- By Robert Abbott
The intrinsic value of IWM
He operates a hedge fund that provides contrarian strategies for institutional investors and other big investors, especially those looking for uncorrelated portfolios.
He has had great successes, including Enron, but for the past five years he has done all right, and that is hardly anything to boast about. That may change with the next correction or collapse.
In the meantime, value investors can learn from him by studying valuation from the short side.
Who is Chanos?
Born in 1957, Chanos grew up in Milwaukee, where his family operated a chain of dry cleaning shops. He went on to earn a bachelor"s degree in economics and political science from Yale University in 1980.
After graduating, he worked briefly as a securities analyst at Deutsche Bank Capital and Gilford Securities. Chanos then went on to work at investment banking firm Blyth Eastman Paine Webber, starting in 1980.
In 1985, he launched Kynikos Associates (Kynikos is the Greek word for "cynic") with $16 million. From that beginning, he has had as much as $7 billion under management, but the current sum is approximately $2.3 billion.
He has been called the "mirror image" of Warren Buffett (Trades, Portfolio) because he goes through the same kind of due diligence, but uses that research to find overvalued, rather than undervalued, opportunities.
Chanos apparently set out to become a financial detective from the time he founded his own firm, and the name he chose for it turned out to be apt.
What is Kynikos Associates?
The Form ADV Part 2A brochure lists the firm as a provider of discretionary investment advisory services.
As of March 30, the firm had $2.3 billion of assets under management. The Form ADV also shows Kynikos" four biggest types of clients were pooled investment vehicles, corporations or other businesses and investment companies. Of that, $355 million is invested in equities (Sept. 30), as reported by GuruFocus.
Chanos and the company first gained prominence by predicting the collapse of--and shorting--Enron Corp. It then went on to score shorting successes with WorldCom and Tyco, before getting into the right position for the 2008 bust.
Being a short seller is a difficult and risky practice, but Chanos has apparently mastered it; he is still going strong more than 30 years later.
As noted, the firm and Chanos are short sellers; their aim is to produce value for their clients by identifying and buying overvalued securities. We might say short sellers are the inverse of value investors, who seek to find undervalued securities.
The firm spells out its strategies in more detail in the Form ADV Part 2A. To find overvalued securities, it uses "extensive" fundamental research on both companies and industries. The company splits its strategies between two sets of funds: The Ursus hedge funds and the Kynikos Opportunity hedge funds.
For the Ursus (and Kriticos) funds, they look for candidates that are expected to be valued downward because of:
Deteriorating profit outlook.
Increased industry competition.
The lack of a viable, long-term business model.
For the Kynikos Opportunity funds, they specify many of the same criteria, but consider long positions as well as short positions. The Kynikos funds are open to any positions they feel they can profitably trade.
Turning to process, both funds use multiple analytical techniques:
Balance sheet analysis.
Income statement analysis.
Flow of funds statement analysis.
Interactions between these three analyses.
Also, per the Form ADV Part 2A, the firm watches the quality of corporate earnings and returns on invested capital.
It uses industry analysis in two ways: first in conjunction with company-specific research, and second as a source of shorting opportunities on its own. Cues come from measures such as increasing industry competition, pending overcapacity, industry risk profiles that are changing and incorrect market size assessments for a company"s product.
They do their own research, using publicly available filings, industry publications, discussions with management, competitors and industry consultants, as well as doing product research.
Technical analysis, market timing or asset allocation models are not used in its research. However, it does say it uses Chanos" extensive experience to identify investment ideas.
Whether going short or long, they use multiple vehicles, including non-listed securities, convertible securities and options (including puts and calls on stocks and warrants).
In 2014, Chanos reported a new strategy for shorting, as explained in a Business Insider article. He said this strategy would focus on companies that bought back stock, calling the buybacks a sign of weakness.
