainous short-seller not even one paragraph into his remarks. This rudimentary and almost Pavlovian response from various officials and executives has become a bit tired over the years, has it not? 'Oh, he's a short seller, that means he's a bad person and must be stopped at all costs!' Nevermind the fact that Eisman, you know, has some credibility in the arena of short selling. He predicted this little thing called the subprime mortgage mess. Maybe you've heard of it?

In fairness to Miller, the CEO does bring up a solid point that comparing education companies to subprime mortgages is indeed a bit of a stretch. There are some similarities between the two situations (ratings agencies/accreditation boards, etc), but the insinuation that for-profit education is the next subprime is a bit hyperbolic. While there is government involvement in both sectors and student loan default is a legitimate concern, let's be honest: for-profit education is not going to wreak near the amount of havoc the subprime mess has. At the same time, there are obviously problems in the industry as Eisman has detailed.

We've labeled for-profit education stocks as an investment battleground for some time now. Hedge funds have taken sizable positions on both the long and short sides of the trade. However, as the year began, more and more hedgies have shifted to the 'sell' or 'short' side of the seesaw. At last year's Ira Sohn event, Stephen Mandel of Lone Pine Capital gave a bullish presentation on Strayer Education (STRA). Immediately following him, noted short seller Jim Chanos presented a bearish look at the for-profit education industry. Fast forward to more recent times and we saw that Mandel is still bullish on education plays. However, when we looked at Lone Pine's portfolio, we did note that they've scaled back their position some.

We shift next to a look at one of Mandel's progeny, David Stemerman. He previously worked at Lone Pine and then left to launch his own hedge fund, Conatus Capital. Stemerman's fund had been long education stocks but by the fourth quarter of 2009 and first quarter of 2010, they had sold out of these stocks, citing increased uncertainty and increased government scrutiny. Additionally, Andreas Halvorsen's hedge fund Viking Global was a big investor in Apollo Group (APOL) as it had previously been one of their most sizable positions. Yet, recently we saw they sold out of APOL, adding to the hedge fund exodus.

Back on the bullish side of the fence, we did however see Roberto Mignone's hedge fund Bridger Management buy shares of Princeton Review (REVU), a test preparation service. The interesting thing to pay attention to here is the difference between full-on schools and test preparation services. While Eisman mainly targets programs distributing degrees, he was also bearish on Washington Post for their test preparation business.

So while a divergence of opinion is clear, we've also highlighted how some prominent players have wavered in their conviction. The moral of the story here is that hedge fund land is very decisively divided on this topic. This sector should be watched closely as it should be filled with opportunity. While the bulk of that opportunity has historically been found on the long side, it's clear that many have grown skeptical. We've already presented the bearish case for the industry via Eisman's presentation. Embedded below is the response from Harris Miller, President & CEO of Career College Association which obviously presents the positive case for the industry:

You can download a .pdf copy here.

So, the war of words has ensued and this sector will continue to be hotly debated. In the end, it seems that government regulation and intervention will likely play a large part in the final outcome, whatever it may be. You can check out Steve Eisman's original presentation where he laid out his short thesis: Subprime Goes to College. Additionally, head to the summary of the Ira Sohn Investment Conference for the rest of ideas hedge fund managers pitched.

Dan Arbess Ira Sohn Presentation: Investing As The Foundation Shifts

Today again courtesy of Dealbreaker we wanted to highlight Dan Arbess' recent presentation from the Ira Sohn Investment Conference entitled, 'Investing As The Foundation Shifts'. We had previously summarized the Ira Sohn Conference and have detailed numerous presentations from the event. This time around, we're taking a deeper look at the slideshow from Dan Arbess, the Xerion Fund manager at Perella Weinberg Partners. Just yesterday, we looked at Dan Arbess' portfolio commentary and identified that he is seeing opportunity in stressed credit and owning what China wants to buy. And now, we'll focus on some of his additional investment ideas.

