Jim Chanos: Beware the Global Value-Trap (Presentation From Value Investing Congress) ~ market folly

Monday, October 17, 2011

Jim Chanos: Beware the Global Value-Trap (Presentation From Value Investing Congress)

At the Value Investing Congress today, Jim Chanos of hedge fund Kynikos Associates talked about various companies to short in a presentation entitled "Beware the Global Value-Trap!"

Be sure to check out all of our notes from the Value Investing Congress.

Jim Chanos (Kynikos Associates): Short Exxon Mobil (XOM), GameStop (GME) & ITT Educational (ESI)

Embedded below is his full slideshow presentation:

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Chanos' entire presentation focused on “how value investors can avoid value traps.” He went from basics things to watch for, to his current specific short themes.

Value Stock Traits
: Predictable, consistent cash flows, defensible business, don’t need superior management, low/reasonable valuation, margin of safety, reliable transparent financial statements, “analyzable.”

Classic Short Selling Themes

1. Booms that go bust, debt-driven asset inflation; real estate in US, telecom overbuild, far east real estate now. Cyclical: Sometimes cycles become secular. Autos, airlines. Overly dependent on one product. Coleco, renewable energy. Illegal does not equal value. Be careful- they often look deceptively cheap. Online Poker.

2. Consumer fads

3. Technological obsolescence: Probably killed more value investors in last 20 years than any other. Examples: Minicomputers, Eastman Kodak, Video Rental. The cash flows drop off faster than you think they do. At some point, cash flows hit a tipping point, and drop precipitously.

4. Structurally flawed accounting: Free cash flow/Run by accountants. Tyco example. Be “Triply careful” whenever management pulls out some metric that they define- such as cash flow. Be careful when they keep pointing to a metric they like. Accounting issues. Confusing disclosure. BFT. Nonsensical GAAP. Sub prime lenders example.

5. Selling $1.00 for $2.00

6. Rapid Prior Growth: “Law of large numbers” Telecom build out example. When tech shift occurs, old metrics that value investors use are totally irrelevant.

7. Value Traps

Other Traits of Value Traps

Marquis management. New CEO as a savior- it is often the business that exits with its reputation intact. Conseco example. Keep doing your work. Look at their incentive- often they win no matter what.

Famous investors: In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always "smart guys" involved all the way down. Don’t let your work stop because a smart guy is in the stock. It always happens, even the best make mistakes.

Appears cheap only using management’s metric. EBITDA example. Almost every major business needs depreciation, capital deprecation, if you don’t consider this, you are cheating yourself. Cable TV example. Stocks have done nothing for years because they always quote EBITDA only, in a capital-intensive business.

Ignore restructuring charges at your own peril. Eastman Kodak. Those charges were actual charges, and they never fixed the revenue line. Yet investors used management metrics and ignored the real situation.

Growth by acquisition. Tyco, roll-ups. Be very careful. Earlier today David Einhorn said to short Green Mountain Coffee Roasters (GMCR) and pointed out that the company has largely grown through acquisition.

Buying low growth low P/E businesses with expensive high P/E stock should be a huge red flag. Be careful when you see big write-downs because management is claiming to be conservative, they are banking some earnings. Rely on a “supranational put”- government will bail me out.

Current Value Traps

Liquidating Trusts: Integrated oil companies. Cost structure grown dramatically; finding and development up from $5/bbl to $22/bbl. Production $5/bbl to $15/bbl. Cost of marginal barrel of oil is up and rising, $37 all-in now, where oil bottomed out in 2008/9. Gas has opposite problem. Monster acquisition in gas area. Exxon Mobil (XOM): FCF dropping off, not even enough to cover its cash needs. Also applies to other national oil companies, look even worse.

Digital Distribution Destruction: video games. Will follow music and movies, to digital distribution. Gamestop (GME): Looks cheap, has lots of stores, in a terrible business. Will appear cheap all the way down. As bandwidth and wireless speed increases, the value of their brick and mortar will collapse, just as it has with movies and music. Also other video rental. (Coinstar (CSTR) perhaps? Didn’t say the name.)

"Mis-education" For-Profit Colleges: Now they look cheap as value investors pile into them, says gainful employment didn’t have teeth. “Can’t think of a more predatory business in the US right now.” Congressional support is waning. 90% of the loans are federal loans, and default rates are skyrocketing, was 20% in 2009, now heading toward 30%. Serious line item in the federal budget now. ITT Educational (ESI): Have an off-balance sheet entity. Cohort default rate 22.4% and rising, one of the most expensive tuition of the colleges. Bulls say Republicans will give them cover, but now Republicans have started to walk away- General Petraues' daughter has been investigating the abuse of soldiers.

Nationalistic Commodity: Be careful- they are down a lot and appear cheap, especially Iron Ore, down from $200 to $150-160. Problem is it was $30 forever. Commodities look cheap, but not if you look at longer-term charts. Leveraged to Chinese growth. Vale (VALE): Looks cheap, but in Brazil, which isn’t your friend as a shareholder. VALE is building its own Navy, which they don’t expect to have a positive rate of return.

China Bubble: Chinese State Banks. Underground lending is a significant risk. CDSs went from 30 bp to 200 bp in the summer. PRC sovereign fund said they would be buying stock in these banks. They are instruments of state policy; they are not there to maximize shareholder wealth. They are cheap, but there are many lurking time bombs. They were recapitalized twice in last 12 years even during strong economy in PRC. The refrain in China is “yes there is a lot of silly stuff going on, but the government won’t let anything happen.” Agricultural Bank of China (HKEX.1288): Cheap, but half the capital is bogus. Chinese banks are very levered. PRC this year will expand credit outstanding by 35% of GDP; it was 25-30% each year for 4 years, 100% of GDP. “The only westerners in history that ever got a dollar out of China were the Opium dealers, and they had the British Royal Navy behind them.”

Q&A Session:

1. Commodity boom not supported by China, what about India? Chanos says India is self-sufficient in Iron Ore, and China demand is 50-80% of many of the commodities.

2. China: real estate sales volume was down 40-50% in golden month. Prices haven't fallen, but transactions always dry up first. High-speed rail crash was a psychological hit- even if only 5% of GDP, it was a source of pride for China. Corners being cut, this crash highlighted to the public that there was a cost to the “growth at all costs” mentality in China.

3. When asked about Japanese bonds, Chanos added some humor to his talk by saying, "we only want to piss off one Asian country at a time."

About Jim Chanos: He manages the short-selling focused hedge fund Kynikos Associates. We've covered how Chanos thinks China is a bubble and that he is also targeting alternative energy, shorting Vestas and First Solar.

You can view our notes from the Value Investing Congress for the rest of the hedge fund manager presentations.

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