The rationale behind the strategy is companies think their stock can return more than their business operations. Chanos is quoted as saying, "Corporate CEOs, with their massive share-buyback programs are in effect investing in the stock market rather than in expanding business opportunities at their companies. Either they expect higher returns from the market, or lower returns in their business, or some combination of both. Given their questionable track record in timing the market, this may be a cause for concern."
So far, it is not known if he implemented this strategy and, if he did, how successful it was.
A couple of years earlier, he explained how he spots companies that look good but are really value traps. In a presentation at ValueX Vail, and reported by Business Insider/ValueWalk, Chanos said value traps have some common characteristics, including:
Being overly dependent on one product.
Expectations driven by hindsight.
Marquis management and/or famous investors (headliners famous for they have done in the past).
Cheap valuations using management"s measures.
In another presentation, Chanos gave a spirited defense of short selling to the U.S. Securities and Exchange Commission Roundtable on Hedge Funds in 2003. He said shorting is beneficial for markets, not only in terms of providing liquidity, but also as an "important bulwark against hyperbole, irrational exuberance and corporate fraud."
He points out there are three types of market participants who sell short:
First, exchange specialists, market makers and block traders who are trying to maintain liquidity and price stability for their customers.
Second, short sellers practicing market neutral arbitrage; they try to profit from temporary or minute price discrepancies.
Third, and most commonly in public perception, investors who believe a stock or market index has become overvalued and may suffer falling prices.
Chanos adds that short sellers are subject to stringent regulations, and typically must hold their positions for extended periods. That makes short positions both costly and risky.
Short sellers are financial detectives, he said, and many major corporate frauds were first exposed by the fundamental research of short sellers. He goes on explain how his detective work brought to light the malfeasance at Enron, and quotes the words of financial historian Edward Chancellor, "We need more, not less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the recent technology, media and telecoms boom."
It is good to be reminded from time to time that short selling performs a useful service for all investors (even though they miss at times). Their ongoing diligence helps protect many individual investors from walking into value traps. It is also helpful to know how short sellers think.
This lopsided chart from GuruFocus illustrates how Chanos positions his equity portfolio:
And these are the top 10 equity holdings:
iShares Russell 2000 (IWM): 11.18%
SPDR MidCap Trust Series I (MDY): 10.89%
iShares Core S&P 500 (IVV): 7.53%
SPDR S&P 500 (SPY): 4.54%
Vanguard S&P 500 (VOO): 4.36%
Vanguard Total World Stock Index (VT): 3.78%
UrtheCast Corp. (UR): 1.88%
Vanguard Total International Stock ETF (VXUS): 1.82%
iShares Core S&P Mid-Cap (IJH): 1.82%
PowerShares QQQ Trust Series 1 (QQQ): 1.68%
UrtheCast, a Canadian company, describes itself as distributor of "the operational software for the first publicly accessible high definition cameras installed on the International Space Station."
A predominance of ETFs in this portfolio, both in terms of sectors and his top 10 holdings.
Chanos has had some very good years, especially those in which he cashed in on Enron, WorldCom, Tyco and the 2008 crisis.
Over the past five years, though, it has mostly been a disappointing experience, as shown in this TipRanks chart:
TipRanks also reports his average annual return over the past three years has been 9.59%.
The bull market keeps going and going; short sellers keep feeling the pain. In Chanos" case, the results have not been too serious, since short sellers might be expected to have trouble just breaking even, while he has had average returns of almost 10%.
For those of us who expect a correction or collapse, Chanos sits in an enviable position. He and other short sellers know how to prepare for and profit from pullbacks better than most.
Of course, there is that pesky question of timing. While waiting for the markets to get back to normal valuations, he and other short sellers must have some sleepless nights.
Still this financial detective has useful information for value investors. All who look for good deals must also be careful to avoid value traps, and Chanos can help. Tracking his activities and knowing how he ferrets out potential flops should help all investors enjoy better long-term results.
Disclosure: I do not own shares or units in any of the companies or ETFs listed in this article, and do not expect to buy any in the next 72 hours.
This article first appeared on GuruFocus.
The intrinsic value of IWM