Long/Short Funds Tend to be more ‘Marketing of Beta’, not ‘Alpha’ Businesses – Jim Chanos

Straight from the Horse’s mouth (i.e. Jim Chanos):

I view macro and short selling as skill-based or alpha businesses, whereas equity long/short hedge funds tend to be more of a “marketing of beta” business. I am always amazed that investors will  pay 2 and 20 for a manager that is always net long.

I have been saying that for 20 years. It is interesting because I run an alpha-based business and I  am more sensitive to it than others. I sit on investment committees and I see it as an investor  who advises these funds. When I ask why a lot of hedge fund compensation is simply embedded market risk, I get very uncomfortable, squirming, dodgy answers. Or no answers at all.

Look at 2013. It is crazy to see managers who were up 15 percent command huge checks, when  the S&P was up 30 percent. Particularly since they were not balanced completely. They were 90 percent long and 30  percent short, or something like that. Not much alpha has been created by hedge funds, and
what was created has been taken by fees. This has been the case for a long time. In a way, short  sellers might still be one of your great bargains out there, at 1 and 20 percent of the alpha. That  is the closest I will get to a marketing pitch.

source: Steve Drobny, The New House of Money

A good friend of mine agrees. In his own words, “people confuse brains with a bull market.”

 

Longs and Investing from a … Short Seller’s Perspective

I Am a Short Seller

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” – Sun Tzu, Art of War

My name is Daniel, and I am a short seller. I became aware of this truth and came to accept it several years ago. I do not think I ‘chose’ to become one, nor did anyone ‘teach’ me to become one*.  In this regard, I agree with Jim Chanos, Marc Cohodes, and others, who believe short sellers are not ‘made’, but rather ‘born’. You are one, or you’re not. Plain and simple. Since then, I’ve fully accepted and embraced the fact I’m a short seller. I’ve experienced my share of losses and victories, but overall, I’ve enjoyed the ride. I still have plenty more to learn about the art of short selling, and am cautiously optimistic I will get better with time. With that said…

*With that said, I am grateful for the on-going mentor-ship and friend-ship that several have provided me. I believe they have played a critical role in my maturation as an analyst, short seller, and overall investor. I also believe they have helped me grow, personally.

 

I Aim to Become an Excellent, Overall Trader and Investor

“The will to win, the desire to succeed, the urge to reach your full potential… these are the keys that will unlock the door to personal excellence.” – Confucius

There are three short sellers – I will refer to them as A, B, and C – who, in their own unique ways, have been encouraging me to strive to be an overall excellent investor (i.e. to learn to go long). Fortunately, this is a desire that I have finally begun to desire for myself. I do not know if I am meant to become competent/excellent at buying stocks, or if I am fated to be a ‘dedicated specialist’ for the rest of my life.

A – I thank A (over a series of conversations) for helping me develop a firm intellectual grasp of the risk/reward characteristics of going long vs. short. For example, the mechanics of a short or long position going against you, risk management, position sizing, scale-ability, the pressures of managing OPM, etc. The reasoning and philosophy underlying selecting longs, shorts, and building portfolios consisting of both. I also thank A for helping me see the need to learn how to buy/long things. A made it clear and convinced me that this is a MUST.

Finally, A made it clear to me that great long-term investing is about finding great businesses (preferably with great management), whereas short selling is about finding terrible people (preferably running terrible businesses).

B – Whereas A really helped me build a solid intellectual foundation , B has helped me primarily “learn by doing”. B has periodically mentioned long ideas that get him really excited (they are not common), and articulated long theses in ways that I can understand and get comfortable. I would say that B is exceptionally good at buying event-driven / special situation longs that have high chance of winning regardless of the overall market environment. I think every single long idea he has mentioned has led to positive P&L (he rarely talks longs). I can’t think of a long idea he has mentioned that has lost money (at least up to the point of the ‘events’ and/or ‘triggers’ he has identified).

I don’t know if B realizes, but in an indirect way, I’ve also learned a lot about longs/investing by B’s comments on short selling. For example, B has often told me “that is not the kind of company you short”, “short sellers do not short ___” (I remember him saying this about Apple, Microsoft, and Tesla) … after observing the times he has said that, I’ve come to realize that these types of names that may seem like good shorts superficially, tend to actually be excellent longs in pullbacks. I don’t think B is saying they can’t work as shorts (from a trading perspective), but at best, they’re singles… not home-runs. So why waste time on them?

