“A stock can be a better short even though it’s gone down, it can be a better long even though it’s gone up if you’ve got new information.” —Jim Chanos
Podcast: Jim Chanos on the Art of Short-Selling
Whenever Jim Chanos speaks I’d like to listen. I have come to appreciate the way he explains things and how he attempts to take on and analyze different kinds of businesses from a fundamental investor’s view. It’s always interesting to hear what he has to say on businesses, industries, and countries etc.
A few days ago I was lucky to find another great interview with Mr. Chanos, this time from FT Alphachatterbox released on April 25, 2016.
The excerpt below contains a discussion about Herbalife where Mr. Chanos shares his and Kynikos reasoning and decision-making that came out of their analysis of the risks and rewards at the time (emphasis added).
MATT KLEIN: So I want to take a moment to actually look at a specific example I think might be relevant to this question, which is Herbalife. It’s a company that certainly got a lot of attention. It’s dropped out of the news recently, but some people, like Bill Ackman, were saying it was a complete scam, other people were saying it was good and were buying it. You were shorting it at one point and then I saw you said you’d exited the short after Ackman gave his presentation. You said the price was no longer compelling in terms of what the upside return would be for you. Can you walk through a little bit how you did that calculation and came to that decision?
JIM CHANOS: Well, so we were short Herbalife, and when Bill put his first report out the stock was down almost 50% in a matter of days. And at that point we just determined the risk reward had changed dramatically. That unless we felt the FTC or someone else was going to immediately move to crimp their business, that two other multi-level marketing ideas that we were also short – which didn’t move as much, they were only down a little bit – actually were much better uses of our capital at that point.
Further on into the interview Mr. Chanos talks about Kynikos short-position in Valeant in connection to a question about how Chanos and Kynikos works to generate new investment ideas.
MATT KLEIN: One of the things you mentioned earlier is the importance of your colleagues or partners and your staff for generating ideas and doing research and managing risk. Can you give some more sense of what is it everyone does and how you pick them, what the value is to the organisation as a whole?
JIM CHANOS: Our model’s a little bit different than a lot of investment management firms I believe, in that one of the things I find interesting about our business is that one of the most essential parts of the process, idea generation, most investment firms hand that responsibility to the youngest, least experienced people on the staff. The portfolio manager will put pressure on the junior analyst to come up with ideas for him or her to evaluate. And I think that’s really, really asking a lot. Particularly on the short side, where you have some of these other barriers like the borrowability and so on and so forth. The rebate structure. And in our view we would rather have the partners head up research and the portfolio managers spend some time on the ideas. And we have analysts who will say: “I think we ought to be looking at something”, but before they do a deep dive, we take a shallow dive and just make sure that this looks interesting from someone who’s got a number of years of experience in doing this and can immediately see something doesn’t look right. Valeant is a good example. That’s a name we’ve been short now for a couple of years, and the first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said: “This looks like Tyco.” In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell-bent on buying companies and making them fit no matter what.
And again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sorts of things before. And having a person running a company to please Wall Street can really be problematic, and even on the first pass through you would see that with a company like Valeant, and that’s why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to… For a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great rollups of the late 90s and early 2000s. So I think that was helpful for us.
MATT KLEIN: Speaking of Valeant, there’s a couple of interesting things there. It’s a pretty strange company. The traditional model of pharmaceuticals is you spend a lot on research and you fund yourself with equity and you have cash because your earnings are going to be lumpy. You have hits and then they die out. And Valeant is the opposite. They have a ton of debt, they spend nothing on research. Their model is essentially they buy a drug someone else has already invented and they try to raise the price. How they get people to overpay is an interesting question they’re now getting in trouble with.
There’s a thing there that’s interesting in terms of the personality of the executive there and at another company that you had a lot of interesting experience with, Enron. I’m not going to say that McKinsey is the cause of either one, but it’s interesting that these are both veteran McKinsey consultants who were beloved by the industries and respected who then came in to run these companies. Initially were very successful, at least on the surface, became very rich doing it. Is this something that people should – is this an automatic signal for you, when a consultant goes into the chief executive role?
JIM CHANOS: Well I’m always wary of accountants who become CEOs too. That’s always a bad sign for me. I don’t know about that, but I do know when I see a mindset, and when you see the mindset, the company is a black box and Valeant has had some of that… Valeant also, one of my partners pointed out that Valeant, in terms of a narrative or a parallel, also resembled Worldcom. Because you had this iconoclastic guy, Bernie Ebbers, and he was apart from his other executives, and again it was this rapid, rapid deal making with questionable numbers and then open feuding with his own executives toward the end of the Worldcom story. So there’s a couple of parallels in there. And then I saw Tyco. So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and Worldcom. You’re probably on the right track if you’re a short seller if it reminds you of not only one of those, but three of those.
