Jim Chanos On Short Selling: The Power of Negative Thinking ~ market folly

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.

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