C – Like B, C has told me that I must learn to go long. He has warned that otherwise, there’s always the risk of going insane, or encountering financial hardship. Whereas A and B have fully engaged my head (when it comes to buying stocks), C has engaged my heart. I feel inspired to become excellent at picking longs, and therefore, become an excellent overall investor. C started out dedicated to short-selling. Over the course of time, he has proven to be an excellent investor. He is living proof that it can be done, and that inspires me. It can be done! C also told me something I suspected: I must find niches on the long side that I can put my heart into. Like shorts, I need to develop a personal passion for certain kinds of longs, and no one can teach me that. As a matter of practicality, C told me that it is far more desirable to focus on finding great businesses rather than statistically cheap(looking) ones.

Investing Lessons I’ve Learned the HARD WAY

“Insanity: doing the same thing over and over again and expecting different results.” – Albert Einstein

Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” – George Soros

When it comes to researching longs, I’m probably a C- analyst (currently, speaking). When it comes to trading longs, B- (when it comes to researching and trading shorts, I’ll let others opine). Bear in mind, I was once an F- analyst and F- trader/investor in longs. In fact, most my longs between 2005-2008 were TERRIBLE. If you were short all my longs in that period, you would’ve made 80+% over that period. It took me a long time to realize, accept, and forgive myself of the mistakes I made. In fact, this process of introspection led me to realize I was a short seller.

Here are some of the (painful) lessons I’ve learned, on the long side:

  1. Just because a security/stock is down (significantly), does not mean it is cheap nor even likely to go up.
  2. Cheap doesn’t mean can’t get cheaper.
  3. If a business is experiencing problems (e.g., accounting, ethics, missing earns) you should assume it is worse than it looks.
  4. CEOs lie/cheat/steal. You should not make investment decisions purely because you ‘trust’ management. A lying CEO will say “trust me” without flinching.
  5. Stock fraud, and material misrepresentations, are real.
  6. Don’t create a concentrated or levered portfolio without knowing who the idiot in the room is (and even this is insufficient). Otherwise, it is YOU.
  7. Book value and earnings can go negative… therefore, statistically cheap (looking) may quickly become statistically expensive.
  8. Bad businesses rarely become mediocre ones. They are more likely to go bust or require a ‘restructuring’ (euphemism for, your equity stake getting wiped out).
  9. In market corrections, nearly everything goes down.
  10. “Be greedy when others are fearful” doesn’t guarantee you will make money.
  11. Being contrarian / counter cyclical / against the trend is not insufficient: you must be right.
  12. You should assume that the markets (which is the collection of all interested human beings) know more about a security than you.
  13. High dividend yields are often predictive of a dividend cut
  14. Textbooks, investor quotes, other investors’ opinions, certificates, etc. are no substitutes for direct experience.
  15. Plenty more stocks go to zero than to infinity.

The Present, The Future, and Prospective (Current) Long Opportunities

“The journey of a 1,000 miles begins with a single step.”

If I were to judge/grade my longs between 2010 – Present… NOT BAD. Definitely MUCH BETTER vs. my longs in 2005-2009. My P&L on longs has been positive over that time period. My batting average is way above zero (I think over 50%). My single biggest mistakes I’ve made time and time again on the long side in the last 4 years… not holding positions for sufficient time.

Some areas that interest me on the long side (I may be long or may initiate long positions in the following):

  1. Offshore drilling (e.g. RIG)
  2. Certain UK Grocery retailers
  3. Certain commodities-related businesses
  4. Gold and silver (I think there is a chance of a buying opportunity this quarter… I personally believe odds are better 3-12 months from now).
  5. Special Situation X
  6. Growth Stock Y

I am fully aware that most of the above are down/cheap(looking) for a reason, and face risk of additional impairment (perhaps even permanent impairment). That is why I am cautiously evaluating.

I am also seeking to divert my attention away from statistically depressed/cheap looking stocks, and focus on finding great businesses (and then determining if they are sensibly priced, or wait for opportunities to buy them at sensible prices). Admittedly, I have tended to focus more on whether a security is depressed rather than whether its underlying business is a great one that will remain great or perhaps even become greater, in time.

