Lessons from traders

Jim Chanos
Jim Chanos: The Financial Detective
Lessons for value investors in Chanos’ thoughts and actions

Jim Chanos (Trades, Portfolio) has taken the road less traveled in his investing career, opting to
emphasize short selling rather than conventional long investing.

He operates a hedge fund that provides contrarian strategies for institutional investors and other big
investors, especially those looking for uncorrelated portfolios.

He has had great successes, including Enron, but for the past five years he has done all right, and
that is hardly anything to boast about. That may change with the next correction or collapse.

In the meantime, value investors can learn from him by studying valuation from the short side.

Who is Chanos?

Born in 1957, Chanos grew up in Milwaukee, where his family operated a chain of dry cleaning
shops. He went on to earn a bachelor's degree in economics and political science from Yale
University in 1980.

IWM 30-Year Financial Data

The intrinsic value of IWM

Peter Lynch Chart of IWM

After graduating, he worked briefly as a securities analyst at Deutsche Bank Capital and Gilford
Securities. Chanos then went on to work at investment banking firm Blyth Eastman Paine Webber,
starting in 1980.

In 1985, he launched Kynikos Associates (Kynikos is the Greek word for "cynic") with $16 million.
From that beginning, he has had as much as $7 billion under management, but the current sum is
approximately $2.3 billion.

He has been called the “mirror image” of Warren Buffett (Trades, Portfolio) because he goes through
the same kind of due diligence, but uses that research to find overvalued, rather than undervalued,
opportunities.
Chanos apparently set out to become a financial detective from the time he founded his own firm,
and the name he chose for it turned out to be apt.

What is Kynikos Associates?

The Form ADV Part 2A brochure lists the firm as a provider of discretionary investment advisory
services.

As of March 30, the firm had $2.3 billion of assets under management. The Form ADV also shows
Kynikos’ four biggest types of clients were pooled investment vehicles, corporations or other
businesses and investment companies. Of that, $355 million is invested in equities (Sept. 30), as
reported by GuruFocus.

Chanos and the company first gained prominence by predicting the collapse of—and shorting—
Enron Corp. It then went on to score shorting successes with WorldCom and Tyco, before getting
into the right position for the 2008 bust.

Being a short seller is a difficult and risky practice, but Chanos has apparently mastered it; he is still
going strong more than 30 years later.

Investing strategy

As noted, the firm and Chanos are short sellers; their aim is to produce value for their clients by
identifying and buying overvalued securities. We might say short sellers are the inverse of value
investors, who seek to find undervalued securities.

The firm spells out its strategies in more detail in the Form ADV Part 2A. To find overvalued
securities, it uses "extensive" fundamental research on both companies and industries. The company
splits its strategies between two sets of funds: The Ursus hedge funds and the Kynikos Opportunity
hedge funds.

For the Ursus (and Kriticos) funds, they look for candidates that are expected to be valued
downward because of:

Deteriorating profit outlook.

Unsustainable growth.

Increased industry competition.

The lack of a viable, long-term business model.

For the Kynikos Opportunity funds, they specify many of the same criteria, but consider long
positions as well as short positions. The Kynikos funds are open to any positions they feel they can
profitably trade.

Turning to process, both funds use multiple analytical techniques:

Balance sheet analysis.

Income statement analysis.

Flow of funds statement analysis.

Interactions between these three analyses.

Also, per the Form ADV Part 2A, the firm watches the quality of corporate earnings and returns on
invested capital.

It uses industry analysis in two ways: first in conjunction with company-specific research, and second
as a source of shorting opportunities on its own. Cues come from measures such as increasing
industry competition, pending overcapacity, industry risk profiles that are changing and incorrect
market size assessments for a company's product.

They do their own research, using publicly available filings, industry publications, discussions with
management, competitors and industry consultants, as well as doing product research.

Technical analysis, market timing or asset allocation models are not used in its research. However, it
does say it uses Chanos' extensive experience to identify investment ideas.

Whether going short or long, they use multiple vehicles, including non-listed securities, convertible
securities and options (including puts and calls on stocks and warrants).

In 2014, Chanos reported a new strategy for shorting, as explained in a Business Insider article. He
said this strategy would focus on companies that bought back stock, calling the buybacks a sign of
weakness.
The rationale behind the strategy is companies think their stock can return more than their business
operations. Chanos is quoted as saying, "Corporate CEOs, with their massive share-buyback
programs are in effect investing in the stock market rather than in expanding business opportunities
at their companies. Either they expect higher returns from the market, or lower returns in their
business, or some combination of both. Given their questionable track record in timing the market,
this may be a cause for concern."

So far, it is not known if he implemented this strategy and, if he did, how successful it was.

A couple of years earlier, he explained how he spots companies that look good but are really value
traps. In a presentation at ValueX Vail, and reported by Business Insider/ValueWalk, Chanos said
value traps have some common characteristics, including:

Cyclical products.

Being overly dependent on one product.

Expectations driven by hindsight.

Marquis management and/or famous investors (headliners famous for they have done in the past).

Cheap valuations using management's measures.

Accounting issues.

In another presentation, Chanos gave a spirited defense of short selling to the U.S. Securities and
Exchange Commission Roundtable on Hedge Funds in 2003. He said shorting is beneficial for
markets, not only in terms of providing liquidity, but also as an "important bulwark against
hyperbole, irrational exuberance and corporate fraud."

He points out there are three types of market participants who sell short:

First, exchange specialists, market makers and block traders who are trying to maintain liquidity and
price stability for their customers.

Second, short sellers practicing market neutral arbitrage; they try to profit from temporary or
minute price discrepancies.

Third, and most commonly in public perception, investors who believe a stock or market index has
become overvalued and may suffer falling prices.

Chanos adds that short sellers are subject to stringent regulations, and typically must hold their
positions for extended periods. That makes short positions both costly and risky.
Short sellers are financial detectives, he said, and many major corporate frauds were first exposed
by the fundamental research of short sellers. He goes on explain how his detective work brought to
light the malfeasance at Enron, and quotes the words of financial historian Edward Chancellor, "We
need more, not less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the
recent technology, media and telecoms boom."

It is good to be reminded from time to time that short selling performs a useful service for all
investors (even though they miss at times). Their ongoing diligence helps protect many individual
investors from walking into value traps. It is also helpful to know how short sellers think.

Holdings

This lopsided chart from GuruFocus illustrates how Chanos positions his equity portfolio:

Jim Chanos equity sectors

Performance

Chanos has had some very good years, especially those in which he cashed in on Enron, WorldCom,
Tyco and the 2008 crisis.

Over the past five years, though, it has mostly been a disappointing experience, as shown in this
TipRanks chart:

Jim Chanos performance

TipRanks also reports his average annual return over the past three years has been 9.59%.

The bull market keeps going and going; short sellers keep feeling the pain. In Chanos’ case, the
results have not been too serious, since short sellers might be expected to have trouble just breaking
even, while he has had average returns of almost 10%.

Conclusion
For those of us who expect a correction or collapse, Chanos sits in an enviable position. He and other
short sellers know how to prepare for and profit from pullbacks better than most.

Of course, there is that pesky question of timing. While waiting for the markets to get back to
normal valuations, he and other short sellers must have some sleepless nights.

Still this financial detective has useful information for value investors. All who look for good deals
must also be careful to avoid value traps, and Chanos can help. Tracking his activities and knowing
how he ferrets out potential flops should help all investors enjoy better long-term results.

Jim uses etfs to shorts the companie, he wants to short

(Long) Interview with Jim Chanos: “A contrarian is told he’s wrong all the time as he goes
against the grain, and it takes a certain temperament to disregard this”
Graham & Doddsville, a Columbia Business School investment newsletter, has recently scored an
interview with Jim Chanos, the founder and Managing Partner of Kynikos Associates and one of the
world’s most successful short-sellers. His most celebrated short-sale of Enron shares was dubbed by
Barron’s as “the market call of the decade, if not the past fifty years. Obviously, he’s still bearish on
China’s property market and banking sector and his positions are starting to move his way. In this
long (though very insightful) interview with G&D, Chanos talks about his background, investment
style, short-selling, contrarian trading and, of course, China.

Here is an excerpt of the original interview (full interview below that… it’s long but it’s worth the
read).

On Wall Street ethics:

“… I handed out a two page memo to the senior banker discussing the impact of buying back stock.
The senior banker looked at me with an icy stare and stated that we were not in the business of
recommending share buybacks to our clients; we were in the business of selling debt. This was my
first douse of cold water regarding Wall Street and I became pretty disillusioned after that episode. I
had learned that Wall Street wasn’t necessarily doing things in their clients’ best interest…”

On timing a short-sale:

“I recommended a short position in Baldwin- United at $24 based on language in the 10-K and 10-
Qs, uneconomic annuities, leverage issues and a host of other concerns. The stock promptly doubled
on me. This was a good introduction to the fact that in investing, you can be really right but
temporarily quite wrong… I went home to visit my parents for Christmas and received a phone call
from Bob Holmes telling me that I was getting a great Christmas present – the state insurance
regulator had seized Baldwin-United’s insurance subsidiaries.”

On being a contrarian:

“… numerous studies have shown that most rational people’s decision-making breaks down in an
environment of negative reinforcement… You’re basically told that you’re wrong in every way
imaginable every day. It takes a certain type of individual to drown that noise and negative
reinforcement out and to remind oneself that their work is accurate and what they’re hearing is
not.”

On shorting:

“We try not to short on valuation, though at some price even reasonably good businesses will be
good shorts due to limitations of growth. We try to focus on businesses where something is going
wrong. Better yet, we look for companies that are trying — often legally but aggressively — to hide
the fact that things are going wrong through their accounting, acquisition policy or other means.
Those are our bread-and-butter ideas…. Valuation itself is probably the last thing we factor into our
decision. Some of our very best shorts have been cheap or value stocks. We look more at the
business to see if there is something structurally wrong or about to go wrong, and enter the
valuation last.

…You need to be able to weather being told you’re wrong all the time. Short sellers are constantly
being told they’re wrong. A lot of people don’t function well in an environment of negative
reinforcement and short selling is the ultimate negative reinforcement profession, as you are going
against the grain of a lot of well-financed people who want to prove you wrong. It takes a certain
temperament to disregard this.”

On China:

“This is a bubble that has a long way to go on the downside. Residential real estate prices, in
aggregate in China, at construction cost, are equal to 350% of GDP. The only two economies that
ever saw higher numbers at roughly 375% were Japan in 1989 and Ireland in 2007, and both had epic
property collapses. So the data does not look good for China.”

…In China, everyone is incented by GDP. They are fixated on growth. In the West, we go about our
economic lives, and at the end of the year the statisticians say, this year your growth was 3%. But in
China, it’s still centrally planned. All state policy goes through the banking system. They decide what
they want growth to be and then they try and figure out how to get there.”
Full interview below.

———

G&D: Mr. Chanos, you studied economics and political science at Yale. At what point did you get
interested in the stock market?

JC: My father had been a stock market investor since the 1950s, in addition to run-ning the family
business. He drilled into me the notion that to be financially independent, I would have to work for
myself, work hard, save my money and invest wisely. He began teaching me about the stock market
when I think I was in third or fourth grade. From this point onward, I became fascinated by investing.
I was fascinated by the math and the numbers and the fact that you could invest and, unlike with a
savings account, you might be able to double your money. This was my first introduction to investing
and it occurred in the late ’60s. I continued to read about investing and took the only two
undergraduate accounting classes while at Yale.

After I graduated I decided that I wanted to pursue an investment career. I didn’t get a job offer
from any of the big New York banks, which in 1980 were the source of most of the employment
offers. I joined one of the first invest-ment banking analyst programs with Blyth Eastman Dillon’s
regional office in Chicago. I put in 16 hour days six days a week work-ing on deals for senior bank-
ers. This was a good introduction into the numbers of investing.

