Short-Selling

Short-Selling: Intellectually Honest, Ethical and Loyal
by Eric J. Fry
The Rude Awakening
Wall Street, New York
Friday, December 23, 2005

Eric Fry discusses the agonies of Short-Selling, even successful Short-Selling.

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Eric Fry, fondly recalling the mid-1980s, reports...

When James Chanos launched his short-selling investment
firm, Kynikos Associates, in 1985, "Miami Vice" was in full
swing, Madonna had just married Sean Penn, Mikhail
Gorbachev had just become the Soviet leader and Czech
supermodel Paulina Porizkova had just made her debut on the
cover of the Sports Illustrated swimsuit edition.

1985 was also the year that Elmo first arrived on "Sesame
Street" and that the final curtains fell on both "Dallas"
and the "Dukes of Hazard." The top-grossing movies of 1985
included Beverly Hills Cop, Rocky IV and Rambo: First
Blood, Part II. And the year's #1 song was a corny
collaboration of Michael Jackson and Lionel Ritchie
entitled "We Are the World." Interestingly, 1985 also
marked the first year since 1914 that the United States had
become a net-debtor nation.

Clearly, much has changed since 1985, but much remains the
same. Hollywood still cranks out big-action flicks, the
music industry still produces corny songs, Czech
supermodels still appear regularly on the cover of the SI
swimsuit issue. ...and the US still borrows more from
foreigners than they borrow from us...much more.

Something else remains the same: Successful short-selling
is just as difficult today as it was in 1985. But Chanos
has seen it all.

When he launched his firm, America's socio-economic
backdrop was quite different from today's. Twenty years
ago, for example, very few Americans were comfortable with
the idea of owing more money to foreigners than they owed
to us. Today, we've become uncomfortable with the thought
that foreigners might not lend us even more money.

Twenty years ago, very few Americans were comfortable with
the idea of pulling cash out of high-yielding CDs to buy
risky common stocks. Today, we're uncomfortable with the
idea of "sitting on cash" and missing the next stock market
rally.

Even though the Dow had soared from 1,000 to 1,400 between
1983 and 1985, the memory of the market's pathetic
performance throughout the 1970s was still very fresh. A
bearish mentality prevailed. So 1985 must have seemed like
an opportune time to open a short-selling hedge fund...but
it wasn't.

The first few years provided plentiful opportunities, but
by 1995 Chanos was struggling. The Dow had more than
tripled over the prior 10 years, and it would double again
over the ensuing five. Chanos admits that the great bull
market of the 1990s almost doomed Kynikos. "We were flat on
our backs," he recalled recently. "But then a handful of
forward-looking investors placed money with us. So we were
able to hang in there and, eventually, begin to flourish.
Without those early investors, we would not have survived."

Indeed, Chanos has managed to hang in there...and
ultimately thrive. So what makes him so good at what he
does? A few weeks ago, I think I may have learned three of
his basic "secrets."

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Intellectually Honest, Ethical and Loyal
By Eric J. Fry

If you believe that war is simply the opposite of peace,
then you might also believe that short-selling is simply
the opposite of long-side investing. But, in fact, you
would be completely wrong on both counts. War has no
opposite and neither does short-selling.

The opposite of peace is discord. War, on the other hand,
is a catastrophic event that is wholly OTHER than peace or
discord or any other human condition. It has no opposite,
and neither does short-selling, although warfare might be
its closest synonym.

Short-Selling: Guerilla Warfare

In fact, short-selling is guerilla warfare. And if you
understand how to fight a short-seller's war, you will
become very well-equipped to win at the relatively peaceful
activity of long-side investing.

Earlier this month, your editor was privileged to attend
the 20th Anniversary party of Kynikos Associates, the
investment firm headed by renowned short-seller James
Chanos. To commemorate the occasion, Chanos rented out a
chic Upper East Side eatery and filled it full of friends,
colleagues and kindred spirits of various sorts.

But Chanos was not merely "the man who called Enron," he
was also the man who called Tyco and Conseco and Boston
Chicken and Coleco and many, many other troubled companies
of the last two decades.

