I call Jim Chanos the Warren Buffett of short selling; he is after all the largest short seller in the world, and he’s also one of the smartest people I’ve met (here is a link to a PDF) Short selling is perceived as a deeply un-American activity. After all, America was built on optimism, growth, prosperity. Short selling, on the other hand, is pessimistic by nature: you bet on decline and thus the loss of wealth. But there is nothing evil, immoral, or even un-American about short selling. In the short run, supply and demand will set the stock price. If investors are bearish on a stock, if they own it they sell it; if they don’t own it, they borrow it and short sell it. If they are bullish, they do the opposite. In the long run none of those things will matter. Stock prices will reflect fundamentals, i.e., companies’ earnings and their proper valuation. If short sellers are right and the company is worth less, they make a killing; if they are wrong – well, they lose. This is capitalism at its best – survival of the rightest and brightest.
Being a short seller is far more difficult than being a long investor, as in the long run population grows, the economy grows (I know this assumption is not as easy to make today than, let’s say, ten years ago), and the stock market goes up. Also, risk/reward is skewed against you – stocks can go up to infinity but can only decline 100%. The inverse is true for short sellers: the upside is capped at 100%, while the downside is infinite. I asked Jim about this a while back. He had, as always, a good one-liner answer: “I’ve seen a lot of stocks go down 100%, but I’ve yet to see a stock that went to infinity”.
Your investment style should fit your personality. I know that my personality is not wired for short selling. A few years back, Jim and I discussed a stock that he was short. After our conversation, for the following year I observed that stock doubling and then almost doubling again. From later conversations I know that Jim did not cover his short, so at some point he was down close to 400%. Of course, a year and a half later that stock (deservedly) collapsed and now is trading 50-60% below the price at which Jim shorted it. I probably would have gone bold and acquired an addiction if something like this happened to me. Jim, however, was very calm and nonchalant while this was happening. His research was telling him the stock market was wrong. I have always thought that value investors are the most contrarian investors. Well, I tip my hat to short sellers.
There is a lot long-only value investors can learn from short sellers. I have a friend who runs long/short. He is a terrific investor. When he looks at a stock, at first he doesn’t know if he’ll go long or short it. This neutral predisposition makes his analysis a lot more objective and removes layers of behavioral blockage.
What I learned from Jim’s presentation this year (as well as from last year’s) is that value investors are prone to stepping into a “value trap” – the value investor’s hell, because we look at a company’s past earnings (and/or cash flows), and that becomes our reference point. But the value of any asset is the present value of its future – not past – cash flows. So we should spend a lot more time focusing on future earnings power and not get anchored in past earnings.
During dinner at VALUEx Jim and I talked about how they do research at Kynikos (Jim’s firm). His analysts always start research with a company’s SEC filings, then listen to the company’s conference calls and presentations, and only at the very, very end do they read outside research. As Jim put it, “It’s like peeling the onion from inside out”. He wants his analysts to form their own objective opinions first, and then once they are armed with facts, they can expose themselves to what everyone else thinks.