There was a defining moment, however, when I real-ized investment banking wasn’t for me. A year
into my stint at Blyth, we were working on a recommendation for McDonald’s to issue a bond. At
that point in its history, McDonald’s was generating a lot of cash and reinvesting it back into its
restaurants, each of which generated high returns. But the stock market was valuing McDonald’s at
only 8 or 9x earnings despite the company growing at 20-25% a year pretty consistently with real
cash earnings. Around this time, I read that Teledyne and Radio Shack were growing earnings rapidly
by buying back stock, as the management of these firms believed that their companies were
underval-ued in the stock market. This was at a time when interest rates were at double-digits. I ran
some num-bers independent of the blue book that the associate, the senior banker and I were
compiling, and determined that instead of the debt deal, we should recommend that McDonald’s
buy back stock with some of its cash flow and cut back its expansion slightly. This could lead to a
larger EPS increase relative to the bond issuance and they wouldn’t have to add lever-age to the
balance sheet. Given where rates were, the impact on EPS from buying back stock rather than
issuing debt was dramatic. When I made this case to the associate, he turned white and said he
wanted no part of present-ing this idea to the senior banker. Being pretty naïve and not realizing the
political implications of such a recommendation, I handed out a two page memo to the senior
banker discussing the impact of buying back stock. The senior banker looked at me with an icy stare
and stated that we were not in the business of recommending share buy-backs to our clients; we
were in the business of sell-ing debt. This was my first douse of cold water regarding Wall Street and
I became pretty disillusioned after that episode. I had learned that Wall Street wasn’t necessarily
doing things in their clients’ best interest but was instead focused on maximizing fees.

G&D: So was it this incident that led to your transition to the buy-side?

JC: Around this time, I had been talking stocks with the head of retail client brokerage at the Chicago
office, Bob Holmes, during my lunch hour. That’s what I really enjoyed; going over to his office and
checking the market and punching tickers into the Quotron machine to see what was up and what
was down. I would look forward to that part of my day more than any other. I had a little money
saved and was trading like a lunatic in my own brokerage account, not making any money. Finally
one day, Bob called me into his office, shut the door, and told me that he was leaving to start a retail
brokerage firm with a couple of partners. He asked me if I wanted to join their new firm as an
analyst. I could barely contain my excitement.

One of the first stocks they had me look at was insurance holding company called Baldwin-United.
Baldwin was growing very rapidly by selling annuities that were uneconomic. To plug the hole that
was developing within their insurance subsidiaries, the holding company was closing acquisi-tions. In
exchange for the insurance companies’ cash, the holding company was providing the subsidiaries
with overvalued securities. However, the regulators of the insurance subsidiaries were becoming
wise to the development as Baldwin- United’s stock shot up. We acquired a copy of the insurance
department public files and we were able to see from regulators’ letters that they were becoming
increasingly concerned about the valuation of those affiliated assets held by the insurance company.
They went as far as to imply that if Baldwin-United didn’t downstream additional capital to its
insurance subsidiaries, they would have to declare the subsidiaries insolvent.

While this was occurring, every brokerage house was recommending the stock. Although the
company was rapidly growing earnings, those were all non -cash earnings because Bald-win-United
was using gain on sale accounting when it sold annuities. This ficti-tious “gain” was based on the
expected persistency of the policies and the present value of the estimated spread generated by
their returns on investment in excess of the annuity payouts. The problem was that they were
paying 14% on the annuities and were far too optimistic on their investment return estimates. My
first research report was published in August of 1982. I recommended a short position in Baldwin-
United at $24 based on language in the 10-K and 10-Qs, uneco-nomic annuities, leverage issues and
a host of other concerns. The stock promptly doubled on me. This was a good introduc-tion to the
fact that in investing, you can be really right but temporarily quite wrong. I put another re-port out
in early December of 1982 with the stock at $50 and reiterated my the-sis while pointing to
additional evidence that had come out in the interim. I went home to visit my parents for Christmas
and re-ceived a phone call from Bob Holmes telling me that I was getting a great Christmas present –
the state insurance regulator had seized Baldwin-United’s insurance subsidiaries. Baldwin filed for
bankruptcy shortly thereafter.
That’s the idea that sort of put me on the map. After that, big New York hedge funds to which we
had been trying to pitch the Baldwin short started calling us to see what other companies were short
candidates. I had no predisposition to be a short seller but I thought that there could be a business
niche in that arena. Maybe I could, as a young analyst, carve out a good business by being an institu-
tional skeptic and come out with two or three really good short ideas that were thoroughly
researched with the evidence clearly pre-sented and documented. This would then be ex-pected to
lead to some nice commissions for the firm.

A lot of what happens in your life is merely serendipitous and really just luck. In a lot of ways, that’s
the lens through which I look at my own career. If the McDonald’s share buyback episode hadn’t
occurred, maybe I wouldn’t have left Blyth and I’d probably still be doing deals and be miserable. To
join a new firm and to have the first company I look at turn out to be an enormous financial fraud
was equally good luck.

G&D: For a brief period, you also worked for Deutsche Bank. How did that come about?

JC: In late1983, Deutsche Bank came knocking and asked me to move to New York to be an analyst in
their new boutique invest-ment research operation. In the summer of 1985, I began looking at the
Drexel Burnham companies which Michael Milken was putting together through junk bonds. I was
particularly focused on a real estate syndicator called Integrated Resources which was playing
unbelievable accounting games and financing itself with junk debt issued at 14%. The company
would overpay for office buildings and then syndicate their ownership interest to wealthy individuals
via tax sheltered partnerships in uneconomic deals. Since there wasn’t enough cash to pay their fees,
Integrated was taking their fees via overvalued third mortgages on the syndicated properties. The
company’s earnings were not only over-stated but were also heavily negative cash flow. I started to
ruffle some feathers, and Integrated put a lot of pressure on Deutsche Bank and others to muzzle
me. Later that summer, there was a Wall Street Journal front page article by Dean Rot-bart
describing an evil cabal of short-sellers who were saying terrible things about nine or ten great
companies including Integrated Resources. According to an illustration on the inside of that Journal
issue, the person orchestrating this short-selling pressure across all categories of investors was me.
Within a day or two, I was summoned to a supe-rior’s office and told that my employment contract
which expired in October of 1985 would not be renewed. Luckily, for a year or so I had been talking
to a couple of investors who wanted me to run a portfolio of funda-mental short ideas for them.
Though my bargaining power had declined a bit since I was going to be out of a job in a few months,
they agreed to set up Kynikos Associates with me. The fund was capitalized with $16 million, $1
million of which was my own, and we started on October 1st, 1985.

G&D: What were the early days like?

JC: From 1985 to 1990 was a golden era for short sellers because it was a highly idiosyncratic,
uncorrelated market. Although the market was slowing, it was dominated by institutions. If you
could make a case that a company was playing games with its num-bers or had some other serious
problem and the company then admitted wrongdoing, the stock would go down quite a bit.
Meanwhile, the broader stock market had a few periods of run-up following some crashes leading
up to 1990. The so-called alpha was off the charts in this time period. It was probably in the 20%
area. Money flooded into any hedge fund that said they had short-selling skills. By 1990 we were
running $660 million and were one of the top ten largest hedge funds in the world. Then it all came
crashing down from ’91 to ’95. After the Gulf War, the Fed eased and the mar-ket took off for a good
three years until ’94 and then began to take off again in ’95. I believe the NASDAQ or the Russell
doubled in 1991. There was no place to hide on the short side. Everything became correlated on the
way up. The worse the news a company reported, the more its stock price appre-ciated. It was a
tear-your-hair-out market if you were a short-seller. With client withdrawals by ’93 and in ’95, we
were down to $150 million and I was wondering if I was going to stay in busi-ness. I didn’t want to do
what a lot of people have done in that situation – close up shop and start again two years later –
because I didn’t think that was fair to my investors for whom I had lost money and who had high
water marks. We agreed to soldier on and I paid most of the em-ployees out of my pocket for a few
years because there were no performance fees. I had a core group of people who were very loyal
and stayed with me through this period. Then in 1995, two large clients came for-ward and said they
believed we were still adding value to their portfolio and that they were willing to invest additional
money. They agreed to lock up some additional capital for a slight cut on the fees. So, in effect,
those two clients saved the business in ’95. We never really looked back.

Their timing was exquisite because although the market kept going up between 1996 and early 2000
during the dot-com era, it was again bifurcated and uncorrelated much like in 1985. If you had a
good short idea, it could still go down; for example, Boston Chicken, Oxford Health, and Sun-beam
were all collapses. So we had some great years despite the bull market. Something else that we did
was to change our compensation formula for our managed accounts so that compensation was
determined based on an inverse benchmark basis. For example, if the S&P was up 20% and we were
up 10%, we would be paid as if we were up 30% but alternatively, if the S&P was down 20% and we
were up 20%, we would be paid nothing because we created no excess return, or alpha. That
arrangement saved the business as well. We gener-ated a lot of alpha in the late ‘90s so those were
some of our best years financially and performance-wise. We still have that compensation structure
today. Most of our dollar assets are paid on an alpha basis, so the clients like it and we think it’s fair.

G&D: At what point did you open your long-short fund in addition to the short -only fund?

JC: In 2003, we launched our first long-short fund – Kynikos Opportunity Fund – because we realized
that through our research process, we were coming across a lot of good long ideas upon which we
couldn’t act. This ability to go long acted as an adjunct to our short research. A stock might collapse
and the bonds might fall in price but based on the work we have already done we might think there
is some value in the firm and that the bonds are money good. The Opportunity Fund allowed us to
capitalize on these types of opportunities. We might also utilize a pair-trade strategy in this fund. For
example, for a number of years we were long Honda and Toyota and short Ford and GM. Right now
in the Opportunity Fund, we’re short Chinese property companies and long Macau casinos.
In 2005, one of the clients that saved us in ’95, inquired about our interest in running a fundamental
short portfolio in Europe with a fund based in London. They were willing to finance it in exchange for
a five year exclusive limited partner stake. Having been in business with this client for many years,
we were cer-tainly interested in the opportunity and we wanted to see if we could apply our process
globally. We opened an office in London for non-US ideas and that too proved to be successful. We
found that our approach to company and security analysis could be ported over to non-US
situations. We had a great run. The exclusivity arrangement expired last year and so we now have a
global short fund which we offer to clients, in addition to the domestic short fund and the long-short
fund.

G&D: Could you describe your process in a bit more detail for our readers?

JC: I used to think that good short-sellers could be trained like long-focused value investors because
it should be the same skill set; you’re tearing into the numbers, you’re valuing the businesses, you’re
assigning a consolidated value, and hopefully you’re seeing something the market does-n’t see. But
now I’ve learned that there’s a big difference between a long-focused value investor and a good
short-seller. That difference is psychological and I think it falls into the realm of behavioral finance.
The best way I can describe it is as follows: almost all of your readers, and I suspect you as well, are
beneficiaries of positive reinforcement. That is, you’re told early in life to work hard, study hard, to
get good grades and get into a good school, and then to do well there and to get a good job and so
on. All of that is a virtuous circle.

On the other hand, numerous studies have shown that most rational people’s decision-making
breaks down in an environment of negative reinforcement. If you think about it, Wall Street is a
giant positive reinforcement machine. When I turn on my Bloomberg at home at night, I’m going to
see that about 20%+ of our ideas have some sort of positive analyst report out or the CEO is on
CNBC or there’s a takeover rumor. Almost all of this is noise; there’s just not a lot of informational
content in this stuff. But this is the music of the investment business. It’s like a (more often than not)
comfortable river that every investor floats down on. If you’re a short-seller, that’s a cacophony of
negative reinforcement. You’re basically told that you’re wrong in every way imaginable every day. It
takes a certain type of individual to drown that noise and negative reinforcement out and to remind
oneself that their work is accurate and what they’re hearing is not. Most people are in the “life’s too
short to put up with this stuff” camp.

The other problem is that there’s an asymmetry on the return patterns of short ideas. Because
markets tend to go up over time and you need discrete news to affect a short idea, you tend to have
weeks and months and even years when you’re not making money in your ideas. Then when you do
make money with a short idea, it happens all at once. Here once again, most people are just not
hard wired to find that asymmetry comfortable but good short sell-ers are. Though I listen to the
noise to make sure there’s no new information that I need to know, I don’t worry about most of it.
You need to be able to drown out what the Street is saying. I’ve come around to the view that to be
a good short seller, in addition to having the important skill set, one must have the right mindset. I
believe this is why a lot of great value investors aren’t particularly good short sellers. Part of what
weighs on value inves-tors is the view that any given stock can appreciate an infinite amount but can
only depreciate in the worst case to $0. They always have this nagging concern that one bad short
idea could bankrupt their firm. I continue to respond to this argument by stating that I’ve seen a lot
more stocks go to $0 than infinity. In general, the short side can come with a more unpleasant
feeling than the long side and I think that’s why there are so few short-sellers out there.

