Jim Chanos: “Nothing Beats Starting With Source Documents”

GD2Yesterday, I came across an interview with Jim Chanos from the spring 2012 edition of Graham & Doddsville – An investment newsletter from the students of Columbia Business School, see pages 16-30. This interview is a good one, and one part of the discussion is about where to start ones investment survey.

Jim Chanos’ teaches his students and analysts “…nothing beats starting with source documents”, and that they conduct their investigation of different businesses in the following order:

  1. SEC filings
  2. Press releases
  3. Earnings calls
  4. Other research

GD3Below are some excerpts from the interview mentioned and quoted above (boldings added by me).

See here for full PDF.

GD4“G&D [Graham & Doddsville]: What are some of the skills that are essential to  succeeding in this field?

JC [Jim Chanos]: I teach a class at Yale’s Business School on the history of financial fraud. One of the things I teach my students, which I also teach my analysts here, is that nothing beats starting with source documents. You have to build a case for an idea, and you can’t do that without doing the reading and the work. We’ve had a little game where we’ve been watching a company that just put out its 10K. When it came out, prominent in the disclosure was that the company had just changed its domicile to Switzerland for a variety of important reasons. I told the analyst, let’s play a game: call the sell side analysts and try to ask them some questions to see if they know that the company, under the advice of their legal counsel, changed their domicile. She said that of the eight analysts that followed the company, it was the seventh analyst who had a clue of what she was talking about. None of the others had any idea, which meant they hadn’t read the document, and that 10K had been out for 10 days. This happens more than you think. It happens because Wall Street research departments are marketing departments. The people with the most experience in these departments spend much of their time marketing. The junior people are back at the shop doing models and such, but there isn’t much thought going into this. So I teach my students and analysts: start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in. They’ll hear a story, then they’ll read some research reports, then they’ll listen to some conference calls, and by that point may have already put the stock in their portfolio. It’s amazing what companies will tell you in their documents. Enron is a great example – most of the stuff was hiding in plain sight. There was one crucial piece of missing information, which was the “make good” in the SPVs that Fastow was running. The reason people invested in those and bought crummy deals from Enron was that there was a provision that if you lost money, Enron would issue stock and make you good. So that was a key missing piece of information. But in any case, it was amazing how much information was out there. Investing is like a civil trial. You need a preponderance of evidence, not beyond a reasonable doubt.

G&D: Do you recommend investors start with reading the newer filings first?

JC: Yes, look for language changes. Read the most current ones and work your way backwards. Read the proxy statements that are often neglected and are full of great information. By doing that and by spending a night or two with those documents, you can have a remarkably comprehensive view about a company. So start there and work your way out. This way you are looking at the most unbiased sources first. People on earnings calls will try and spin things, and analyst reports will obviously have a point of view. All of that is fine, because hopefully you will have first read the unvarnished facts. Primary research is crucial and not as many people do it as you think. Because there is so much information out there, it almost behooves people to read the source documents. If you are an airline analyst, you could be reading about airplane orders, traffic trends, fuel price trends, etc. all day long, and not have a better idea of what is going on at Delta Airlines or Japan Airlines. Start by reading the documents of Delta Airlines or Japan Airlines. Overtime, understanding what to read and how much time to spend reading various things becomes an art as much as a science. You need to become a good information editor nowadays.


G&D: What are some of the avoidable mistakes that you see analysts make?

JC: One of the biggest things I see quite often is getting too close to management. We never meet with management. For all of the bad asymmetries of being on the short side, one of the good asymmetries is that we don’t rely on the company. We can get information from the company if we want to, as we can go through the sellside. Those that are long the stock and are close to the company almost never hear the negative side in any detail. The biggest mistake people make is to be co-opted by management. The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive. A second mistake some people make is not reading all of the documents. I guide people to always start with the SEC documents, and then go to other sources for information. It’s amazing how few analysts actually read SEC filings. It blows me away. We have the greatest disclosure system in the world and people by and large don’t take advantage of it. I am a big believer in looking for changes in language in a company’s filings over time. During the year we were short Enron, each successive filing had incrementally more damning disclosure about the company’s off-balance sheet entities. It was obvious that internal lawyers were pushing management to give investors more detail on these deals that were being done, as they felt uncomfortable about them. Language changes are not accidental. They are argued over internally.”