And it’s interesting because what made the stock attractive to the bulls was its new way of doing business. R&D’s terrible. It doesn’t yield anything. That was the new mantra. So why do it? Why don’t you selectively buy drugs that seem to be overlooked and then run them through this sausage grinder of your reimbursement model and derive all this value that others are just leaving on the table? And that was my first problem. Because it was just this easy to raise prices 800% and get reimbursed, why wouldn’t everybody do that? Why wouldn’t the guys who owned the drugs not do that? That’s the first thing that I couldn’t get an answer on. And we now know why. In Pearson’s own words from his January 2013 conference call: “Well, there are ways even if a payer refuses to pay for a script [prescription], there are ways to get paid.” I’m paraphrasing, but that was a real warning sign for us that these guys were going to play somewhat fast and loose. Then he came up with the idea, well I’m going to buy drugs, so that’s my R&D in effect. So every other drug company that’s spending 16% of sales on R&D or 15% of sales on R&D, Valeant’s spending 2% or 3%. And the difference is meaningful, number one. Number two, of course Pearson would have you add back any purchased R&D amortisation that was running through the income statement, because of course drugs don’t last forever. They do have lives. And he was buying things sometimes with relatively short lives. And in any case no drug has more than a 20 year patent.
So if you were rational about this, if he bought $40 billion worth of companies, you might want to set aside $2 billion a year – at least – to replenish that portfolio over time. And that would be the equivalent of your R&D expense. Well, no, he wanted you to add back any amortisation and he called that his proforma cash earnings per share. And Wall Street dutifully pointed out: “Oh, that’s great, because it’s noncash.” And we pointed out: “Well, yeah, but take a look at Hewlett-Packard and some of these other companies that have had to buy companies to keep their revenue growth just constant. That’s the same as maintenance capex. In the drug business, that’s the same as maintenance R&D.” So he got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5.
MATT KLEIN: The Valeant trade, I’m curious more on the specific timing. Now the share price has gone down tremendously from its peak, but there was a period when it was going up by…
JIM CHANOS: It went up 100% on us.
MATT KLEIN: Right. How is that…?
JIM CHANOS: We started in the low 100s and our first blended set of average prices was somewhere around 130. So, yes, it got our attention. It doubled first.
MATT KLEIN: You mentioned the way that Valeant was creating an alternative pro forma accounting metric that was popular with Wall Street. One of the things that I’ve been reading a lot recently is this growing gap between the official…
JIM CHANOS: GAAP [generally accepted accounting principles] and “GAAP”, yes.
MATT KLEIN: Right, the “GAAP gap”. And it seems like it’s mostly coming down to treatments of things like one-offs and stock based compensation, which sounds familiar from 15 years ago. Is this something that we should be aware of in general? Are there legitimate reasons why this could be happening?
JIM CHANOS: Well, there are always legitimate reasons why you can break out something on a line out. Doesn’t always mean it’s legitimate to give the management the benefit of the doubt if common sense belies what they’re telling you. So it’s a problem. I teach a course on the history of financial market fraud, and usually trying to ferret out when companies are playing games with their numbers, as many do, takes some digging and some figuring out. What’s so amazing about the past five or six years is they lay it all out for you. And then they just tell you: Disregard it. So whether it’s stock based compensation, which of course is compensation…my favourite is the annual restructuring charge. There are companies now that have been charging off charges every single year for nine, ten, 11, 12 years. And sometimes every quarter. And Wall Street dutifully takes that out, to which I keep pointing out: “It’s happening five years in a row. Seems like it’s recurring to me.” But Wall Street gives them the benefit of the doubt for the fact that they break it out on a line item. And this has been going on for a while now, and the problem with it, Matt, is that now the disparity between the so-called operating EPS [earnings per share] and the GAAP number, I think it’s getting close to $30 a share for the S&P [index of large American companies]. I think the trailing 12 months’ now are somewhere in the high 80s and I think the operating number is somewhere in the 115, 116. And people say: The market’s not so expensive. I’m always raising my hand and will say: Depending on what? On the $88 it certainly is expensive. But we’re going to disregard that bad stuff. And then of course I love the people that say: “Well, but of course that’s energy. Energy’s down, you’ve got to take that out.” And I say: “Well, what about when energy goes back up? Are we going to take it out then?”
But again Wall Street is always a glass half full kind of place. But in this case it’s been interesting to us just how obvious some of these things are that they want you to disregard. Valeant was a master at that. This pro forma cash EPS, which by the way was just multiples of its real cash flow, was just one for the ages.