G&D: Is there anything in particular that you look for to determine if a company is a good short
candidate? How do you distinguish between a stock that is truly overvalued and one that might grow
into its valua-tion?

JC: We try not to short on valuation, though at some price even reasonably good businesses will be
good shorts due to limitations of growth. We try to focus on businesses where something is going
wrong. Better yet, we look for companies that are trying — often legally but aggressively — to hide
the fact that things are going wrong through their accounting, acquisition policy or other means.
Those are our bread-and-butter ideas. In fact, I’ve given some lectures on the concept of value traps.
Probably our best ideas over the past ten or 12 years have been ideas that looked cheap and which
actually ensnared a lot of value investors. The investors didn’t realize that these businesses were
dete-riorating faster than their ability to generate cash. Eastman Kodak was a great example of that.
A few famous value investors were buying it all the way down because they assumed that the
decline in the business would be a slow glide that would allow the company to harvest cash flows for
the benefit of shareholders. The fact of the matter is that, for most declining businesses,
management tends to redeploy cash flow into things outside of their core competencies in a
desperate attempt to save their jobs. In the case of Kodak, they took some of their patent proceeds
and cash flow and invested in a printer business, which is another de-clining business model. They
ended up being deci-mated by their own invention of digital photography. When analyzing Kodak as
a short candidate, valuation was almost the last aspect that we considered because, as I said, some
of the best short ideas can look cheap from a valuation standpoint.

G&D: Can you talk about your valuation framework?

JC: We look at the same things everyone else does, but with the idea that these are moving targets.
Balance sheets should give you some sense of intrinsic value on the downside. On the upside, we
have to worry about the unlimited potential. We look at things like market sizes and the law of large
numbers, as to whether companies can grow their way out of a bad accounting situation or a
leveraged situation. On the short side, the financials are often misleading. What might appear to be
value sometimes is not. A book value that is comprised of goodwill and soft assets sometimes might
not provide downside support if a company is troubled. Valuation itself is probably the last thing we
factor into our decision. Some of our very best shorts have been cheap or value stocks. We look
more at the business to see if there is something structurally wrong or about to go wrong, and enter
the valuation last.
G&D: Some investors be-lieve in the life cycle of in-vesting in that a company can go from a growth
stock to a value stock to a value trap – do you look at com-panies that way?

JC: I try not to. Companies can certainly go through life cycles. I think people who put themselves in
a category of being a growth investor or a value investor limit themselves. A “growth” stock can be a
great investment at the right price and sometimes “value” stocks are too expensive. On the short
side, we’ve been generalists globally for six or seven years. The further you look for ideas the greater
the chance you will see a unique idea.

G&D: It seems like you’ve initiated short ideas in prac-tically every industry. Are there any industries
that you gravitate to more than others for ideas?

JC: We’ve historically been drawn to financial services, where companies can really boost earnings
by generating bad loans for a while. We’ve also been in consumer products, certain parts of the
natural resource situations (which effectively become accounting plays) and generally companies
that grow rapidly by acquisition. Where we see the juxtaposition of a bad business combined with
bad numbers, that’s really in our wheel house.

G&D: Do you find more examples of fraud in smaller companies?

JC: There is probably more evidence in smaller compa-nies, but we usually don’t short many small
cap com-panies due to the restraints on borrowing and our size. So it was hard to short some of
those Chinese reverse merger opportunities last year, though we did have a couple. Most of our
positions are mid cap or large cap companies.

G&D: Could you talk about some characteristics that would make for an en-ticing yet, in reality, risky
short candidate?

JC: Open-ended growth stories tend to have a life of their own. Our celebrated disaster was America
Online. We shorted it in ’96 at $8 a share and cov-ered our last share at $80 two years later. It was
never a big position so it didn’t kill us but it was very painful for two years because people were able
to make open-ended growth forecasts. We try to avoid those to some extent or we get involved
further along the growth curve.

G&D: With short-selling, the timing of your idea can be particularly important. How do you address
this somewhat unique challenge?
JC: That is certainly one of the unique aspects of short-selling. It is possible that when you see
something developing, others are seeing it as well so at that point you may be unable to bor-row the
shares. This is why sometimes short-sellers borrow the shares when they can get their hands on
them, even if they are early on the thesis playing out. In the ‘80s and ‘90s, when interest rates were
high, you were effectively paid to wait out your short thesis because you could earn interest on the
proceeds re-ceived from the short sale. However, in a rate environment like the one we’re
experiencing today, initiating on a short too early can be somewhat more painful relative to those
prior decades.

G&D: How is your firm different from other hedge funds with respect to sourc-ing new ideas?

JC: From an approach point of view, one of the things that distinguish other hedge funds from us is
that a typical hedge fund has the intellectual ownership of an idea separate from the economic
ownership of that idea. By that I mean you have the partners and the portfolio managers at the top
and you generally have the analysts, who are more junior at the firm, at the bottom. The way the
model works at most firms is that the guys at the top command the people at the bottom to come
up with good ideas from which the portfolio managers ultimately select the additions to the
portfolio. The problem with this model is that the profits go disproportionately to the people at the
top of the pyramid but the risk — or the intellectual ownership of the idea as I like to call it —
resides at the base of the organization with the most junior, inex-perienced people. Conse-quently, if
things go right, everyone makes money, but if things go wrong, the per-son at the bottom
disproportionally shares the blame and the risk. This is why turnover is so high in the hedge fund
industry. People try to do carve-outs, which I think are very bad policy. This model puts all of the
power of the idea genera-tion, and therefore the alpha generation, with the most junior people in
the firm, whereas the senior people are just doing portfolio allocation. We’ve always viewed it the
opposite way. We have six partners at Kynikos who have 150 years of experience in the securi-ties
business amongst us and we have been together 100 years in aggregate. For example, my number
two has been with me for 20 years. Because of our experience, we generate ideas up at the top. We
are looking for the new ideas and we’ll do the first read-through of a company’s 10-K and other re-
search in addition to talking to people in the industry. The next step is to then send the idea down
the chain to our research team to process. I will never blame the analyst for a stock that goes against
us. Putting the stock in the portfolio is my responsibility and the other senior part-ners’
responsibility. I think this leads to a better intel-lectual environment at the firm. So we get analysts
who love working here and will stay for 10 or 15 years. It’s a much more stable model in terms of
process than some other models.

G&D: What are some of the skills that are essential to succeeding in this field?

JC: 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 com-pany,
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
mod-els 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 pre-ponderance 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 re-ports 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 read-ing 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: When you make macro calls, what primary sources do you use?

JC: People think we make big macro calls, but the fact of the matter is we don’t. We might end up
with some macro calls but that’s only a function of our calls on the micro side. China is an example.
People think we made a big macro call on China. In fact, our position on China came from the mining
and commodity stocks in the summer of 2009. We were scratching our heads trying to figure out
how in this terrible recession the prices for industrial commodities were going up. Well, we very
quickly ascertained that China, which was 8% of the world’s economy, was gen-erating 80% of the
marginal demand for iron ore, cement, and steel. It didn’t take much work from there to realize that
it was be-cause of fixed asset build-out. As we did more and more work, we focused on the Chinese
property sector and couldn’t believe what we saw, and then we moved to the banks, etc. So it was
our work on individual com-panies that led us to the view that this was a macro problem in China
property market. It was similar to our work on subprime lending in the U.S. We started by looking at
the Florida real estate market in 2005, which was the first to go. I have an apartment in Miami Beach
and I remember counting cranes along the horizon in 2005 and 2006. They were just multiplying. At
the same time, we were doing some work on the banks and property companies in Florida. We saw
that the securitization business was fueling this build out, and then we looked at the rating agencies
and the big banks and worked right up the chain and realized it was a system-wide problem. The
same occurred with the commercial real estate market in the 1980s. We started with Integrated Re-
sources, the syndicator I mentioned, and then tax laws changed in 1986. The laws meant that you
could no longer write off passive losses from real estate against ordinary income, and that
devastated the industry as they were just leveraging up to buy buildings every-where. So we looked
at syndicators, we looked at the savings and loan indus-try, and worked our way up the system.
We’re not macro people. Even though we have a macro call on China real estate, it really derived
from our work on individual companies.

G&D: Chinese students we spoke with seem to think that although the real estate bubble in China
seems to be bursting as we speak, it may heat back up if the government starts stimulating the
market. What would you say to that?

JC: That is the overall belief in China. When we first started talking about this, my critics said, well,
Mr. Chanos doesn’t speak Man-darin and has never been to China. I said, that’s true, though my
clients pay me for performance, not how many visas I have in my passport. Most people who go to
China visit Shanghai and Beijing. That’s like say-ing I went to London and New York and didn’t see
any problems in 2006 and 2007. Well, if you had gone out to Phoenix or Las Vegas maybe you would
have seen them. So the critics, who initially in 2010 said our call was wrong, are now saying “well,
there are problems, but the government can reflate and fix them.” My response to that is the gov-
ernment is the one that got you into that problem. Peo-ple in the U.S. always said, if the U.S. gets
into trouble, the Fed will just cut rates. The problem is that the government policy has been loose in
China regardless. The one restriction they have in place is the House Purchase Restrictions (HPRs),
which apply for second and third homes. But people who own more than a couple homes are almost
always speculators. The bulls are saying the government will loosen the HPRs, but the problem is
that the government doesn’t want speculation in real estate. So I think that’s a pretty bad argument.
Secondly, the flood of construction has continued apace, and the unsold inventory is piling up. What
if the speculators turn into sellers as opposed to buyers when the HPRs are relaxed?

G&D: Do you think the government is seeing that?

JC: They are seeing it, and just a few weeks ago Premier Wen gave a speech saying they are going to
keep the restrictions in place because they still think prices are still too high and they want to stop
specula-tion. Anyone who is counting on the government to fix that market is, I think, counting on
hope rather than analysis. This is a bubble that has a long way to go on the downside. Residen-tial
real estate prices, in aggregate in China, at con-struction cost, are equal to 350% of GDP. The only
two economies that ever saw higher numbers at roughly 375% were Japan in 1989 and Ireland in
2007, and both had epic property collapses. So the data does not look good for China.

G&D: If a collapse occurs, will it be very damaging to the global economy?

JC: Interestingly enough, it may not impact the U.S. all that much. The U.S. might even be a
beneficiary due to lower commodity costs. The commodity companies however will be hit hard. I
also think the renminbi is overvalued. If there is some depreciation of the currency, that could lead
to cheaper products from China, which could actually help the U.S. economy. Places like Australia
and Canada and Brazil would be hit pretty hard, however, because they rely on exporting
commodities to China.

G&D: You talked at the Value Investing Congress a few years back about the difficulty of investing in
com-panies with so much of their profitability tied to com-modities. How do you de-termine what’s
a sustainable average price for a com-modity-focused company?

JC: It’s difficult, and you determine the price based upon a probabilistic range. If you look at the price
of iron ore in real terms since the 1920s, it basically traded between $30 and $45. Iron ore is not
hard to find, it’s pretty much everywhere. The cost to extract it was around $30 per metric ton in
real terms. In 2005 it suddenly took off and it got to $180 last year. It’s back down to $140 right now,
and people are modeling out their profit forecasts based on a range of $120 to $160. Well, what if it
gets back to $30 or $40? You might want to put your lower bound a bit lower here. Everyone’s just
looking at the last four years. The last four years was the China boom. It was a once in a lifetime
build out of infrastructure in the most populous country of the world. After you have your third
international airport in Hainan, China, you probably don’t need a fourth one – especially when no
one is using the second one. In this case, things are really two or three standard de-viations from the
norm, and that’s what you need to be looking for. If iron ore prices were $50, I really wouldn’t care,
but at $140- $180 with more capacity coming on and lower demand in the future, I think we’re in for
a disaster.