When we summarized the Ira Sohn Investment Conference, we noted that Arbess was bullish on China exposure and in particular, Yum Brands (YUM) given their prolific expansion into the country. He isn't alone in his conviction here as we've seen a slew of hedge funds add positions in Yum Brands in recent quarters. In particular, we made note of Bill Ackman's YUM stake.

If you hadn't already guessed from the title, the theme of Arbess' presentation centered around a shift in the global economy. He wants to 'shake hands' with China and overall sees less borrowing in the Western world coupled with more consumption in the Eastern world. He says you can play this theme by shorting overleveraged Western producers, shorting weak currencies, and hedging monetary debasement with precious metals and miners. Arbess is also bullish on Ivanhoe (IVN) due to its solid assets and position in the metallurgical coal space.

This echoes what many hedge funds have already practiced. Hedgies have been quite short the euro (currently a weak currency) but they have been covering as of late. Additionally, tons of prominent investment managers have boosted gold exposure in their portfolios either by adding the physical metal or gold mining companies. Arbess doubts this is a top in gold and is using exposure there to hedge against inflation.

Sticking with the Asian growth theme, the Xerion Fund manager also likes Solutia (SOA) and Celanese (CE) as they both are seeing solid growth overseas. Arbess also seemingly pokes fun at a previous presentation we've posted up from Vitaliy Katsenelson entitled, China: The Mother of All Black Swans by including a picture of the lead slide from that slideshow with a giant "NOT" stamped across it. (How about a nice little Borat impersonation here for our comedic readers: "China is the mother of all black swans..... ... .....NOT.")

Ahem, anyways. Embedded below is Daniel Arbess' presentation from the Ira Sohn Conference, "Investing As The Foundation Shifts":

You can download a .pdf copy here.

For more from Arbess, head to his Xerion Fund portfolio commentary. We also recommend viewing the other presentations from the Ira Sohn Conference including David Einhorn's speech, as well as Bill Ackman's presentation and last but not least, Steve Eisman's latest investment thesis. You can also view a summary of the conference here.

Wednesday, June 23, 2010

Hedge Funds Aggressively Cover Euro Short Positions

Bank of America Merrill Lynch has released their weekly hedge fund monitor that updates the latest exposure levels from hedgies. Last time around, we saw that global macro hedge funds were short equities. This time, we see that they've been aggressively covering the euro. Obviously due to the European turmoil in recent months, hedgies have been very short the euro. Thus, this interruption in trend is worth pointing out.

Hedgies have been short the euro in size and so volatility will most likely continue in the forex market. To put this euro position in perspective, hedge funds were short -$13.4 billion notional as of two weeks ago. Last week, this position decreased to -$7.7 billion notional. The euro has essentially been in a 'crowded short zone' for much of 2010 so there is always that pressure of a sudden short squeeze. Bank of America thinks such a squeeze at best would take the Euro up to 1.30 but they don't see that happening anytime soon.

Shifting to equities, one trend worth highlighting is the fact that many hedgies continue to sell the Russell 2000 futures. In energy, it appears as though hedge funds were buying crude oil. Additionally, they remain long metals.

Long/short equity is one of the best performing strategies this month, up 0.33%. This is in stark comparison to last month where May was a brutal month for many prominent long/short operators. Position wise, we see that this strategy overall has increased its market exposure. Don't put too much weight on that though, as they are only 25% long, way below the typical range of 35-40% net long. Long/short funds also reduced emerging market exposure last week.

Shifting to market neutral funds, we see that recently they've reduced market exposure. Over the past few months it seems as though m/n funds and l/s funds have moved completely converse of each other with regard to equities. When l/s funds go long, market neutral funds seem to sell and vice versa.

Global macro hedge funds have been adding to shorts in commodities as well as in 10 year treasuries. Additionally, they've been adding to longs in the US dollar. This trade has become an opposite reflection of the one many funds put on during the crisis. (Back then, they were long commodities and short the dollar). As we detailed last week, global macro players have been net short equities in recent weeks and we see that they've continued to hold these positions.

Embedded below is Bank of America Merrill Lynch's latest hedge fund monitor report:

You can download a .pdf copy here.

For more on the topic of position movements, head to our examination of the hedge fund herd mentality as well as our continuous portfolio tracking series.