JC3Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.


The Enron Fraud & the “Not So Smart Guys” In the Room

“It’s good to learn from your mistakes.
It’s better to learn from other people’s mistakes.”
Warren Buffett

“More money, it has been noted, has been
stolen with the point of a pen than at the point of a gun.”
Warren Buffett

This weekend I watched the documentary Enron: The Smartest Guys in the Room. See the bottom of this post for a link to YouTube

I have seen it once before, a few years back. But this one is definitely worth watching again.

After finishing the movie I ordered the books The Smartest Guys In the Room and Power Failure: The Inside Story of the Collapse of Enron, both of which I have not read before. Still waiting for the books to come!

So, take a look at the documentary and maybe read some (or both) of the books if you haven’t already done that.

Here is Enron’s annual report for fiscal year 2000. In the annual report Jeffrey K. Skilling (President and CEO) together with Kenneth L. Lay (Chairman) began the shareholder letter in the following (kind of pretty optimistic) way.


Below is an overview and discussion of Enron’s net income compared to a calculation of owner earnings (Source: FWallstreet.com). From this its clear that net income not really match owner earnings.


A great book is Financial Shenanigans: How to Detect Financial Gimmicks & Fraud In Financial Reports written by Howard M. Shilit and Jeremy Perler. In the book the authors discuss the Enron case awarding Enron for “Most Outrageous Financial Shenanigans”, see image below.


The discussion of the Enron case in Financial Shenanigans and the financial shenanigans is summed up as follows.


The Enron Scandal

Here is some background about what came to be known as the Enron scandal. (Source: Wikipedia)

“The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure.

Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, by the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives not only misled Enron’s board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues.

Enron shareholders filed a $40 billion lawsuit after the company’s stock price, which achieved a high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy offered to purchase the company at a very low price. The deal failed, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron’s $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom’s bankruptcy the next year.

Many executives at Enron were indicted for a variety of charges and were later sentenced to prison. Enron’s auditor, Arthur Andersen, was found guilty in a United States District Court, but by the time the ruling was overturned at the U.S. Supreme Court, the company had lost the majority of its customers and had ceased operating. Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes-Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.”

The (Smartest) Guys in the Room

In his 2003 letter to shareholder Warren Buffett recommended the book The Smartest Guys in the Room, written by Bethany McLean and Peter Elkind.


Another book written about the Enron collapse is Power Failure: The Inside Story of the Collapse of Enron.

“Power Failure is the electrifying behind-the-scenes story of the collapse of Enron, the high-flying gas and energy company touted as the poster child of the New Economy that, in its hubris, had aspired to be “The World’s Leading Company,” and had briefly been the seventh largest corporation in America.

Written by prizewinning journalist Mimi Swartz, and substantially based on the never-before-published revelations of former Enron vice-president Sherron Watkins, as well as hundreds of other interviews,Power Failure shows the human face beyond the greed, arrogance, and raw ambition that fueled the company’s meteoric rise in the late 1990s.” (Source: Amazon.com)

There has also been a documentary made about Enron and its demise.

“Enron: The Smartest Guys in the Room is a 2005 documentary film based on the best-selling 2003 book of the same name by Fortune reporters Bethany McLean and Peter Elkind, a study of one of the largest business scandals in American history. McLean and Elkind are credited as writers of the film alongside the director, Alex Gibney.

The film examines the 2001 collapse of the Enron Corporation, which resulted in criminal trials for several of the company’s top executives during the ensuing Enron scandal; it also shows the involvement of the Enron traders in the California electricity crisis. The film features interviews with McLean and Elkind, as well as former Enron executives and employees, stock analysts, reporters and the former Governor of California Gray Davis.

The film won the Independent Spirit Award for Best Documentary Feature and was nominated for Best Documentary Feature at the 78th Academy Awards in 2006.” (Source: Wikipedia)

So, never forget to “Ask why”.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. This article is informational and is in my own personal opinion.