G&D: But why do you think the government is tolerating this?

JC: It’s all about incentives. In China, everyone is incented by GDP. They are fixated on growth. In the
West, we go about our economic lives, and at the end of the year the statisticians say, this year your
growth was 3%. But in China, it’s still centrally planned. All state policy goes through the banking
system. They decide what they want growth to be and then they try and figure out how to get there.
The easiest way to do that, in an economy where consumption is only 30% of the total economy and
net exports are deter-mined by the world markets, is to stick a shovel in the ground and build
another bridge, since that con-tributes to GDP. So a random party chief knows they will never be
sacked if they make their GDP targets.

G&D: Why are they targeting 8% instead of some-thing like 4%?

JC: Because that’s how they’re compensated. These are not profit maximizing enterprises. China
doesn’t produce GNP numbers, they don’t put out figures net of capital depreciation. If they did, the
numbers would be much lower because there is so much that needs to be depreciated. The problem
is that Western investors have fallen for the idea that, if there is rapid growth in this country, they
must be able to make a lot of money. Well, not necessarily. In fact, GPD growth in China is poorly
correlated with stock returns. If you were a European investor in 1832 and you were looking for a
great growth story, you would have invested in the U.S. The U.S. went through probably the greatest
100 year period of growth in history from 1832 to 1932, and yet, if you had invested over that period
you would have probably lost all of your money five different times. Just because something’s
growing over the long term doesn’t make it a great investment.

G&D: Given your Greek heritage, we’re especially curious about your observa-tions about the
situation in Greece?

JC: It’s dire for Greece. Clearly the European Union has made an example out of the country. As has
been said, the problem with the EU is that it’s a currency union without a fiscal union. The incentives
are all skewed. People who say that Germany suffers from having to share the EU with these
Southern countries like Greece are missing the point. Germany is very happy to have those Southern
countries in the EU, because it keeps the cur-rency lower than otherwise. If Germany had its own
currency, it would go through the roof, and harm German exports, which are the big driver of that
economy. So in effect what’s happening is that German taxpayers are bailing out European banks,
who’ve lent money to the Southern European coun-tries, which are buying German products. The
problem is that it’s a political issue and so many people just want to look at it as a financial and
economic issue. There’s an interesting align-ment of interests where the taxpayers in the donor
countries are upset, and rightly so. In other words, the typical German taxpayer is saying, why should
I pay for this? The other thing is the recipient countries are upset, too. It’s not as if the typical Greek
citizen wants this money. They’re not seeing any positive results from the money – it just goes right
to the European banks. It’s not financing any new growth initiatives. I’m not going to apologize for
Greeks who didn’t pay their taxes or retired at 42. The stories are out there and they’re all true. But
be that as it may, there are an awful lot of law abiding Greeks who are being destroyed by what is
going on in Greece now. The new twist in 2011 is that the donor countries installed their technocrats
in Greece’s ministries to oversee tax collections and interior pol-icy, and that has really hit a nerve.
Now Germany is basically dominating Europe. You ignore that political calculus at your peril. All of
this connects to historical issues, such as how the Germans treated the Greeks in World War II.
Greece lost one million people in World War II out of a population of eight million. The only country
with a comparable (and higher) ratio was the Soviet Union. In the fall of 1941, after the Germans
invaded Greece, they left the Greek government in-tact but they put Reich’s ministers in charge of
all the ministries to oversee them. One of the things they did was to loot the country of its harvest.
Eight hundred thousand Greeks died in that famine of 1941. Almost every Greek family has someone
who died in that famine. So this twist has opened up a 70 year old wound. Keep an eye on Spain and
Portugal because they’re next. The other issue that is coming about is cutting your way to growth. Is
austerity key to getting these countries back on track? So far the evidence is pretty poor that it is.
We may look back and say, wow, what a policy mistake.

G&D: Where do you come down on the nature vs. nurture debate? You made a great investment in
Baldwin United at 24, a time when many are barely learn-ing about investing.

JC: I always used to say, on the short side, people are made not born. I’ve changed my view on that a
bit. I do think there are enough asymmetries between the long side and the short side that it makes
it difficult for people who are otherwise very bright investors, particularly people in the value world,
who look at things and see great short opportunities, but can never get their mind to the point
where they can become good short sellers. I do think, to some extent, the temperament of a good
short seller is probably genetic. So I think the skill set is the same in terms of try-ing to do deep
research and finding unique value in companies is the same, the mindset can be very differ-ent. You
need to be able to weather being told you’re wrong all the time. Short sellers are constantly being
told they’re wrong. A lot of people don’t function well in an environment of negative reinforcement
and short selling is the ultimate nega-tive reinforcement profes-sion, as you are going against the
grain of a lot of well-financed people who want to prove you wrong. It takes a certain temperament
to disregard this.

G&D: How often do you see companies that are fudging the numbers able to maneuver their way
out of it?

JC: If a company is very fraudulent, it is very difficult to recover. Where companies have simply
fudged the numbers, such as Tyco International, they are able to come back but the share-holders
and sometimes bondholders are wiped out. If we end up being right on the fundamentals, it’s very
rare that a company in mid-problem can turn itself around. Usually it requires a cleansing of the old
order for things to change. Generally the problems we see are deep-seated enough where they need
to confront them, pay the eco-nomic price, and move on.

G&D: Could you give us an example of some current ideas?

JC: Currently we are short the natural gas industry in the U.S. for a few reasons. First, there has been
a ma-jor technological innovation — fracking — that has created displacement. This has driven
prices from high sin-gle digits per MCF of natural gas down to $2 per MCF. Most of the companies in
the natural gas area began an exploration boom that has created this glut. These companies counted
on the price to remain above $6-7 per MCF. A number of companies that had structured their
balance sheets and paid up for acquisitions with this expectation of higher prices are now struggling.
So they’ve got weak-ened balance sheets in a commodity business that is in oversupply, and on top
of that, many of them are engaged in some pretty egre-gious accounting games, like hiding negative
cash flows in various ways. I think this area will be a very fertile area on the short side for a number
of years. The good news is that this happens to be an amazingly positive development for the U.S.
because energy prices have dropped so much.

As an ancillary development, the other industry that gets killed by this is coal. Natural gas prices are
now half the price of coal. Coal used to be one of the cheapest sources of energy, but it was the
dirtiest. Now it’s becoming one of the most expensive fuels and is still the dirtiest. Utilities and
others are rapidly trans-forming from burning coal to burning natural gas, which I do not think bodes
well for the coal industry.

G&D: Haven’t some of the stocks of companies in these industries been hit hard already?

JC: You have to remember that if you are shorting a leveraged company, with 90% of the
capitalization in debt and 10% in equity, a 50% decline in the stock price only wipes out 5% of the
total capitalization. You have to look at the total capitalization. In some of these cases the total capi-
talization is only down a little while cash flow has been cut by 75%. This is the reason that some
investors get killed in value traps. They look at the stock and they don’t look at the total
capitalization. They don’t realize that the debt burden is forever, meaning it’s not shrinking, whereas
the eq-uity capitalization may fluctuate in the market. If the cash flows have diminished dramatically
the company’s ability to service the debt, then the stock going down by half doesn’t mean anything.
You could still be at risk of losing all you capital.

G&D: Any other ideas that we can talk about?

JC: I think for-profit education business is a flawed business model. The out-comes are very poor, as I
feel that these degrees are sold, not earned. Anyone that wants to sign up for these things can get
in, but tuition is up there with many private schools. People are coming out of these schools with
$20,000 – $50,000 in debt and many don’t even graduate but incur the debt nonetheless. Some of
the technical schools do good practical training, but most of the business has now shifted to online
degree granting because it is more lucrative. I remember a couple of years ago, the head of human
resources at Intel was quoted in a front page New York Times article saying that if someone came in
from an online college, they won’t even look at them. The types of jobs these graduates get are no
better than if they just had a high school degree, and yet they are incurring all of this debt.
Ultimately defaults will go so high in the student loan area that the federal government will see
mounting losses and will change the student loan program guar-antee to force institutions to take a
bigger chunk of the risk. Once this happens, the business model is broken. The only reason these
companies exist is because of the federal loan guarantee on student debt.

G&D: What are some characteristics of the best analysts that have worked for you?
JC: The thing I look for most is intellectual curiosity. One of the best analysts we ever had was an art
history major from Columbia. She had no formal business school training. She was so good because
she was very intellectually curious. She was never afraid to ask why and if she didn’t understand
something she would go figure out everything she could about it. This is almost something that you
can’t train. You either have it or you don’t.

G&D: Who are other investors that you respect?

JC: I have a lot of respect for other investors that have gone public on the short side. People like
David Einhorn and Bill Ackman have been willing to go negative and be public. To the extent that
they are willing to take a controversial stand, I think it is a courageous thing to do. It is also an
important thing to do because for too many years short sellers have been demonized for being
anonymous. We have been one of the few public figures out there. We believe that if you are willing
to put an investment hypothesis out there before people with a face on it, it adds to the overall level
of investment debate. All kinds of people are willing to say why they own something, but are afraid,
because of retaliation by the companies, to say why they are short something.

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 manage-ment. 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 com-pany. 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 man-agement. 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 sys-tem in the
world and people by and large don’t take ad-vantage 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 succes-sive
filing had incrementally more damning disclosure about the company’s off-balance sheet entities. It
was obvious that internal lawyers were pushing man-agement 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 inter-nally.

G&D: What is your view on the banking industry today?

JC: I believe that right now the banking industry is at the tail-end of its credit problem in the United
States. We addressed it before everyone else. I call it the ‘pig-in-the-python’, where the python is
the world credit situation. If the pig at the end of the snake is the U.S., the pig in the middle is
Europe, and the pig being eaten now is China and Asia.

G&D: The investment management industry is extremely competitive. What do you recommend
students do who have not be successful in getting the job of their choice?

JC: In one word, network. Go to as many lunches and dinners as you can. Try and meet as many
investment management people as you can. Find out where the investment management people at
your firm hang out, or join an investment ideas group. There are lots of different doors that can
open throughout your career. Stay intellectually curious and meet as many people as you can.

G&D: What are some of the things that you think business school students who want to follow in
your footsteps should do?

JC: If you ever have an idea and you think you need to take career risk to accomplish it, do it early in
your career. Life intrudes — as when you get older you end up with more responsibilities and your
ability to take risk diminishes. If you are 25 and have a great idea and you fail, no one is going to hold
it against you, and future employers and investors might actually look favorably upon it. So if you
really want to pursue some-thing, do it while you’re young – you’ll have more energy and you’ll be
able to take more financial and career risk. If it doesn’t work you still have your whole life ahead of
you.

G&D: In the beginning of our interview, you men-tioned how your father’s advice about working
hard and working for yourself was important for you in your life. What kind of advice do you give to
your children?

JC: Do something you really want to do. There are few feelings worse in the world than waking up
every morning and not liking what you do. Whatever field it might be, you should do what you want
to do. Life is too short. The people that are the most productive are those that are happiest in their
jobs and find intellectual curiosity and stimulation in what they do.

And when fortune smiles your way as it does in any business career a number of times, take
advantage of it. That’s when people grow, that is when you see quantum leaps and step functions in
career moves.

Jim Chanos Contrarian trading style – short seller

A Short History Of The Bear Market

The Daily Reckoning Presents: A Guest Essay in which Edward Chancellor, author of “Devil Take the
Hindmost”, considers a recent proposal for legislation in the U.S. to temporarily ban short-selling.

A SHORT HISTORY OF THE BEAR

The professional life of the bear speculator is normally short and full of misery.

Powerful forces are aligned against the bear. They include, the bull speculators, whose capital
outnumbers that of the bears by at least one hundred to one; the public, who perceive short-selling
as an injurious activity; and politicians, who are always eager to blame the short-sellers for economic
woes.

In addition, the bear pits himself against the forces of economic progress, which over the past two
hundred years have been accompanied by the most tremendous gains in share prices, so that $100
invested in the U.S. market in 1802 would have been worth around $700m by the new millennium.