Perella Weinberg Partners: Xerion Fund Portfolio Review & Commentary From Dan Arbess

Thanks to Dealbreaker who posted up this gem: Perella Weinberg Partners recent May 2010 portfolio review and commentary regarding their Xerion Fund managed by Dan Arbess. If you're unfamiliar with them, here's what you need to know: Xerion is named after a legendary alchemical tool that is supposedly capable of turning base metals into gold and is also believed to be an elixir of life or enlightenment. The hedge fund "seeks to draw on fundamental valuation skills to identify opportunities that offer the potential for asymmetric returns--downside protection with upside potential." Xerion returned 0.31% in 2008, a year in which many other hedge funds suffered greatly. In 2009, Xerion returned 35.33% versus 26.46% for the S&P 500.

Thus far this year, Perella Weinberg's Xerion has had a decent outing, sitting up 3.37% for the year. The month of May was brutal for hedge funds, and the same applied to Xerion which ended the month down 4.23%. In their portfolio, Xerion's top performers were an alpha macro short on the Euro, beta hedges on the S&P 500, as well as a -6.3% short in the Australian dollar (a hedge to their mining and materials exposure). The first position of course ties in with the fact that many hedge funds have been drastically short the euro this year. However, as you'll see in a forthcoming article this morning, many hedgies have been covering their euro shorts as of late.

Arbess' portfolio commentary took somewhat of a concerning turn when he proclaimed that, "The twilight of the debt supercycle may be less dramatic yet more chronic and possibly more difficult to position around than the '08 financial crisis." He focuses on the fact that addressing the issues at hand will require fundamental changes. As the world re-balances, he feels that outbursts of asset classes and markets trading in correlation will become more frequent.

Shifting next to investment opportunities, Arbess identifies the following as areas ripe with potential:

- Owning what China's government and consumers want to buy
- Stressed credit opportunities
- Process-driven credit opportunities
- Hedging monetary instability with metals, bonds and currencies

His last point is intriguing as throughout his commentary you'll notice he is very fixated on hedging. As we've detailed countless times before, many prominent hedge funds have exposure to gold in some form. Some argue that gold is good, but gold mining is better, while others prefer to own the physical metal. John Paulson has a hedge fund dedicated to investing in gold related entities. While he primarily takes stakes in gold miners, he also owns derivatives on the precious metal. So, it seems the Xerion Fund is interested in these tools as well, but mainly for hedging purposes.

Arbess points out that May was an 'anomaly' month because there was essentially nowhere to hide on the long-side as asset classes correlated to the downside. Xerion's top losers included an equity stake in a post-emergence chemicals company, a large cap agricultural sector position, and an energy special situation. Despite the rough month, Arbess viewed May as a buying opportunity for their highest conviction ideas. Xerion has essentially been running "lean and mean" by reducing other positions in favor of their highest conviction plays.

Arbess notes that, "quality credit is just where we want to be in an uncertain environment, because it has a built-in catalyst called maturity, which delineates our return based on our conservative assessment of company performance even against a weak economic backdrop." These comments echo that of investment guru Seth Klarman who prefers bonds and recently reiterated his preference.

In overall portfolio exposure, Xerion has been 86.5% gross long and -30.7% gross short, leaving them 55.8% net long. Given that Xerion's main focus is on distressed credit, it should come as no surprise that their largest exposure levels can be found in that arena. To see how Xerion compares to other managers, check out our recent look at hedge fund exposure levels.

Embedded below is the portfolio commentary from Dan Arbess' Xerion Fund of Perella Weinberg Partners:

You can download a .pdf copy here.

For more insightful commentary and analysis from prominent investment managers, head to the latest thoughts from Dan Loeb's hedge fund Third Point, global macro fund Prologue Capital's commentary, and the latest portfolio positioning from John Burbank's Passport Capital.

