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.

Richard Blum's Firm Buys More ITT Educational Services (ESI)

Richard Blum's hedge fund Blum Capital has filed an amended 13D with the SEC regarding shares of ITT Educational Services (ESI). Due to portfolio activity on October 14th, Blum Capital has disclosed a 12.1% ownership stake in ESI with 4,076,705 shares.

The firm also filed a Form 4 disclosing recent trades in the stock as they purchased 200,000 shares of ESI at $54.73 on October 14th, amongst other smaller transactions. Blum Capital has been buying ESI in small spurts through September and October and originally filed a 13D on ITT Educational Services back in March of 2008.

This isn't the only education-focused stock they own either. Blum also has a sizable position in Career Education Corporation (CECO). The for-profit education sector has been a battleground of hedge fund activity as well as regulatory concerns and changes. Richard Blum's firm is obviously on the long side of the trade, as are Lee Ainslie's hedge fund Maverick Capital and Chase Coleman's Tiger Global Management (with shares of Apollo Group ~ APOL. Or at least they were as of the end of Q2. Given the shake-up in the industry, it's hard to know for sure if they still own it).

There are other hedgies on the short side of the trade. Steve Eisman of FrontPoint Partners has seemingly led the charge against for-profit education with his presentation, "Subprime Goes to College." Whitney Tilson's T2 Partners has been short various names in this sector and recently commented that they haven't covered their position yet despite the sharp declines as of late. We've also posted Footnoted Pro's research on the for-profit sector which they highlighted back in May before many of the stocks dropped 40%+.

With big names on both sides of the trade, we'll have to see how this one shapes up as regulatory change seems to be the determining factor. One thing's clear though, Blum Capital is betting on ESI and CECO.

Richard Blum founded San Francisco based Blum Capital in 1975. The firm focuses on controlling investments in public and private domains. They typically focus on small and mid-cap names and seek to extract shareholder value. He received both his BA and MBA from the University of California at Berkeley. This is the first time we've detailed portfolio activity from this firm and we'll track them from here on out.

Taken from Google Finance, ITT Educational is "a provider of postsecondary degree programs in the United States. The Company offered master, bachelor and associate degree programs to approximately 80,000 students. It has 125 locations (including 121 campuses and four learning sites) in 38 states."

For more of our daily coverage of SEC filings, scroll through our breakdown of hedge fund portfolio activity.

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

You'll recall that MarketFolly.com 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.

Steve Eisman & FrontPoint Partners Ira Sohn Presentation: Subprime Goes to College

Earlier we aggregated a compilation of notes from the Ira Sohn Investment Conference where some very prominent hedge fund managers detailed investment ideas. One of those managers was Steven Eisman of FrontPoint Partners (Morgan Stanley). You may be familiar with him as he was profiled as one of the successful subprime traders in Michael Lewis' book, The Big Short.

Eisman thinks he has identified the next 'subprime' so to speak and gave a presentation at the Ira Sohn Conference entitled, "Subprime Goes to College." This speech provided a negative thesis on the for-profit education plays. In particular, Eisman is bearish on Apollo Group (APOL), ITT Educational (ESI), Corinthian Colleges (COCO), and Education Management (EDMC). Lastly, he also dislikes Washington Post (WPO) due to their ownership of the Kaplan test preparation business. His general thesis focuses on two factors: Washington clamping down on the industry and a rise in employment (generating a decline in enrollment). He notes that a key to the problem here is the 'rating' these institutions receive from accreditation boards and he likens these boards to the ratings agencies who blessed subprime mortgages.

Embedded below is the Ira Sohn presentation from Steven Eisman & FrontPoint Partners entitled, 'Subprime Goes to College':



You can download a .pdf copy here.

As we've detailed numerous times, the for-profit education space is an investor battleground with a clear divergence of opinion. Stephen Mandel's hedge fund Lone Pine Capital has been bullish on education plays. In fact, at least year's Ira Sohn event, he gave a bullish presentation on Strayer Education (STRA). While he has since scaled back his position some, we saw he still owned it when we detailed Lone Pine's portfolio. We also recently saw Roberto Mignone's hedge fund Bridger Management buy shares of Princeton Review (REVU), another test preparation service.

That said, we've also noted that some of these managers have had a recent change of heart. David Stemerman's hedge fund Conatus Capital had been long and sold out of their education plays. Andreas Halvorsen's Viking Global also exited Apollo Group recently. Additionally, there are also numerous high profile detractors such as Jim Chanos who gave a negative presentation on for-profit education at last year's conference. And now, Eisman has joined the mix with his negative view too. We'll watch with great interest to see how this one plays out. For more great ideas from hedge fund managers, head to our aggregation of notes from the Ira Sohn Investment Conference and be sure to also check out our hedge fund portfolio tracking series.