The earliest speculative markets witnessed the tussle of bulls and bears. In the second century
before Christ, the playwright Plautus identified two groups in the Roman Forum engaged in trading
shares. The first group he called “mere puffers” (the security analysts of the day), and the second
group Plautus described as “impudent, talkative, malevolent fellows, who boldly, without reason,
utter calumnies about one another.” In England, the origin of the term “bear” to describe
speculating for a fall, deriving from a trader who sold the bear’s skin before he had caught the bear,
first appeared in the early 18th century several years before the appearance of the corresponding
“bull.”

Bears have always been unpopular. In 1609, Flemish-born merchant, Isaac Le Maire, organized a
bear raid on the stock of the Dutch East India Company [even though a founding member of the
company]. Although the Amsterdam bourse maintained that the decline in the East India stock was
due to poor business conditions – not short- selling – in 1610 the government outlawed all short
sales. As with most laws seeking to curtail the activities of bears – the market’s natural libertarians –
this edict was a dead letter from the start. The Dutch banned short-selling again in 1621 but to no
effect.

As the stock markets became established in Britain and France in the eighteenth century, further
legislative traps were laid to catch the bears. Following the collapse of the Mississippi bubble in
1720, bears, who had profited from the decline in the Mississippi stock, were fined and a law was
introduced outlawing short- sales.
At around the same time, the English had witnessed the startling rise and collapse of the South Sea
Company, which had risen from around ?100 to nearly ?1000 in the first six months of 1720, only to
fall back to where it started in the autumn of the same year. Some thirteen years later, a bill was
brought before parliament by Sir John Barnard, M.P. Its aim was to “prevent…the wicked, pernicious,
and destructive practice of stock-jobbing [speculation] whereby many of his Majesty’s good subjects
have been directed from pursuing their lawful trades and vocations to the utter ruin of themselves
and their families, to the great discouragement of industry and to the manifest detriment of trade
and commerce.”

Sir John Barnard’s Act, as it was called, outlawed the use of futures, options, and short sales of stock
(by an error of drafting, this was later understood by the courts to relate only to British government
stocks).

It remained on the statute book until 1860. From its beginning, however, few paid attention to the
letter of the law: brokers continued to engage in short sales which were enforced through a
gentlemanly code of conduct – “my word is my bond” – rather than legal sanction.

These two early pieces of legislation against short- selling reveal a common theme in the history of
the bears. Bubbles occur when speculators drive asset prices far above their intrinsic value. The
collapse of a bubble is frequently accompanied by an economic crisis. Who gets the blame for this
crisis? Not the bulls, who were responsible for the bubble and the various frauds and manipulations
perpetrated to keep shares high, while cashing in their profits.

No, it is invariably the bears who are blamed for the post-bubble crises and are the main objects of
anti- speculative legislation. Yet during the bubble periods it is the bears who are generally the lone
voice of reason, warning people of the folly of investing in overpriced markets. In the aftermath of a
bubble, they continue their forensic work of exposing unsound securities and bringing prices back in
line with intrinsic values, a point which must be reached before the recovery can start.

Ever since the trauma induced by the collapse of the Mississippi Bubble, the French have retained a
more pronounced aversion to financial speculation than the English. Napoleon disliked bears and
believed that shorting was unpatriotic. In 1802, he signed an edict subjecting short-sellers to up to
one year in jail. The French prejudice against so-called Anglo-Saxon capitalism continues to the
present day: after George Soros and other speculators drove sterling from the Exchange Rate
Mechanism in September 1992, the French finance minister, Michel Sapin, commented that “during
the Revolution such people were known as agioteurs, and they were beheaded.”

Only the other day, following the fall of the markets after September 11, the Belgian finance
minister said he had “strong suspicions” that the UK markets were used for speculative trading!
Bears have always operated more freely in the United States than in Europe. Despite a ban on short
sales by the New York Legislature in 1812, the bear operator was a familiar figure in the nineteenth
century. A few gained celebrity. Jacob Little, a saturnine figure, was a leading bear operator in the
first half of the century. Known variously as the “Great Bear,” the “Old Bear,” and the “Napoleon of
Wall Street”, Little also operated on the long side, and perfected the technique of catching shorts in
corners, which became a characteristic feature of the U.S. market. Little was destroyed in the
“Western Blizzard” crash of 1857.

His place was taken by Daniel Drew, also known as the “Great Bear”, “Ursa Major”, and the “Sphinx
of Wall Street”. Drew was described by a contemporary as “shrewd, unscrupulous, and very illiterate
– a strange combination of superstition and faithlessness, of daring and timidity – often good-
natured and sometimes generous.” He was the great rival of Cornelius Vanderbilt and a sometime
partner of Jay Gould.

Drew’s bear operations sometimes involved the Erie Railroad, of which he was a director. Drew
would manipulate Erie’s stock upward, sell it short and then “water” the stock by issuing a vast
number of unauthorized shares. Drew is famous for his ditty on the legal obligations of the bear:

“He who sells what isn’t his’n,

Must buy it back or go to pris’n.”

The roaring twenties, of course, belonged to the bulls. But as the market turned in September 1929,
the bears regained control. The celebrated speculator Jesse Livermore, who as a teenager made his
first fortune shorting the stock of the Union Pacific Railroad during the San Francisco earthquake of
1906, made another pile during the October crash.

[After the crash] stocks continued to fall, until by the summer of 1932, the Dow Jones reached a
floor of 41.88, nearly 90% off its 1929 peak. By this date, the country’s national income had shrunk
by 60% and one third of the non-agricultural workforce was unemployed. President Herbert Hoover,
who came to office in early 1929 promising that “the end of poverty was in sight,” faced an uphill
task in the forthcoming election. America needed a scapegoat.

Wild rumors spread of bear raids, of fabulous profits made by short-sellers, and of political
conspiracies hatched by foreigners interested in bringing down the market, the dollar and the U.S.
economy. In early 1932, the Philadelphia Public Ledger maintained that “European capitalists had
supplied much of the cash needed to engineer the greatest bear raid in history. These proverbially
open-handed and trusting gentleman had accepted the leadership of New York’s adroit Democratic
financier, Bernard Baruch.” Baruch, the best known short-seller in the country, shrugged off the
charge.
Hoover, on the other hand, apparently became convinced that bear raids on the stock market were
intended to damage his presidency. In April 1932, a French stock market rag was raided by Paris
police, its female editor accused of being in the pay of Russian and German interests who were
trying to induce a panic on the New York market. In desperation, Hoover ordered the Senate to open
an investigation into the affairs of Wall Street.

In fact, there is remarkably little evidence of organized bear raiding on the U.S. market following the
October Crash. In order to dispel the myths, the economist of the New York Stock Exchange, Edward
Meeker, published a book, entitled Short-Selling, in 1932. Meeker claimed that bears had not
precipitated the crash. In November 1929, the NYSE found that around one hundredth of one
percent of outstanding shares had been sold short. A later study in May 1931 found the short
interest had risen to 3/5 of one percent of the total market value. More than ten times as many
shares were held on margin. Nor could the stock exchange identify any bear raids in the subsequent
market decline.

Meeker provided an eloquent defense of short sales. He argued that the bears stabilize prices by
providing liquidity and creating demand – by covering their shorts – in a falling market. Shorting was
not illegitimate, in his view. “A short sale,” wrote Meeker, “represents a debt contracted in goods
rather than money.” In this it was similar to many other business contracts.

“Short-selling,” wrote Meeker, “is really an expression of opinion, subject to personal risk, as to the
value of securities…Short selling has no effect upon the assets or earning power of operating
companies, even in the case of banks. It cannot determine value, but only estimate what prospective
values really are and will be.”

It is unlikely that many were swayed by Meeker’s argument. The politicians certainly were not.
However, the Senate investigation into Wall Street, intended to uncover the nefarious activities of
the shorts, found little to go on. A list of 350 leading bear speculators presented to the committee
contained only one familiar name…Having no luck with the bears, the investigation turned its
attention to the bulls of yesteryear. This was much more fertile ground.

The Pecora hearings, as they became known (after their lead counsel, Ferdinand Pecora), revealed
the seamier side of Wall Street during the bull market: the involvement of leading firms and bankers
in the manipulation of share prices, the dumping of unseasoned securities on an innocent public, the
fleecing of the firms’ own clients, the preferential distribution of shares to favored friends, and so
on.

In other words, rather similar behavior to what we have witnessed from the investment banks in
recent years.These findings led to the New Deal legislation of 1933 and 1934, which involved among
other things, thecreation of the Securities and Exchange Commission andthe separation of
commercial and investment banking.

The bears of the early 1930s had a mixed fate. Joseph Kennedy, the father of JFK, was appointed the
first chairman of the SEC shortly after participating in a bear pool in the stock of Libby Owens Ford.
Roosevelt apparently decided he needed a fox to guard the hen coop. Jesse Livermore had a less
happy time. He lost an estimated $32 million anticipating a bull market which never arrived. In 1934,
Livermore was declared bankrupt. He blew his brains out in the washroom of the Sherry-
Netherlands hotel in 1940. The note he left behind, repeated over and over again: “My life has been
a failure. My life has been a failure…”

The pattern of boom and bust has continued in the post- war years. Inevitably the bears have been
blamed during every major downturn…Japanese authorities complain[ed] that mysterious foreign
interests were responsible for the decline in their stock market, following the great boom of the
bubble economy. (In 1998, the Japanese imposed restrictions on short-selling in an attempt to shore
up their market).

In every instance when bears are accused of bringing down a market, we find that it was the
preceding bull market, with its accompanying misallocation of resources and unsustainable
accumulation of debt, which was the root cause of the decline.

Today is no different. Earlier this year, as markets declined, there were isolated complaints of bear
raids. After September 11 these complaints assumed a more hysterical tone. It was alleged that
terrorists had arranged to short airline and insurance stocks prior to the attack on the United States.
I do not know whether this is true.

However, I am doubtful. As we have seen in the past, foreigners have frequently been identified as
leading a conspiracy of bear raiders. And besides, there were good fundamental reasons to short
airlines and insurance companies even before their position deteriorated in September.

Nevertheless, last month lawmakers in the U.S. asked the SEC to consider a temporary ban on short
trading. According to newspaper reports, UBS Warburg and Bear Stearns tried to limit short sales by
their clients.

It has been said that “progress in finance is cyclical rather than linear.” Certainly attitudes towards
short- selling seem to have progressed very little over the centuries.

The most eloquent justification for the bear is provided by the American financier Bernard Baruch,
who was called to Washington in 1916 after a market panic to explain his short-sales of the stock of
the Brooklyn Rapid Transport Company, a go-go stock of that era. At the time some members of
Congress were calling for short- selling to be banned. Baruch stood his ground, politely explaining to
the politicians that “bears can only make money if the bulls push up stocks to where they are
overpriced and unsound.” He continued:

Bulls always have been more popular in this country because optimism is so strong a part of our
heritage. Still, over-optimism is capable of doing more damage than pessimism since caution tends
to be thrown aside.

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and
bears. A market without bears would be like a nation without a free press. There would be no one to
criticize and restrain the false optimism that always leads to disaster

JAMES CHANOS
PREPARED STATEMENT
U.S. SECURITIES AND EXCHANGE COMMISSION
ROUNDTABLE ON HEDGE FUNDS
Panel Discussion: "Hedge Fund Strategies and Market Participation"

My name is James Chanos and I am the President of Kynikos Associates, a New York private
investment management company that I founded in 1985.1 I am honored to have the opportunity to
participate in today's panel entitled: "Hedge Fund Strategies and Market Participation." I would like
to commend the Commission for undertaking such a thorough review of all the possible issues
surrounding hedge funds as a prelude to making its recommendations for any changes to the
regulatory structure.

Kynikos Associates specializes in short selling, an investment technique that profits in finding
fundamentally overvalued securities that are poised to fall in price. Kynikos Associates employs
seven investment professionals and is considered the largest organization of its type in the world,
managing over $1 billion for our clients.

On behalf of our clients, Kynikos Associates manages a portfolio of securities we consider to be

overvalued. The portfolio is designed to profit if the securities it has sold short fall in value. Kynikos
Associates selects portfolio securities by conducting a rigorous financial analysis and focusing on
securities issued by companies that appear to have (1) materially overstated earnings; (2) an
unsustainable or operationally flawed business plan; and/or (3) engaged in outright fraud. In
choosing securities for its portfolios, Kynikos Associates also relies on the many years of experience
that our team has accumulated in the equity markets.