The impression I get from A, B, and C is that it is a better strategy to find great businesses, and then wait to buy them at sensible prices, vs. any other approach. Practically speaking, I think this will require spending less time observing securities prices, and more time observing the real world, people, and the world of commerce.

Time will tell if I am able to do this, and be able to get passionate about it.

 

The UnRIGged Transocean: On Watch (as a Long)

I considered going long Transocean (“RIG”) in fall 2011, and did so (briefly) for a trade. It would not have been a bad investment had I stayed on. I am re-visiting RIG as a long through the end of the year, and may initiate a long (and update this post) at any time. Per @mmtul:

RIG the pig, below ’08 lows. Well done! For the past 20 years, P/B range = 0.7 to 4.1. Currently 0.77. What do you think, Carl [Icahn]?

I initiated a long earlier today, and (accidentally via ‘fat finger’) put on a position 10x larger than I had intended. I closed it (fortunately, not at a loss) to re-evaluate. I may start building a long position tomorrow.

A few things that interest me and are worthy of further examination:

  • Short interest is high – 12 days to cover, over 20% of float is short. Short interest is nearly 10x higher than 12 months ago.
  • Day rate trends, price of oil.
  • Russia
  • Secular/structural considerations

The Madoff Ponzi Scheme: For every $1 “invested” how much have investors recovered? More Than MF Global Shareholders

In this day and age, the name ‘Madoff’ is synonymous with ‘financial fraud’, ‘ponzi scheme’, etc. Yet how much harm has Madoff done, in $ terms and % terms? While Madoff’s wrong-doings are indisputable, the damage all too real for its victims, the answer may surprise you…

As of July 23, 2014, the Securities Investor Protection Act (SIPA) Trustee has recovered or entered into agreements to recover approximately $9.825 billion, representing approximately 56 percent of the estimated $17.5 billion in principal lost in the Ponzi scheme by Bernard L. Madoff Investment Securities LLC (BLMIS) customers who filed claims. This recovery far exceeds any prior restitution effort related to Ponzi schemes both in terms of dollar value and percentage of stolen funds recovered.

source: http://www.madofftrustee.com/recoveries-04.html

Madoff’s victims have recovered 56% of their principal, whereas Corzine/MF Global’s victims – I mean, shareholders – is ZERO. To be fair, Madoff’s scheme and lies were longer lasting, and probably much more deliberate/malicious. Yet economically, who has harmed investors more? I will that to those far wiser to answer, but I believe it is a fair question.

In Anticipation of the Next “AOL-Time Warner”

This post was inspired by a @PlanMaestro who wrote: “Prediction: #PullingAnAOL will start trending soon.” I fully agree.

As “everyone” knows:

  • Interest rates remain low (and in many cases, negative)
  • Corporate cash balances remain high (at least in the United States, part of the reason there are inversion/tax related “controversies”)

As some know:

  • Capital/wealth has really nowhere to go other than the private sector, as public sector returns are de minimis. Corporate bonds/equities, hard assets, venture capital and private equity are the only game in town. I believe US is (largely) the only game in town as well.
  • Confidence in the corporate sector (C-level suites) is increasing.
  • Mergers and acquisitions are “back”
  • US Equity valuations are on the higher end historically, but can arguably go much higher given the prevailing low interest rate environment AND due to the pressure capital has to flee public sector and go SOMEWHERE.
  • The relatively high equity valuations have some interesting effects: (1) C-level executives face greater pressure to justify their existence, and so will look for ways to prop/grow EPS. (2) high valuations mean cheap currency, so acquisitions may seem, and may occasionally even be “accretive” (3) High valuations may lead otherwise mediocre/poor managers into thinking they are actually competent, and deserving of their absurdly high compensation packages. This dangerous and misplaced rise in confidence may encourage people to take on risks via M&A they otherwise would not.