Monday, June 21, 2010

Market Strategist Jeff Saut Removes Hedges During May Turmoil

It's been a while since we covered the market commentary of Jeff Saut, Chief Investment Strategist from Raymond James. Back in April, Saut advocated caution and he turned out to be right as the markets saw a precipitous decline. During the correction in mid-to-late May, Saut said the market was in a bottoming process. Obviously, May was quite a volatile month and he felt it was a constructive pullback. In his latest commentary, Saut focuses on the debate as to whether the rally since the March 2009 bottom is just a rally in the midst of a bear market or the beginning of a new secular bull market.

Generally speaking, Saut's portfolio construction has been tilted 80% toward wherever he feels a secular bull market has developed and 20% to a dynamic approach that swings with the market. So while the majority of his portfolio seems to be more static, the dynamic portion of his portfolio comes into play as he started adding hedges in April to protect his portfolio. Into the May turmoil, we learn that Saut shed those hedges. It's often said that the hardest thing to do is to remove your hedges when they are protecting you the most. Yet, that appears to be exactly what Saut has done so kudos to him for the conviction. Also, take note that the secular bull market portion of his portfolio lies essentially in "stuff stocks." Since the fourth quarter of 2001, Saut has been bullish on energy, agriculture, and metals stocks with a yield.

All said and done, Saut still leaves a few questions unanswered. It's not clear if we're in a new bull market or merely a bear market rally. In the near-term though, he feels that his call to remove hedges into the May tumult was the correct move and he obviously feels that the recent action is constructive. He'll obviously stay nimble with a portion of his portfolio but that is the latest update direct from the market strategist.

Embedded below is the most recent market commentary from Jeff Saut, Chief Investment Strategist at Raymond James:

You can download a .pdf copy here.

Saut has been right-on as of late as he called for caution in April and then recently said the market was in a bottoming process. We now see he's shed his hedges and appears to think the market is in decent shape here. While the markets and economy don't always move stride for stride, we do make note of global macro hedge fund Prologue Capital's cause for concern which we detailed this morning. Though the various economies of the world still have structural problems to work through, the market could have very well discounted this fact as they are forward looking mechanisms. This of course ties directly into the archaic market debate of perception versus reality. As always, we'll have to wait and see.

Global Macro Hedge Fund Prologue Capital Sees Cause For Concern

Global macro hedge fund Prologue Capital is out with their most recent letter to investors. They immediately address the most volatile month in the markets this year wondering, "Was it all just a storm in a teacup? And if so, will the economic recovery continue unabated? We don't think so. Rather, recent events are symptomatic of economic and financial vulnerabilities that will remain for some time." This is an interesting stance and we'll detail how they've positioned their portfolio below.

While May was a brutal month for hedge funds, Prologue did well to avoid carnage as they were up 0.85% through May 28th. This brings their year-to-date performance to 2.80%. Prologue now manages over $1 billion and were up 18.86% in the crisis-ridden 2008 and up 12.41% in 2009.

In assessing the global macro scene, Prologue's Chief Economist Tomas Jelf evaluates the US, Europe, and UK. Economically speaking, Jelf feels that there are still two main concerns. He writes, "The fiscal accounts of most developed countries create two immediate problems. First of all, the need for fiscal consolidation is a drag on economies at a time when recovery attempts to morph into an expansion. Furthermore, governments' indebtedness limits their ability to provide the type of backstop we have seen in recent years. Second, banks have yet to clean up their balance sheets to a degree that removes solvency concerns."

Overall, Jelf notes that repairing balance sheets and fiscal consolidation takes time. As such, Prologue expects some sort of turmoil to return in future quarters/years. It's obviously hard to peg the timing of such turmoil, but they are more concerned here than they have been in recent months certainly. They are concerned that this could "create more drawn out risk asset deflation and potentially halt the recovery." This isn't the first time we've seen such concern from a global macro hedge fund. Louis Bacon's Moore Capital Management pondered a return to a bear market in their past commentary. At the same time though, Prologue fully acknowledge that this turmoil could amount to nothing more than just 'hiccups' on the road to recovery.

Focusing specifically on the US, Prologue highlights the slowdown in discretionary spending. They are also concerned by an assumed rollover in housing now that the home buyers credit has expired. Overall, Prologue expects "declining year over year inflation figures throughout 2010. That, coupled with the worsening growth momentum, may lead to a decline in inflationary expectations. Suffice to say that the Federal Reserve will keep rates on hold for a long time."

