Jim Chanos on Shorting (Prepared Statement to the SEC)

From Santangel's Review:

This is a prepared statement Jim Chanos gave to the SEC back in 2003. It is interesting because it shines a little light on his methodology for successfully shorting as he goes through an in-depth case study on his short of Enron. Before I dig into his Enron short, I want to mention this quote he uses in his testimony as it is quite interesting.

“If you own shares in a company that declares war on short sellers, there is only one thing to do: sell your stake. That’s the message in a new study by Owen A. Lamont, associate professor of finance at the University of Chicago’s graduate school of business. The study, which covers 1977 to 2002, shows not only that the stocks of companies who try to thwart short sellers are generally overpriced, but also that short sellers are often dead right.”

We touched on this in How Eric Sprott got Solar Burn. Warning sign number six was “The company lashed out against its critics”.   The Wall Street Journal coined the term “Being Einhorned” today, but if I remember correctly, some of Einhorn’s best shorts have been the ones where the company most vigorously lashed back out at him. Lehman, Allied and Green Mountain come to mind.
Some takeaways from Chanos’s short of Enron:
Sometimes the best ideas are hiding in plain sight

“In October of 2000, a friend asked me if I had seen an interesting article in The Texas Wall Street Journal, which is a regional edition, about accounting practices at large energy trading firms. The article, written by Jonathan Weil, pointed out that many of these firms, including Enron, employed the so-called “gain-on-sale” accounting method for their long-term energy trades. Basically, “gain-on-sale” accounting allows a company to estimate the future profitability of a trade made today and book a profit today based on the present value of those estimated future profits.”

Even though Enron was incredibly complex, Chanos started with just the annual report

“The first Enron document my firm analyzed was its 1999 Form 10-K filing, which it had filed with the SEC. “

The major red flags were visible right away if you understood the accounting and had a sense for what the returns should look like

“What immediately struck us was that despite using the “gain-on- sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7 percent before taxes. That is, for every dollar in outside capital that Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm, a 7 percent return on capital seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7 percent and probably closer to 9 percent, which meant from an economic point of view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its return on investment became the cornerstone for our bearish view on Enron and we began shorting Enron common stock in November of 2000 for our clients.”...MORE

HT: Market Folly