All the above conditions lead me to believe we are in ripe territory (said differently, in dangerous territory) for a few eventual AOL-Time Warner debacles… I mean, deals. I’m giving it 5-6 quarters. Personally speaking, I am less interested in identifying potential targets on the long side… I’m not “smart” enough to do that. I’ll leave that to other Long/Short and Event-driven folks (I may change my mind, as I somehow magically transform into a super talented long focused guy with the power to foresee acquisitions). I am much more interested in getting involved ex-post. This leaves me plenty of time to observe the frauds and follies that I believe will come to fruition in the near future. 

 

About AOL-Time Warner

“Every time it [AOL] got to a clean quarter, it would buy something so you never saw internal growth. Total scum.” – Lisa Thompson from http://twitter.com/LTommy256/status/508807681579425792

It is my understanding that the AOL Time Warner deal gloriously harmed quite a few short sellers. Kynikos Associates, Rocker Partners, etc. I believe the list of those who lost money shorting in that situation is a “who’s who” list. I believe losses on shorting AOL were in the order of 10x. Note that time actually vindicated the AOL shorts… but little comfort in being “right” and losing considerable amount of capital.

 

David Rocker, Rocker Partners on AOL:

“Ask what the bull case is, other than bull generally,” demands David Rocker, a New York hedge fund head who says AOL is still one of the market’s most overvalued stocks. 1996

source: http://articles.baltimoresun.com/1996-07-28/business/1996210078_1_aol-america-online-steve-case

In addition, the company used questionable accounting practices for new  subscribers and marketing revenue to improve its short-term financials. These practices  would lead to a $385 million write-off in 1996, and accusations that the company was
“morally bankrupt.” 

Former CEO Kimsey described the accounting issue
as “the big turd” that “sat in the middle of the company and smelled up the place.” Id. at 57. Short-seller Rocker
claimed that for AOL, “every revenue is ordinary, and every expense is extraordinary.

http://blogs.law.uiowa.edu/jcl/wp-content/uploads/2012/01/1-Bodie-FINAL.pdf

A well-known short seller of America Online, meaning he has bet that its stock price will decline, Mr. Rocker said that the company inflated its quarterly results by spreading its high marketing costs over two years. At the same time, it was reporting costs to the Government, reporting a loss to receive tax breaks.

”They have been telling the Government the truth, but they tell investors something else,” he said.

source: http://www.nytimes.com/1996/10/30/business/america-online-announces-a-newer-transformation.html

 

Jim Chanos, Kynikos Associates on AOL:

Q: what was your biggest mistake?
A (Jim Chanos): AOL. It was a short due to accounting, we thought they were masking higher churn then they reported. We thought the value of a subscriber would turn out less than they thought. We started shorting at $2-$4, covered as it went up, and covered the last at $80. We kept it to a 1%-1.5% position. We knew we were in the midst of a bubble, so we kept it small, but it still cost us 10% over 2 years.

source: http://myinvestingnotebook.blogspot.com/2010/05/jim-chanos-power-of-negative-thinking.html

 

What if the SEC were to Launch a Largecap Fraud Task Force: the Ode to the SEC Edition

The Securities and Exchange Commission (“SEC”) recently launched a Microcap Fraud Task Force. It appears that the SEC’s efforts are already bearing fruit:

Washington D.C., Aug. 5, 2014

The Securities and Exchange Commission today charged four promoters with ties to the Pacific Northwest for manipulating the securities of several microcap companies, including marijuana-related stocks that the agency has warned investors about in recent weeks.

The SEC alleges that the four promoters bought inexpensive shares of thinly traded penny stock companies on the open market and conducted pre-arranged, manipulative matched orders and wash trades to create the illusion of an active market in these stocks.  They then sold their shares in coordination with aggressive promotional campaigns that urged investors to buy the stocks because the prices were on the verge of rising substantially.  However, these companies had little to no business operations at the time. The promoters reaped more than $2.5 million in illegal profits through their schemes.

Two of the companies manipulated in this case – GrowLife Inc. and Hemp Inc. – claim to be related to the medical marijuana industry.  The SEC has issued an investor alert warning about possible scams involving marijuana-related investments, noting that fraudsters often exploit the latest growth industries to lure investors into stock manipulation schemes.  Other schemes by these four promoters involved an oil-and-gas company – Riverdale Oil and Gas Corporation – and three other microcap stocks, ISM International, Allied Products Corp, and Aden Solutions.