Kynikos has sometimes been called a "hedge fund," but it is not a hedge fund following the classic
model first established by A.W.Jones & Co. We operate a short fund. With the proliferation of
private investment funds, however, the term "hedge fund" is now used so broadly in some quarters
to refer to any private investment fund that I do not believe that it accurately describes Kynikos'
business model accurately.

In almost any market environment, professional short-sellers are a small percentage of those
actively engaged in the markets. The bull market of the 1990s drove a number of previously short
funds into alternative strategies or out of the market altogether. In today's less robust market
environment, however, a number of new participants have emerged and, with them, heightened
public, corporate and regulatory scrutiny of the practice of short selling has ensued, as it does during
almost every prolonged market downturn.

Following a brief discussion of the general benefits of short selling, I wish to address, in the strongest
manner, my belief, which is borne out by testimony, experience and empirical analysis, that short
selling is beneficial to the markets not only in the technical aspects of providing liquidity or a hedge
against long positions, but also as an important bulwark against hyperbole, irrational exuberance,
and corporate fraud. As Bernard Baruch said nearly ninety years ago: "To enjoy the advantages of a
free market, one must have both buyers and sellers, both bulls and bears. A market without bears
would be like a nation without a free press. There would be no one to criticize and restrain the false
optimism that always leads to disaster."2

Who Sells Short?

There are three main categories of market participants who sell short, and they do so for differing
reasons.

The first category is exchange specialists, market makers and block traders who will sell short for
technical reasons in order to maintain customer liquidity and price stability.

The second category of short sellers are those who are engaging in market neutral arbitrage and are
seeking to take advantage of temporary or minute price discrepancies in markets or in similar
securities.

While the above activities are common market techniques, they are not what the public generally
has in mind when any discussion of short selling arises. The last category of short sellers is the
investor expressing his or her view that a specific stock or market index is overvalued and will
decrease in price over time. It is this activity that is often associated with hedge funds and is also the
frequent target of corporate criticism.

Regulatory Requirements and Economic Costs of Short Selling

First and foremost, it is important to note that short selling, like any market activity, is subject to the
full panoply of anti-fraud and anti-manipulation provisions of the securities laws. There is no
loophole or gray area of which I am aware in the federal securities laws that makes it illegal to
manipulate the price of a stock upward but simultaneously permits the manipulation of the price of
a stock downwards. In fact, and contrary to the allegations of some, short selling is one of the most
heavily regulated market strategies around.

First, open short interest is disclosed monthly by both the New York Stock Exchange and the
NASDAQ Stock Market for every listed company. Any investor can take a look and see how much
short interest exists for any particular company. So the charge that short selling is a wholly opaque
practice is spurious.
Second, alone among market transactions, short selling is subject to the "uptick rule" on both the
New York Stock Exchange and the NASDAQ Stock Market. Every short sale transaction must be
disclosed as such. The uptick rule requires that a short sale could, in fact, only be made at (zero plus
tick) or above (plus tick) the last transaction price. Thus, it is mechanically impossible for short sellers
to drive down the price of the stock. It is an open question whether the harm done to price
efficiency in the marketplace is warranted by the supposed protection offered to investors against
so-called bear raids. An inquiry into the transaction-by-transaction functioning of the uptick rule may
in fact disclose that significant numbers of sell orders get trapped behind the gate, thus making it
more difficult for investors of all sizes and sophistication levels to sell their securities when they
wish.

Third, Regulation T, administered by the Federal Reserve Board, requires that short accounts post at
least 50% of the value of all shorted shares as a margin requirement. Of course, margin calls can
arise if the price of the shorted stock increases, thus triggering additional collateral deposits in order
to meet the strictures of Regulation T.

Collateral requirements on securities loans used by shorts to deliver shorted securities pose a
further control on short selling. Short sale proceeds are used to collateralize borrowed securities and
they are not available to leverage the portfolio and enable additional short sales. This represents a
further control on short selling.

Lastly, many institutional investors such as pension funds, mutual funds, and endowments have
been prohibited or are severely restricted in shorting stock by the prudent investor rules under
which managers operate such funds.

To this regulatory burden, there are also significant economic costs and market risks. Short-sellers
typically must hold their short positions for extended periods--often months--until the market
realizes how badly overvalued a particular stock is and the price declines. Holding the short positions
is expensive and risky for the short seller. A joint Harvard Business School-University of Michigan
Business School working paper in 1999 summarized these factors:

The proceeds from a short sale are not available to the short seller. Instead, the proceeds are
escrowed as collateral for the owner of the borrowed shares. Typically, the short-seller receives
interest on the proceeds, but the rate received ("the rebate") is below market rate. The difference is
compensation to the lender of the stock. Thus short-sellers cannot directly use the proceeds from
short sales to hedge their short positions. The tax treatment of short positions contributes to the
high cost of short selling. All profits from a short sale are taxed at the short-term capital gains rate,
no matter how long the short position is open. Finally, the short-seller is required to reimburse the
stock lender for any dividends or other distributions paid to the shareholders of the shorted stock
while the short position is open. The standard stock-lending practice is that the loan must be repaid
on demand. This practice exposes the short-sellers to the risk of being "squeezed."3

The fact that there is a significant regulatory and economic burden to short selling is not to say that
it cannot be a profitable transaction. Nevertheless, I would hope that this brief overview of the
regulatory and economic forces in play when anyone chooses to short stock, puts to rest the carping
of critics who allege that this is a lightly regulated or wholly unregulated endeavor that one would
enter into cavalierly.

Short Sellers as Financial Detectives

The public benefit of the "long" side of the market is well understood by almost everyone in 21st
Century America: companies raise capital to fund investment, research and job creation; retail and
institutional investors seek out equity investments in order to share in the creation of wealth that
flows from well-managed, honest companies.

The public benefit from the "short" side of the market is less well understood, but no less valuable.
As Edward Chancellor, the noted expert in the history of finance, wrote in 2001, "we need more, not
less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the recent
technology, media and telecoms boom."5

Many of the major corporate frauds and bankruptcies of the past quarter century were first exposed
by short sellers doing fundamental research: Enron, Tyco, Sunbeam, Boston Chicken, Baldwin
United, MicroStrategies, Conseco, ZZZZBest and Crazy Eddie are but a few examples of this
phenomenon.

The short sellers provide the kind of independent research that is the marketplace's best antidote to
the myriad conflicts of interest so amply revealed in the global settlement with ten leading Wall
Street investment banking firms. Short sellers ask the tough questions and dig out the discrepancies
in the financial statements and other regulatory filings made by publicly traded companies.

Paul Asquith and Lisa Meulbroek, in a Harvard Business School working paper, found a strong
correlation between short interest and subsequent negative corporate returns:

"Using data on monthly short interest positions for all New York Stock Exchange and American Stock
Exchange stocks from 1976-1993, we detect a strong negative relation between short interest and
subsequent returns, both during the time the stocks are heavily shorted and over the following two
years. This relationship persists over the entire 18 year period, and the abnormal returns are even
more negative for firms which are heavily shorted for more than one month."6

For an investor seeking warning signs in the market, corporate conflicts with short sellers may be
just the canary in the mineshaft that is needed. As the New York Times recently reported:

"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."7

In fact, Professor Lamont's recent study confirms anecdotal evidence collected by the National
Association of Securities Dealers in 1986 as part of former SEC Commissioner Irving Pollack's report
to the NASD entitled Short Sale Regulation of NASDAQ Securities:

"The Pollack Report chose eleven securities for analysis, based upon media articles, complaints from
issuers, and indications of unusual trading patterns. The Pollack Report found that, with respect to
two of the securities studied, rumors of extensive short selling were unfounded - large short
positions did not exist. With respect to the nine other securities, six of the issuers suffered significant
operational losses and five of the issuers were the subject of adverse regulatory action."8

In testimony presented to Congress in 1989, the SEC's Associate Director of Enforcement, John Sturc,
was even more pointed in dissecting the underlying reasons that issuers and others complain about
short sellers. Mr. Sturc outlined five reasons that the SEC "frequently finds that the complaints of
downward manipulation that we receive from issuers or their affiliates do not lead to sustainable
evidence of violations of the antifraud provisions of the federal securities laws " including:

" negative statements which persons holding short positions are alleged to have disseminated to the
marketplace may be true or may represent expressions of investment opinion by professional
securities analysts. many of the complaints we receive about alleged illegal short selling come from
companies and corporate officers who are themselves under investigation by the Commission or
others for possible violations of the securities or other laws." [emphasis added]9

Short sellers also help stabilize falling markets by buying shares to close out their short positions.
This results in market support and can reduce volatility and market declines caused by a lack of
buyers.

An Example of Research Based Short Selling: Enron

It may be useful for the Commission to understand some of the mechanics of research based or
informationally motivated short selling. I have received a fair amount of attention for Kynikos' early
negative views of the Enron Corporation and it may be useful to provide the Commission and public
with one example of why and how a short seller develops his investment view.

My involvement with Enron began normally enough. 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.

Our interest in Enron and other energy trading companies was piqued because our experience with
companies that have used this accounting method has been that management's temptation to be
overly aggressive in making assumptions about the future was too great for them to ignore. In effect,
"earnings" could be created out of thin air if management was willing to push the envelope by using
highly favorable assumptions. However, if these future assumptions did not come to pass, previously
booked "earnings" would have to be adjusted downward. If this happened, as it often did,
companies wholly reliant on "gain-on-sale" accounting would simply do new and bigger deals--with a
larger immediate "earnings" impact--to offset those downward revisions. Once a company got on
such an accounting treadmill, it was hard for it to get off.

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

We were also troubled by Enron's cryptic disclosure regarding various "related party transactions"
described in its 1999 Form 10-K, as well as the quarterly Form 10-Qs it filed with the SEC in 2000 for
its March, June and September quarters. We read the footnotes in Enron's financial statements
about these transactions over and over again and we could not decipher what impact they had on
Enron's overall financial condition. It did seem strange to us, however, that Enron had organized
these entities for the apparent purpose of trading with their parent company, and that they were
run by an Enron executive. Another disturbing factor in our review of Enron's situation was what we
perceived to be the large amount of insider selling of Enron stock by Enron's senior executives.
While not damning by itself, such selling in conjunction with our other financial concerns added to
our conviction.

Finally, we were puzzled by Enron's and its supporters' boasts in late 2000 regarding the company's
initiative in the telecommunications field, particularly in the trading of broadband capacity. Enron
waxed eloquent about a huge, untapped market in such capacity and told analysts that the present
value of Enron's opportunity in that market could be $20 to $30 per share of Enron stock. These
statements were troubling to us, because our portfolio already contained a number of short ideas in
the telecommunications and broadband area based on the snowballing glut of capacity that was
developing in that industry. By late 2000, the stocks of companies in this industry had fallen
precipitously, yet Enron and its executives seemed oblivious to this fact. And, despite the obvious
bear market in pricing for telecommunications capacity and services, Enron still saw huge upside in
the valuation of its own assets in this very same market, an ominous portent.

Beginning in January 2001, we spoke with a number of analysts at various Wall Street firms to
discuss Enron and its valuation. We were struck by how many of them conceded that there was no
way to analyze Enron, but that investing in Enron was instead a "trust me" story. One analyst, while
admitting that Enron was a "black box" regarding profits, said that, as long as Enron delivered, who
was he to argue.

In the spring of 2001, we heard reports, later confirmed by Enron, that a number of senior
executives were departing from the company. Further, the insider selling of Enron stock continued
unabated. Finally, our analysis of Enron's 2000 Form 10-K and March 2001 Form 10-Q filings
continued to show low returns on capital as well as a number of one-time gains that boosted Enron's
earnings. These filings also reflected Enron's continuing participation in various "related party
transactions" that we found difficult to understand despite the more detailed disclosure Enron had
provided. These observations strengthened our conviction that the market was still over-pricing
Enron's stock.