In the UK, Prologue thinks there will be ample opportunities to take advantage of given that the monetary policy outlook is quite uncertain. While inflation expectations there have risen, the Bank of England's models have led them to a continued dovish stance. In Canada, Prologue favors flatteners but also thinks that bonds are cheap relative to US Treasuries. In Australia, they've reduced their exposure to the currency until the monetary path is more lucid.

Given their macro assessment, let's see how Prologue is positioned. In their last commentary, they detailed why macro factors are positive for risk assets. This time around, they are certainly more cautious as the month of May seems to have given them cause for concern. Here are their latest positions:

- Tactically long duration in the US and Eurozone

- Continued active participation in the underwriting process of government bonds

- Cross market Fixed Income - long US vs UK

- Exploiting dislocations in futures versus cash and swaps caused by flight to quality fears

- Volatility in FX options

Unfortunately, we can't post up the actual letter due to revealing watermarks. It's always interesting to see how global macro hedge funds are positioned given the fragile nature of many economies and the constantly morphing economic landscape. Those of you interested in this macro hedge fund's views can see their past commentary. For more global macro research, we have previously detailed investment commentary from John Brynjolfsson's Armored Wolf. And to learn from some of the most knowledgeable global macro fund managers around, we highly recommend Steven Drobny's new book The Invisible Hands: Hedge Funds Off the Record.

Forbes on Warren Buffett: A Multi-Decade Look At His Career

Forbes is out with an excellent compendium of articles they've released over the years regarding the Oracle of Omaha himself, Warren Buffett. Their chronicles of Buffett start on November 1st, 1969 where they introduced the soon-to-be legend to their audience. This very first article in particular details Buffett's Partnership and is of great interest of those seeking more information of how he managed money in his early days.

If you think about it, the 'early' Warren Buffett is the one investors should look to mimic and learn from. His modern day vehicle of Berkshire Hathaway is an investing behemoth and as evidenced by its full-scale acquisition of Burlington Northern Santa Fe, it's much harder for him to put money to work these days. Buffett has repeatedly said he'd be reaping much better gains if he managed a much smaller pool of capital. So, Forbes' look at the earlier stages of Buffett's career certainly prove useful here.

Given that Buffett is one of the most successful, if not the most successful value investor out there, those looking to follow in his footsteps should head to Warren Buffett's recommended reading list. The man is full of quotable quips, almost too many to list. However, one of our favorites (and one that is partially responsible for the name of this website) is, "Profit from folly rather than participate in it." Those of you seeking more words of wisdom from the Oracle can do so via our top 25 Warren Buffett quotes.

Embedded below is 'Forbes on Buffett', an excellent collection of resources regarding the investing legend himself:

You can download a .pdf copy here.

For all the Buffett disciples out there, definitely head to Warren Buffett's recommended reading list if your pursuit is to become a better investor. We've of course covered the Oracle of Omaha extensively on the site and some other points of interest might be Warren Buffett's portfolio as well as some notes from Berkshire Hathaway's annual meeting.

What We're Reading ~ 6/21/10

An addendum to our usual weekly linkfest since there have been a lot of good reads out there as of late...

Exclusive interview with Greenstone Value Opportunity Fund [Distressed Debt Investing]

Investors: individuals versus institutions [Abnormal Returns]

A closer analytical look at BP [Peridot Capitalist]

And also an in-depth look at driller Ensco plc [Manual of Ideas]

Fears of a BP bankruptcy are overblown [Bnet]

BP's wakeup call to bond investors [Morningstar]

A very in-depth look at what went wrong with the oil spill [NY Times]

Chief economist of Paolo Pellegrini's PSQR set to launch own firm [FINalternatives]

An intriguing past look at how value investors often piggyback each other [SeekingAlpha]

And if you missed it, our recent post on the hedge fund herd mentality [Market Folly]

Major investor bets big on Vegas [Las Vegas Sun]