On this night, the attendees smiled and chuckled over these
short-selling "war stories." But they would never forget
the war itself, or the pain it inflicted on their
professional – and sometimes personal – lives. They seemed
to remember all too well the difficulty of selling short
throughout the go-go 1990s. Even your editor, himself a
former short-seller of no particular repute, remembers
vividly the agony of short-selling throughout that bullish
decade. (One former client threatened to sue, simply
because your editor had dared to sell-short "one of
America's greatest companies," Coca-cola. Proving once
again that timing is everything, your editor's 1996 short-
sale of Coca-cola did produce a loss. But a 1998 short-sale
of Coke would have produced excellent results. The stock
reached its all-time high that year and has fallen more
than 50% over the ensuing seven years!)

Short-Selling: Agony

Short-selling is agonizing on every level, even successful
short-selling, of which the practitioners are few. It
usually requires arduous research, well-seasoned
experience, fortitude, patience...and deep pockets.
"Markets can remain irrational longer than you can remain
solvent," as John Maynard Keynes once observed.

Throughout his career, therefore, Chanos has battled
tirelessly to achieve his many successes. He has battled
against prevailing market trends, against public opinion,
against entrenched Wall Street interests and against almost
every other possible obstacle to investment success. But
such is the life that short-sellers chose...or that they
are cursed to endure.

In particular, every short-seller wages war against the
popular (and powerful) delusions of the day, as expressed
in the incessant, sycophantic cover stories that decorate
America's leading business magazines.

An early 2000 Business Week article, for example, praised
Enron's Kenneth Lay as one of the "Top 25 Managers of the
Year." "Kenneth L. Lay doesn't like to put on airs,"
Business Week explained, "Over the past 15 years, he has
transformed Enron (ENE), a once-struggling pipeline
company, into a cutting-edge energy powerhouse."

In April 1999, Barron's published a bullish cover story
about Tyco International and its "hard-charging" CEO,
Dennis Kozlowski. Two years later, Business Week ran a
cover story entitled, "The Most Aggressive CEO," which also
heaped praise on the Tyco chief.

"Kozlowski's ambitions stretch far beyond his audacious
five-year plan of adding another $50 billion of
acquisitions and reaching $100 billion in sales while
maintaining 25%-plus annual earnings growth," Business Week
gushed. "He aspires to nothing less than guru status, the
sort of peer recognition that would once and for all put
behind him an army of short-sellers and other critics. He
isn't modest in stating his goals. 'Hopefully, we can
become the next General Electric,' Kozlowski muses in his
Exeter (N.H.) office as his helicopter waits outside to
whisk him to yet another dealmaking session. He wants to be
remembered as 'some combination of what Jack Welch put
together at GE...and Warren Buffett's very practical ideas
on how you go about creating return for shareholders.'

Unfortunately, Kozlowski's fondness for grand larceny
derailed his grand designs for Tyco. But we will always
remember him nonetheless...as "inmate #05-A-4820."

Unfortunately for short-sellers, a company's fall from
corporate superstardom to ignominy or bankruptcy or
criminal investigations, or all of the above can take a
VERY long time. And it is no simple task to short a stock
that your research says is woefully flawed, even while all
of Wall Street tells you that you are dead wrong, and an
idiot besides.

Short-Sellings: Everything Wall Street Is Not

But Chanos has mastered the art of short-selling as well as
anyone. And as I listened to his brief speech at the
anniversary party, I thought I learned some of the key
reasons why.

"When we founded Kynikos 20 years ago," Chanos explained to
the roomful of friends and peers, "we wanted to create a
firm that was intellectually honest, ethical and
loyal...And I think we've done that."

"Intellectually honest, ethical and loyal." Hmmm...That's
exactly it! These exact three qualities represent
everything that Wall Street is not. Only the investor who
pursues rigorous research in an intellectually honest way
stands a chance of identifying truly troubled companies. An
ethical world view also advances the success of a
fundamental short-seller...and loyalty certainly does not
impede the process. The fraternity of short-sellers relies
upon a great deal of mutual loyalty.

In February 2001, at the "Bears in Hibernation" meeting
that Chanos hosts annually in Miami, he mentioned Enron one
of his two short picks. "He counted on the fact," a
Barron's story explains, "that many of the attendees,
including other well-known bears and hedge-fund managers,
would be intrigued by his Enron story and assist him in
much of the heavy lifting in researching such a complicated
situation."

And so it came to pass. Your editor, who was present at
that Miami meeting, recalls the moment very well. Enron was
a Wall Street darling in February of 2001. So when Chanos
recommended the stock as a short sale, he kicked off a
lively debate. But over the ensuing months, many of the
investors in that Miami hotel room aided and abetted the
research effort on Enron.

Loyalty doesn't hurt.

To be continued tomorrow...

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