In the summer of 2001, energy and power prices, specifically natural gas and electricity, began to
drop. Rumors surfaced routinely on Wall Street that Enron had been caught "long" in the power
market and that it was being forced to move aggressively to reduce its exposure in a declining
market. It is an axiom in securities trading that no matter how well "hedged" a firm claims to be,
trading operations always seem to do better in bull markets and to struggle in bear markets. We
believe that the power market had entered a bear phase at just the wrong moment for Enron.

Also in the summer of 2001, stories began circulating in the marketplace about Enron's affiliated
partnerships and how Enron's stock price itself was important to Enron's financial well-being. In
effect, traders were saying that Enron's dropping stock price could create a cash-flow squeeze at the
company because of certain provisions and agreements that it had entered into with affiliated
partnerships. These stories gained some credibility as Enron disclosed more information about these
partnerships in its June 2001 Form 10-Q, which it filed in August of 2001.

To us, however, the most important story in August of 2001 was the abrupt resignation of Enron's
CEO, Jeff Skilling, for "personal reasons." In our experience, there is no louder alarm bell in a
controversial company than the unexplained, sudden departure of a chief executive officer no
matter what "official" reason is given. Because we viewed Skilling as the architect of the present
Enron, his abrupt departure was the most ominous development yet. Kynikos Associates increased
its portfolio's short position in Enron shares following this disclosure.

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. Let me now turn to the question of whether, in light of the important work
they do, short sellers should be subject to greater, or perhaps less, regulation.

Is There a Need for Regulatory Change?

It is important to separate the questions regarding additional regulation of hedge funds, on the one
hand, and the possibility of additional regulation of short selling, on the other. Unfortunately, the
two are often linked, even though there is little evidence that there is a relationship between the
two that warrants changes in public policy.11

A. Short Selling

As I have outlined above, short selling is already a heavily regulated strategy with significant legal
and economic constraints. Strong capital markets in the U.S. require a robust short side; restrictions
on short selling impede the market's efficiency and decrease the amount of independent research
necessary to mitigate against irrational exuberance and outright fraud. Short selling represents only
a very small fraction of market activity. It is very costly and full of risk for the short seller to execute
and maintain a position, waiting for the rest of the market to realize the stock is overvalued.

There are already tight regulatory requirements and economic costs that restrict short selling.
Imposing further barriers and restrictions upon short sellers may shrink an already small number of
professional short investors and further limit their incentive and ability to serve as the
counterbalance to hype and irrational optimism that frequently drive stock valuations to
unsustainable heights, resulting in the misallocation of capital in our markets.

Any manipulation of stock prices, whether upward or downward, should be prosecuted to the full
extent of the law, and I firmly believe that the enforcement agencies - federal, state and SRO - must
have the tools necessary to accomplish that objective. But I believe that the record - as evidenced by
the NASD's Pollock Report in 1985, the SEC's testimony in 1989 and Professor Lamont's study in 2002
- demonstrates that the allegations about illegal short manipulation activity are frequently spurious.
One can even go back to the Senate investigation that led to the enactment of the Securities Act of
1933. It started out as an investigation of alleged "bear raids" and short manipulation in the 1929
market crash, but found instead issuer and investment banker hype, conflicts of interest and
inadequate disclosure. The investigation vindicated short selling as an important market activity and
led instead to the enactment of the federal securities laws, regulating issuers and investment
bankers.

In a more modern context, the Commission testified before Congress in 1989 (again addressing
allegations of short selling and market manipulation) that it "frequently" found the negative
statements of short sellers to be true; and, that it also found that "many of the companies from
whom we receive complaints about alleged illegal short selling are themselves under investigation
for possible violations of the securities or other laws at the time they make the complaints."12

Obviously, we will willingly comply with any new law or regulation that is enacted. But it is my hope
that a careful examination of any allegations of regulatory gaps will reveal that the facts do not
support the case for new regulatory action.

In fact, the Commission itself contemplated relaxing restrictions on short selling at a number of
points in the 1990s, most recently issuing a concept release in 1999 on the topic. I believe that the
facts underlying those releases are much the same today as they were then. Thus, if as part of this
inquiry into hedge funds the Commission will also examine short selling, I hope that it will give as
much consideration to removing antiquated and inefficient regulations as it does to imposing new
regulations.

B. Hedge Funds

Chairman Donaldson in his April 10, 2003 testimony on hedge funds to the Senate Committee on
Banking, Finance and Urban Affairs identified a number of the important issues to be considered in
reviewing and considering changes to private investment fund regulation. I applaud Chairman
Donaldson and other Commissioners for holding these roundtable discussions in order to get the
insights of a variety of academics, investment managers and other observers of the investment
management industry in order establish a policy and factual basis for any possible future activity.

In his April 10th testimony, the Chairman identified "retailization" of hedge funds as a problem.13
From a business perspective, I know that I am not comfortable soliciting funds from individuals who
simply meet the minimum criteria of the Regulation D/accredited investor/3(c)(1) exemption of
either $200,000 in annual income or $1 million in net worth. As a business practice, I do not find that
I can make a presumption that an individual or business entity that meets those criteria is sufficiently
knowledgeable about the risks associated with Kynikos' investment strategy to make an informed
decision. Short selling is an inherently risky proposition. Profits are limited to a maximum of 100% of
the proceeds on the date of sale; losses, however, can be infinite, depending on how high the stock
price moves after the sale. Private investment companies like Kynikos also set different rules for
withdrawal of funds than do most mutual funds or other traditional money managers. I do not want
someone who is not able to tolerate these risks to invest with me. It is simply not good business.
Therefore, the prerequisites for investing in our funds are much more stringent than they are for
these other managed investment vehicles.
When Regulation D was adopted over twenty years ago, its definitions of accredited investor of
$200,000 of annual income or $1 million in net worth were considerably higher standards than they
are today. In general, the investment strategies of private investment funds involve substantial risk
and illiquidity. They are not appropriate for the average investor.

I do not know, as a matter of public policy, what the right level of income or net worth is to make a
presumption about market sophistication. I am aware that when Congress enacted an expansion of
the 3(c)(7) exemptions in 1997, that it used the criteria of $5 million in "investible assets" - a more
selective barrier - as the presumptive basis for market sophistication. Given the increase in the
number of hedge funds over the past decade, perhaps it is appropriate to re-examine the Rule 506
accredited investor/3(c)(1) standard.

In addition to the NASD's recent move to improve broker-dealer suitability standards for sales of
hedge funds, additional steps can be taken to keep investors limited to those who can understand
and bear the risks associated with private investment funds. One such step would be setting a higher
minimum investor qualification standard than the current "accredited investor" definition. This could
include both a higher net worth and a limit to an investment in a fund to a percentage of that net
worth (some states, such as California and North Carolina, historically have used a cap on privately
placed investments at 10% of the investor's net worth as a rough benchmark or limit, while others
have used a 20% limit).

This change would not necessarily require an amendment to Regulation D's definition of "accredited
investor." Other regulatory provisions could be amended--for example, the pending rulemaking
under Section 18 of the Securities Act of 1933 to preempt state filing requirements for sales to
"qualified purchasers," would define "qualified purchasers" by reference to the Regulation D
definition of "accredited investors." Rel. No. 33-8041, 66 Fed. Reg. 66839 (Dec. 2001). Why not set a
somewhat higher investor qualification standard for private placements that seek to rely on
preemption to avoid all state filings?

In addition to the "retailization" issue, Chairman Donaldson in his April 10 testimony also noted
conflicts of interest, valuation, performance reporting, fraud, misappropriation of assets, and
relations with prime brokers and other service providers. Each of these is a significant issue that all
managers of a private investment fund should be required to address as a condition to operating in a
relatively unregulated format.

One simple means to address these issues would be to impose some basic prudential restrictions on
hedge funds that wish to rely upon the regulatory exemptions from investment adviser registration--
17 C.F.R. §§ 275.203(b)(3)-1 & 275.222-2 (which treat a private investment fund as a single "client"
of the manager for purposes of determining whether the manager has 15 or more clients and is thus
subject to registration and regulation under the Investment Advisers Act). The rule could be
amended to require a "look through" to count the investors in the fund if the fund does not meet
certain basic investor qualification and investor protection requirements such as:
Minimum investor qualifications above current accredited investor levels (addresses retailization
issue);

Custody of private investment fund assets in a broker-dealer or bank and compliance with SEC
interpretations on constructive custody (addresses misappropriation of assets, fraud and
transparency issues);

Annual audit and delivery of financial statements to investors (addresses fraud and transparency
issues);

Quarterly unaudited financial reports to investors (addresses transparency issue);

Clear disclosure of financial arrangements with interested parties such as investment manager,
custodian, prime broker, portfolio brokers, placement agents and other service providers, both in
terms of description and with some periodic historic quantification of amounts paid to each category
and benefits received (addresses conflict-of-interest, transparency and fraud issues);

Clear disclosure of investment allocation policies (addresses conflict-of-interest, transparency and

fraud issues); and

Clear, objective and transparent valuation standards, that are clearly disclosed, not stale, and
subject to audit, for use in calculating current unit values for investor reports, admissions and
withdrawals and calculations of performance and volatility information (addresses valuation,
transparency and fraud issues).

Simple, basic standards on each of the above points could be added to Advisers Act Rule 275.
203(b)(3)-1(a)(2)(i) as a condition to reliance on the "single client" treatment of a private investment
fund. Those investment managers who operate investment funds that meet these standards would
be allowed to treat the fund as a single "client" and thus continue to avoid registration under the
Advisers Act. It may be appropriate to exempt family partnerships, family trusts, and gift & estate
situations and "knowledgeable employee" funds from these requirements (to mirror exemptions
contained in current Investment Company Act §§ 2(a)(51)(A)(ii) & (iii); 17 C.F.R. §§ 270.3c-5, 270.3c-
6 on the grounds that these types of closely-held arrangements do not involve marketing to
unrelated investors). Investment managers that operate private investment funds that do not meet
these standards would be required to look through the investment fund and treat each of its
investors as a "client", thus subjecting the investment manager to registration, SEC examination and
regulation under the Investment Advisers Act.

While we are not advocates of increase in the general regulation of private investment funds or
short selling, we are concerned that the misdeeds of a few could result in a backlash against the
industry. Requiring private investment funds to follow a few basic requirements on investor
qualifications and investor protection along the lines set forth above as a condition to continuing to
operate in a relatively unregulated fund environment could protect both investors and the private
investment fund industry from the actions of a few bad actors.

Carson Block
Short-seller Carson Block believes he has found a better way to bet against companies.
He says the strategy can make a “few percentage points” when the market rallies but can do much
better when the market declines.

With market “volatility still so low, this [new] strategy depends on options,” he said at the Kase
Learning: The Art, Pain and Opportunity of Short Selling conference in New York. “We look at the
capital structure. If there is debt, we can go long those bonds and use cash flows to buy long-dated
out-of-the money puts. ”

The investor said the strategy, which he calls the “future of short-selling,” does well in this market
environment versus shorting stocks directly. He said it can make a “few percentage points” when the
market rallies but can do much better when the market declines.

A put gives an investor the option to sell when a stock hits a certain price. The bond part of the
strategy involves buying corporate debt that generally would benefit when a stock goes higher but
would get hit if it falls.

“Senior credit recoveries tend to be very good,” he said.

The fund manager said senior credit bonds prices often drop marginally when a company’s stock
price falls dramatically.
Sahm Adrangi
Renowned short seller has Globalstar in crosshairs
Sahm Adrangi was selected as one of The Hedge Fund Journal’s Tomorrow’s Titans in the 2014
survey, sponsored by EY. His firm, New York-based Kerrisdale Capital Management, has followed a
spectacular growth trajectory – it has grown assets from $1 million in 2009 to c.$300 million in late
2014, and has done this without the help of any seeder. He has also multiplied day-one investors’
capital by a factor of 10, net of fees, achieving double-digit performance every year since inception.
Year-to-date through the middle of October, Kerrisdale is again beating the S&P 500 by 1,000 basis
points. This entrepreneurial success story offers a tremendously refreshing break from the constant
cacophony of complaints that regulations, rising costs and institutionalization of the hedge fund
industry have resulted in barriers to entry making it impossible to sustain a hedge fund without
hundreds of millions of dollars on day one.

