Editor’s note: This article was first published in November 2013; Chanos’s bet against China, Ackman’s open short on Herbalife and the surge in Herbalife’s shares reflect that time. Herbalife settled with the US FTC in 2016 without being declared a pyramid scheme, and Ackman closed the position in 2018.
As many of you already know, in stock market investing you can make a lot of money whether a company goes up or down. The reason many people specialise in short (bearish) positions is that short positions can be much more profitable than long ones (above all because the move is usually faster), if you have seen or studied something that makes you think a company is going under.
The problem that sometimes arises is that we may know something is going to collapse because it isn’t viable or sustainable, but we don’t know exactly when. That is why there’s a saying in investing: “The market can stay wrong for longer than your pocket can hold out.”
But Jim Chanos, an expert in short selling (bearish positions) who currently has a short position on China, gives us some wise advice for any investor who wants to make money by shorting.
Just as billionaire George Soros made $1 billion with a short position that forced the Bank of England to devalue the currency, Chanos made a fortune betting against Enron. But to be a good short seller, you need to follow some guidelines. These are Jim Chanos’s tips for short sellers:
1. Primary research is essential
Chanos believes investors should start by looking at the company’s most recent filings and then work backwards.
“Read the statements in the filings that tend to get overlooked and that are full of great information. Doing that, and spending a night or two with the documents, can give you a very complete view of the company’s future. Above all, you should analyse it from an impartial point of view.”
And the truth is that many investors have more desire to see something fall than well-founded arguments for why a company should fall.
2. There’s nothing like starting from the source documents
Chanos says the most important thing for success in this industry is knowing “that there’s nothing better than starting with the source documents”.
“I always teach my students and analysts to start first with the SEC filings [the CNMV in Spain], and then go to the press releases, the earnings reports and the other research, which everyone gets to in their own way.”
While we’re at it, remember that the CNMV’s Twitter account for material announcements by listed companies is @CNMV_HR.
3. Avoid meeting company management
This tip is perhaps aimed more at fund managers who deal face to face with the chairmen of listed companies, since the average investor doesn’t usually have access to the top of a listed company’s organisational chart.
“We never meet with management. By default, we don’t trust the company. If we want information, we can get it without meeting the executives.”
In other words, if a short seller had met the chairman of Pescanova, the chairman might have convinced him that Pescanova’s accounts were fine and talked him out of shorting the company, so he could have missed out on making money from the company’s fall.
4. Short sellers are better than regulators at uncovering fraud
Chanos considers short sellers to be real-time financial detectives who, on top of that, have a financial incentive to uncover fraud, and that makes them more effective than the SEC’s own regulators and the people in charge of auditing the accounts.
5. A short can be very profitable, but it can go very badly for a while
Chanos tells a short story about the first short he recommended, on Baldwin-United: he could clearly see that the company’s business model wasn’t profitable and that it also had high levels of leverage, among many other problems.
But the share price doubled in a short time after the stock received buy recommendations, going from $24 to $50. Instead of closing the position, he increased his exposure and stood by his bearish view. When Chanos went to visit his parents at Christmas, he got a phone call that was his Christmas present: Baldwin-United was declaring bankruptcy.
That made Chanos a lot of money and, of course, wiped out the capital of all the investors who had put money into the company simply because the analysts were recommending it at the time.
6. Try to focus on companies where something is going very wrong
“We never try to short a company on its valuation, although at some price even reasonably good businesses become targets for a short position because of the limits on their growth. We focus on companies where something is wrong or very wrong.”
In fact, Chanos gives Kodak as an example, a company that spent a long time trying to hide its real situation through its internal policies and its accounting.
7. There’s a big difference between a value investor and a short seller
We could say that investors who specialise in short positions usually have the same skills as value investors (value investing), because in reality both study the company to find something the market hasn’t seen. In value investing, that means finding hidden value and strengths in the company that the market has missed.
With short positions, you are looking for the cancer that is eating away at the company and that the market has not yet diagnosed. The biggest difference, according to Chanos, is the psychological factor, which falls within the field of behavioural finance.
8. You have to withstand everyone telling you you’re wrong all the time
A good short seller’s psychological strength lies in being able to withstand everyone else (investors, analysts and the market as a whole) repeating every single day that your position on that company is completely wrong, while you watch the stock actually move in the opposite direction to your bet.
It takes a lot of self-confidence to put up with that. The most recent example is Bill Ackman’s short position against Herbalife, a position Ackman continues to defend even though Herbalife’s shares have soared.
If the authorities were finally to prove Ackman’s theory (that Herbalife is a pyramid scheme rather than a multi-level marketing company), we could say the activist investor had done a good job. If Ackman turns out to be wrong and is forced to close his position at a loss, he will have made one of the biggest fools of himself in the history of short selling.
Sources: The Globe and Mail | Business Insider. Adapted and modified.
Further reading
- Quotes from the best investors that will help you understand the stock market
- What I learned from Keynes about investing
- Economist wins a grant for showing that most investors are idiots
Featured image: Warren LeMay, CC BY-SA 2.0, via Flickr.
