The art of short selling and other insights from the gurus

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Lasse Heje Pedersen

by Greg Bright

I’ve always been fascinated by predominantly short-selling managers – those whose style have a dedicated short bias – of whom there are a sprinkling in the US but none in Australia. At least none who raise money from the public. They tend to underperform for long periods, often several years, and then shoot the lights out. It’s the Hollywood studios approach to investing.

In a new book, written by academic and fund manager Lasse Heje Pedersen, ‘Efficiently Inefficent’*, one of the world’s most public proponents of the style, James Chanos, shares his thoughts, including handling the problem of always being seen as ‘the bad guy’. “We like to have Murphy’s Law working for us,” Chanos says.

The book is actually full of interesting interviews with famous fund managers but doubles as a text book for all the different investment styles. It should please quants and fundamentalists alike, and also those of us who just like to hear the stories of the world’s top managers.

Pederson works for AQR Capital, so one of the top managers interviewed is AQR’s famous co-founder Cliff Asness, who always provides a good read. Others include George Soros, David Harding of Winton Capital, Nobel Laureate Myron Scholes, Ken Griffin of Citadel, Lee S. Ainslee III of Maverick Capital and John Paulson of Paulson & Co. For academics and students the interviews are wrapped within a descriptive framework which provides an up-to-date backgrounder on proven investment strategies.

But back to James Chanos and dedicated short bias. Chanos and his firm, Kynikos Associates, made their name with the Enron disaster, which they started to investigate in 2000 because of an article in the ‘Texas Wall Street Journal’ about energy companies using an accounting method known as ‘gain on sale’. Here, profits were booked in advance, based on assumptions of the future value of today’s trades. With his interest piqued, Chanos and his team continued to investigate and their enthusiasm for the short reached a crescendo in August 2001 with the sudden resignation of Enron’s CEO, Jeff Skilling, “for personal reasons”. Chanos tells Pedersen that this resignation was the most ominous development and Kynikos increased its short position at that point. Enron filed for bankruptcy on December 2, 2001, which was the largest ever in the US until Worldcom a year later.

In defence of his investment style, Chanos says: “The effort we devoted to looking behind the numbers at Enron, and the actions we ultimately took based upon our research and analysis, show how we deliver value to our investors and, ultimately, to the market as a whole. Short sellers are the professional skeptics who look past the hype to gauge the true value of a stock.”

Other successful examples are quoted in the book and some unsuccessful ones too. Chanos says: “Obviously Enron was a story that put us on the map and it was an interesting short story. I think that being short a number of the Drexel Burnham stocks back in the late 1980s was also an interesting situation on the short side, including the junk bond companies Integrated Resources and First Executive. More recently some of the real estate companies…

“Our biggest loser was America Online, which we shorted in 1996, I think, and basically covered in 1998, when the stock was up eightfold. We shorted it because we believed that the company was not properly accounting for its marketing costs. It then took a big bath write-off in ’96, and people said, ‘Okay. Everything must be fine’. We simply pointed out that the big write- off meant that they were never profitable, and our view was that they probably never would be. But we underestimated the power of the Internet and the euphoria of retail investors, who just didn’t care. And because it was an Internet stock and one of the Internet leaders, the stock just kept going up and up and up.

“Fortunately, it was never more than a 1 per cent position for us. So we kept trimming it back, even as it kept doubling. But having said that, we probably lost 5, 6, 7 per cent over two years on the position. While not a disaster, certainly you never want to see a short go up eightfold against you. This trade underscores the risk of the short side, and it taught us a lesson on how to size positions in volatile stocks. You can never be too big in the volatile stocks; you need to have more names to diversify your risk.”

Kynikos, which is the world’s largest dedicated short-bias manager, uses a diversified portfolio of about 50 positions to try to mitigate against prolonged underperformance due to share markets, which generally go up rather than down. The Hollywood analogy, though, still applies. This refers to the heyday of the studio system, when companies such as Warner Bros, Universal and MGM owned their backlots and contracted stars for multiple movies. Their rule of thumb was that one out of every seven movies should generate enough money to account for the losses or modest earnings of the other six.

But, not everyone, it seems, would be cut out for this style of investing. In his book, ‘The Art of Short Selling’, published in 1997, K. F. Staley says: “Short sellers are odd people. Most of them are ambitious, driven, antisocial, and single minded. As individuals, they are not very likely to own a Rolex watch or a Presidential springer spaniel or any other symbolic trapping of success; they are likely to have a wry slightly twisted sense of humor. As a group, short sellers like to disagree, and they like to win against big odds. Typically, they have an axe to grind, a chip on the shoulder. As in the general population, some of them are cretins and some are not, but they are all smarter (most of them, in fact, are intellectual snobs) and more independent than most people. Contrary to popular wisdom, they do not form a cabal and bash stocks senseless. They normally are secretive and slightly paranoid. And they are frequently irreverent in their regard for business leaders and icons of Wall Street.”

Chanos may not disagree. He tells Pedersen that there tends to be an enormous amount of positive ‘noise’ about individual stocks and short sellers have to try to ignore that. He says: “I think that good short sellers are born, not made, quite frankly. I never used to think that. But I do think that now, after 30 years of doing this. That is, you have to have some mental makeup that allows you to just drown out that positive noise, disregard it, and just focus on your work, your facts, and your conclusions, based on that.”

*Efficiently Inefficient: How Smart Money Invests and Market Prices are Determined’, Lasse Heje Pedersen, published by Princeton University Press. 368 pages. Online and hardcopy order information here:

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