Capitalize for Kids – Interview with Jim Chanos, March 1, 2017
Where are investors most significantly miscalculating risk?
- With the obvious caveat that I am not a geopolitical strategist or macro guy, one of the least appreciated risks is the political set of risks the world is now facing
- At a point where pendulum between capital and labor has swung so far over to capital or globalism that populism, nationalism, and labor are beginning to swing back
- Growing amount of evidence that nationalism is rising, protectionism is rising, authoritarianism is rising
- Beginning to see tensions rise in the Pacific, with the South China Sea and the new dynamics in Korea and the Philippines and an apparently hardening posture by Trump administration toward China
- Balkans is one area where its underappreciated but worth paying attention to; Balkans are getting to be a simmering place again
- Rise of Erdogan in Turkey, who wants to bring a second Ottoman Empire, increasing activity by Slavic people in that region because of the feeling that Putin has their back
- People like Serbs, Greeks and all of that area, which was a hot bed in the 90’s, the temperatures seems to be rising again
- Borderline failed states in Africa: both South Africa and Nigeria are increasingly showing signs of major political problems
- All the commodity exporting countries are still probably facing more trouble than opportunity of the inextirpable slowing down of China
Are short opportunities more prevalent under a Trump Administration than they otherwise would have been under a Clinton Administration?
- All the big money we’ve ever made has been under Republican presidencies; toughest times were under Bill Clinton and Barack Obama; under Reagan, Herbert, Bush and his son, markets were quite volatile and I will leave it at that
Insights on individual names?
- I have a big problem with most Chinese companies: low returns on capital, odd accounting, flows that you can’t track, byzantine corporate structure; shareholders just own a piece of paper with a promise as these companies get more leveraged
- Are Alibaba affiliates advertising on Alibaba platforms? Unconsolidated Alibaba affiliates that they put money into but it just comes back?
- These kinds of governance and accounting issues are right in our wheelhouse and we would urge investors to be cautious on too good to be true stories coming out of China
- Cynicism of Elon Musk’s empire
- We think it’s ascendance of hype over reality in some really tough businesses (selling cars and residential panels)
- Cash burn with those companies is enormous and it’s going to get worse as they get bigger
- Companies that need more cash as they get bigger especially when deadline after deadline hasn’t been met should scare investors
- Risk/reward of the debt securities of some of these companies
- With the bull market, companies have been able to issue debt at 4-5% if they are in the right industry; rationale has been that because of equity gap, they can always sell more stock
- North American E&P space
- Absolutely convinced that fracking business is uneconomic and I will claim that to my dying day
- If you do the cash flows, do the returns on capital, and depreciate the wells properly, this is a very poor returning or negatively returning business
- No FCF at $100, $30, or $50 – and yet, capital markets have now reopened to these companies; it’s a very scary area
Auto cycle – are you cautious on the sector?
- Little pattern of recognition on the auto cycle (sort of where we were in ’05): SAAR had sort of peaked out and stayed flat for the next few years but the rate of change had slowed dramatically
- Cars are usually the first thing out of the cycle and so now we’ve been at this sort of 17 million SAAR now for a while and what we’re seeing is classical: you are seeing more incentives, manufacturers cut plant production on the margin, use of aggressive credit, lengthening lease terms, lowering residuals
- I think this will be one area in particular that a run up in rates would probably hit hard because everyone buying cars is doing so on monthly payments
- Without naming the security, this company was earning 6% on their capital at the peak of cycle; giant company; not one of the OEM’s and has a finance arm
- Earned below its cost of capital when things were good – what’s going to happen when things are bad? Today, it’s trading at its highs
Does today’s market environment remind you of a similar time in history?
- They’re all different because different things drive different bull markets
- Late 80’s: had the first bout of economic boom and then too much leverage and you had the stock market crash in ’89 and ‘90
- 90’s: it was the Internet; that went on for a decade until you had the inextirpable excess and blow off
- Next one: rise of China and leveraging up of American consumer in real estate; monstrous rally in commodities, emerging markets, in the US off the back of consumption and increased debt – that led to ’08 and ‘09
- Since ’08 and ’09: advent of central banking – saves the world and makes you rich
- So how is this going to change if it does, and how does that manifest itself?
- Are we going to see companies that just can’t possibly do well if interest rates go up by 300-400bps?
Current makeup of Kynikos, how does that compare to what you originally envisioned when you started the firm?
- Original ethos of the firm hasn’t changed – portfolio of good fundamental short ideas that we provide a hedge for clients
- Actual makeup of the firm in terms of number of partners, capital employed, size of operation
- Nice thing about the firm is continuity – I have 7 partners and we have over 150 years on Wall Street but 100 of it under this roof
As Kynikos grew in size, how has your ability to detect frauds or bad actors changed as a result?
- Back in 1985 and for 10+ years, spent a lot of time in the SEC micro-feed rooms in New York just looking at 10-Qs; today, everybody has instant information – the question is what do you do with it?
- Information edge which short sellers were known for in the 80’s and 90’s are much less important today than actually understanding the way that businesses work, understanding how the numbers are flowing and when bad actors are playing games with you
You spoke about information becoming ubiquitous. How has the past experience of your team allowed you to see what could potentially unfold?
- Valeant Pharmaceuticals: I’ve been on record saying that it might be the largest single stock loss in the hedge fund industry (greater than Lehman and Enron) because hedge fund concentration was so high
- When our pharma analyst brought up the idea in 2013, we immediately drew parallels to Tyco International – an aggressive roll up run by two guys who ended up going to prison; situation was different but they were employing some of the same stuff that Mike Pearson was doing at Valeant
- In 2015, saw a website called FiercePharma which pointed out an aggressive pharmacy called Philidor and its association to Valeant; we sent out analysts to check out Philidor and we saw a big operation – warehouses, drops, the whole nine yards and it was enormous; this was not in the disclosure and we questioned what else was not disclosed
- This was when the stock was around $240 or $260
- Fact that they were using these mall order pharmacies and were booking through the pharmacies that they effectively controlled became crucial to the whole Valeant story
- Valeant is a good example of lots of different aspects but is having some good institutional memory where senior decision makers at the firm have seen these kinds of things before
How do you see Kynikos evolving? Do you see machine learning being integrated into the firm?
- At some point, yes. But I think there are some things the human brain still does very well (like having institutional memory). What makes us a little less susceptible to big data is that it is only as good as its inputs. In our universe, companies are actively trying to give you false inputs
- Because we’re questioning the actual inputs and not how they interact with the market price, we might still have an edge
How do you think of your own legacy and what you’ve been able to accomplish?
- I don’t think about my legacy. I have 4 amazing kids so my first and foremost priority was always my own family
- In terms of the firm, very proud of what we’ve built here. I just think that doing anything for 30 plus years is tough in a society that is increasingly seemingly short-cycled
- We’ve built an organization and that’s been fun – ultimate irony of a short seller: building things up
James Chanos is the founder and President of Kynikos Associates, a hedge fund specializing in short selling.
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