The SEC was able to unearth the schemes through the work of its recently created Microcap Fraud Task Force.

“Our Microcap Fraud Task Force is taking direct aim at abusive practices and serial violators within the microcap markets like these four promoters seeking to exploit retail investors for personal gain,” said Michael Paley, co-chair of the SEC’s Microcap Fraud Task Force.  “In this case, we meticulously reviewed trading records and developed the evidence necessary to connect these four promoters and their coordinated trading efforts.”

Source: http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542594818#.U-GbJvldVz7

Here are a few thoughts that come to my mind:

  • The SEC has done an excellent job recently in addressing microcap related fraud. The SEC (nor any government or private operator) cannot eliminate bad behavior, nor is it to blame for others’ wrong-doing. It can, however, react swiftly, justly, and thoughtfully in the instances of alleged wrong-doing.  The SEC is very clearly part of the solution, not the problem. It is evident to me that they have responded very effectively in many of these recent microcap fraud cases. The SEC was remarkably quick to respond to the CYNK fraud recently, contrary to claims otherwise. The SEC is very clearly part of the solution, not the problem. The SEC deserves praise and the full support of all those willing to speak up against bad behavior in the markets.
  • It remains a shame that it is far easier to earn $2 million by manipulating and promoting stock frauds, rather than exposing them. That being said, we Americans are blessed that the SEC targets the stock fraud promoters, rather than the short sellers who seek to expose them. It seems clear that the SEC is aware that for every 1 short seller who may break the law, there are likely 100s-10,000s+ longs and corporate issuers/managements who break the law via stock manipulation, fraud, etc. Nearly all the illegal profits/injust enrichment are reaped by the longs/corporate issuers.
  • If the SEC were to create a thoughtful and nimble Largecap Fraud Task Force (coinciding with similar efforts on the part of the Justice Department and certain state Attorney Generals)… one can only dream. The societal and market-places benefits would be immeasurable. I estimate the societal and market-place benefits would last for at least a generation. More on this (possibly) later.

 

“My business is to comfort the afflicted and afflict the comfortable” – Mother Mary Jones

The Greatest Victory is the one with Least Bloodshed: The Microsoft/Valueact Edition

Even former Microsoft CEO Steve Ballmer noticed a change at his company when ValueAct showed up last April, saying shares were undervalued in part because investors were overlooking Microsoft’s continued success selling many of its software products to corporations. The longtime executive credited ValueAct for helping to change investor sentiment toward Microsoft.

“Maybe starting with the ValueAct investment…there was a wave of, ‘Oh yeah those guys have a phenomenal enterprise business,’” Mr. Ballmer said in a May interview.

The other sea change at Microsoft around ValueAct’s investment was Mr. Ballmer’s surprise retirement, announced a week before ValueAct got on the board. Mr. Ballmer and other Microsoft officials said pressure from ValueAct played no role in his departure.

Source: http://blogs.wsj.com/moneybeat/2014/06/20/success-of-valueact-hedge-fund-has-dented-its-maneuverability/

 

As measured by market cap impact, it seems Valueact’s Microsoft activism has been the most effective. And they achieved it with minimal heads rolling, minimal/zero glitz/glamour, and minimal/zero Jersey Shore media campaigns. In short, the greatest activist victory (in recent memory), was achieved with the least bloodshed (and fanfare).

I believe it’s safe to say Valueact wants to remain low key, maintain a low profile (except to the extent that further attention will cultivate and bring about culture change in the investment world, specifically but not limited to, shareholder activism).

That being said, it would seem that it will be very difficult (for now) to maintain a low profile:

But its maneuverability appears to have been dented. For most of its history, stock prices of companies it took activist stakes in generally ticked down in the year after the firm disclosed its positions, letting it scoop up more shares for a discount  said ValueAct President and Microsoft board member Mason Morfit. In the last year, the stock prices of its picks have “popped” as other investors mimic ValueAct’s moves. All the attention is “to our chagrin,” Mr. Morfit added.

Here are some ideas:

  • Talk to management teams under assumed names (rather than Valueact’s)
  • Add some serious capital allocation to short selling (probably need to hire someone to lead the charge). This way, it’ll be easier to confuse market participants

 

 

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