Adrangi is most famous for short selling, taking an activist approach and publishing research,
particularly on Chinese companies, which contributed to his 180% return in 2011. All of these
differentiators are true, but none of them is a basis for making generalizations about Kerrisdale. The
fund is currently long-biased and expects to remain so in the future – Adrangi says, “We would never
run net short; we think that’s highly risky. Shorting long-term is not optimal, not an ideal strategy,
and it’s not as easy to compound wealth shorting as opposed to investing long.” That said, roughly
half of Kerrisdale’s percentage returns have come from the short side, since inception. Most
positions are passively held without any activist agenda; Kerrisdale does not publish research on
most of its names, and the majority of the portfolio is not invested in Chinese companies.

Publishing research

Nonetheless, Adrangi states, “publishing research makes Kerrisdale unique,” and the Canadian
national’s first job after graduating with an Economics degree from Yale University was as a trainee
journalist at Toronto’s Globe and Mail. Kerrisdale’s corporate culture emphasizes writing – it hires
strong writers, and analysts write detailed investment memos and reports both for internal and
external distribution. The percentage of research published does vary over time, and Adrangi
prioritizes external publication for under-followed longs and overhyped shorts where he feels
Kerrisdale can add value by correcting misunderstandings and educating the investment community.
As well, Kerrisdale welcomes an open dialogue with readers about investments: he says, “We
sometimes receive feedback challenging our thesis, giving us the opportunity to examine additional
or new risk factors.”

Many of Kerrisdale’s followers are institutional investors, and its research is disseminated through a
variety of avenues, including an email list; its own website, www.kerrisdalecap.com; Twitter; and
third-party websites such as Seeking Alpha. “It is very time-consuming and labour-intensive to put
out very high-quality research,” says Adrangi, and the firm’s recent report on Globalstar, Inc. took
many months of research. Adrangi thinks the expenditure of time and effort was worthwhile,
because Globalstar shares are down 50% since the report was published.

When it comes to publishing research, Adrangi has identified “best practices” by observing the
behaviour of other activists. Carson Block of Muddy Waters was one of the first to start publishing
reports upwards of 40 pages long, and detailed reports have since become commonplace. Andrew
Left of Citron Research is also someone Adrangi respects, praising Left’s “prolific, high-quality
research and tremendous decade-long track record”. Recently, in relation to Globalstar, Adrangi
copied strategies employed by Pershing Square’s Bill Ackman on Herbalife. Kerrisdale rented the
same auditorium, hired the same web-stream production crew, and created a similar website
providing research on his subject company at www.factsaboutglobalstar.com. Adrangi keeps an
open mind about collaborating with other activists, but for now Kerrisdale has carved out a niche as
an independent thinker.

The Globalstar debate

“Putting out the highest-quality research pays dividends in the future,” says Adrangi, and cites its
latest report on a short, Globalstar (GSAT), which Kerrisdale calls The Most Egregious $4 Billion Stock
Promotion Since Sino-Forest. Adrangi says that his Globalstar report “lays out our strong grasp of the
company and industry via a comprehensive and lengthy 60-page write-up”. He claims that, “Our
Globalstar work is very sophisticated – and we believe that our understanding of Wi-Fi spectrum is
better than even management’s”.

This brief article is nowhere near long enough to do justice to the nuances, subtleties and
technicalities of the debate. But anyone with an interest in Wi-Fi and mobile telephony should read
Kerrisdale’s report, and Globalstar’s responses, which are both freely available online. Nonetheless,
we will touch on some points of contention to give readers a taste of Kerrisdale’s research.
Globalstar is misunderstood, according to Adrangi. The bulls’ thesis rests on three premises: the FCC
will approve repurposing Globalstar’s spectrum to enable a new offering called Terrestrial Low
Power Service (TLPS), partly to alleviate Wi-Fi congestion; this asset will attract buyers who want a
private Wi-Fi network; and buyers will ascribe valuations to the spectrum in excess of GSAT’s
enterprise value.

Kerrisdale has gathered opinions from dozens of industry experts, including Wi-Fi engineers, and
methodically refutes each pillar of the bulls’ case. While Globalstar claims that Wi-Fi is congested,
Kerrisdale’s report argues that Wi-Fi congestion can be resolved in the vast majority of environments
by utilizing modern technology and proper network planning.

Kerrisdale is of the opinion that Globalstar’s TLPS channel is worth zero, even if the FCC does
approve repurposing GSAT’s spectrum as a paid-for Wi-Fi channel. This is due to the wide availability
of 25 Wi-Fi channels that are available for free. Kerrisdale summarizes its argument with the
catchphrase, “Competing with free while selling an inferior product: this is the TLPS vision.”
Kerrisdale’s report claims that there are already plenty of these 5GHz channels available for free,
and “a whole ecosystem already revolving around them”. By contrast, Globalstar does not think that
5GHz will supersede or render obsolete 2.4GHz, for various reasons, including coverage issues.

Kerrisdale also points out that GSAT’s channel, if authorized, will only be approved for “low-power”
usage, which it says would require a larger and more expensive network of access points than the
base towers that currently provide higher-power cellular services. The cost of building out a
nationwide footprint of these access points is another reason to question the value of the spectrum,
according to Kerrisdale. In contrast, GSAT says its TLPS channel has “build-out cost advantages
compared with 5GHz,” and could be made immediately accessible.

Differences of opinion are perfectly normal in cases of short selling – Adrangi himself has been on
the other side of Bill Ackman’s short in Herbalife.

Other shorts

Although Kerrisdale is known best for its work exposing US-listed Chinese frauds, and Adrangi
believes that numerous public Chinese companies are continuing to commit fraud, lately Kerrisdale
has been focused on other areas. In a sense, Kerrisdale has been a victim of its own success here – in
alerting the Western investment community to questionable Chinese companies, Kerrisdale has
made it harder for fraudulent Chinese firms to obtain excessive valuations! Yet Kerrisdale is finding
no shortage of overvalued companies closer to home.

For instance, Kerrisdale published its short thesis on Bank of Internet (BOFI) earlier this year. Unlike
many other Kerrisdale shorts, BOFI is a “well-managed business that has grown over time,” says
Adrangi – after all, this was once a Kerrisdale long position. The concern lies with its valuation. At
four times tangible book value, the company’s market multiple is much too high, according to
Adrangi. The key arguments are that internet banks have to pay high interest rates to attract
funding, whereas bricks-and-mortar banks such as J.P. Morgan have a much lower cost of funding.
Online banking, furthermore, is becoming a commoditized business, where customers are less sticky
and will gravitate to whichever online savings account is offering the highest savings rates.

Adrangi is wary of over-crowded shorts. Unilife and Plug Power are two companies that Kerrisdale is
short which Adrangi characterizes as being mainly vehicles for management to raise capital from
investors, rather than bona fide businesses. Adrangi states that they are “stock promotions”. While
Kerrisdale published on these companies earlier in the year, the position sizes were relatively small
partly due to the high short interest.

Undervalued and overlooked longs

While Kerrisdale is well known for publishing on shorts, the firm also releases research on long
holdings. Often the longs on which Kerrisdale publishes have limited sell-side research coverage, are
undergoing a complex financial or operational transformation, feature a hidden asset, or are
otherwise underfollowed or misunderstood by the market. Last year, the firm published on AMERCO
(UHAL), which operates the United States’ leading do-it-yourself moving brand, U-Haul. Since
Kerrisdale’s first report on the company in February 2013, the stock is up more than 150%, an
impressive performance for a relatively unlevered company.

Kerrisdale has also engaged in more traditional corporate activism, and earlier this year ran a proxy
contest to replace the directors of Morgans Hotel Group. His slate won approximately 45% of the
shareholder vote, with two directors being elected to the board. Activism on the long side remains
an occasional option to generate returns, but it is not a core part of the firm’s strategy. Adrangi
believes that “impacting perceptions of a company’s valuation is a more attractive strategy for us
than effecting changes within the company.” Long-oriented shareholder activism is not a central part
of Kerrisdale’s strategy because “changing management and directors is very time-consuming”, and
“typically involves problematic companies where there is something wrong with the company.”
Adrangi prefers to invest alongside strong management and attractive business models.

On the long side today, Adrangi sees value in UK real estate brokers trading at discounts to their US
peers. He is also selectively venturing into some emerging markets, including Russia and Brazil, in the
search for neglected value. “Sberbank is a very cheap stock with strong deposit growth in an under-
levered economy,” he says, and argues that a valuation of three times book value could be more
appropriate than the prevailing 0.8x valuation. A Brazilian retailer also features in the top 10
positions. India has been a source of long positions, although Kerrisdale has taken profits recently,
partly in response to the post-Modi rally. Longs also contain US-centric companies such as fund
administrator SS&C Technologies, which Kerrisdale finds appealing for its superior business model
that can be purchased at an attractive 5% free cash flow yield.
Team and process

Kerrisdale’s investment process may be different in part because Adrangi started his financial career
in credit – performing high-yield debt refinancings and post-bankruptcy refinancings, as well as
advising creditor committees in bankruptcy and out-of-court restructuring situations. This
experience was at Deutsche Bank and Chanin Capital Partners LLC, and subsequent to his investment
banking experience, Adrangi spent several years at a multi-billion-dollar distressed debt hedge fund,
Longacre Management. Although Kerrsidale does not focus on distressed debt, the credit-oriented
employment positions provided “a great training background in more complex companies and
capital structures.” In particular, they gave Adrangi a focus on cash flows, whereas he finds many
equity investors can fixate on reported earnings that may diverge materially from actual operating
cash flows.

Adrangi may be the public face of Kerrisdale, but the firm’s heavy-duty research is very much a team
effort. “We have a great team across the board,” he says. Kerrisdale likes to hire experienced
professionals with investment banking, private equity, and hedge fund backgrounds. Director of
research, Jordon Giancoli, has been with the firm for several years, having previously worked at
corporate finance boutique Ondra Partners and HSBC Securities. Principal and senior analyst, Navi
Hehar, came with a hedge fund and investment banking background, having stints at Royal Capital
Management and Genuity Capital Advisers. Analyst Shane Wilson was hired from hedge fund QVT
Financial, while analyst Isaac Ahn came from Tailwind Capital, a middle-market private equity firm.
Trader Mathew Petrocelli has worked for two hedge funds: Diamondback Capital and Steve Cohen’s
SAC Capital (now known as Point72 Asset Management).

As well as scouting for overvalued short candidates, the research process seems to involve many of
the typical steps of fundamental equity research – reviewing financial statements and filings,
speaking to competitors, customers, and suppliers, financial modelling, and creating internal
projection models.

The 180% returns achieved in 2011 could only be repeated “if we hit a few home runs,” he says.
Right now Globalstar seems like a perfect example of one of those home runs. Since launching the
fund, Adrangi has had one “tenbagger”, BOFI. Kerrisdale is always “looking for the next big trade,
and every year there are dislocations we can take advantage of,” he says.
Andrew Left
Citron Calls This Stock 'Poster Child of Cannabis Bubble'
India Globalization Capital Inc. (IGC) is the latest high-flying cannabis stock to be targeted by Citron
Research.

The stock commentary website founded by activist short seller Andrew Left, which has also taken
aim at CV Sciences Inc. (CVSI), Cronos Group Inc. (CRON), Namaste Technologies Inc. (N) and Tilray
Inc. (TLRY) in the past, labeled IGC “the poster child of a cannabis bubble” in a Twitter post. Citron
urged investors to bet against the stock, warning that the Maryland-based company, whose shares
have risen 458% over the past six trading sessions to $13, has “no product” and is “all hype.” (See
also: Marijuana Stocks: Citron Fails to Kill Buzz.)

$IGC. If you are able to short, it is a gift. No product. All hype. Raised Money 2 weeks ago at $1.15
Finger traders will get burned. This hype stock is the poster child of a cannabis bubble. Always
cautious but nothing but air. Could write pages about this scheme

— Citron Research (@CitronResearch) October 2, 2018

“If you are able to short, it is a gift,” it said on Twitter. “No product. All hype. Raised money 2 weeks
ago at $1.15 finger traders will get burned. This hype stock is the poster child of a cannabis bubble.
Always cautious but nothing but air. Could write pages about this scheme.”

Correction. $IGC has raised money 3 times in 3 weeks at an average price of $3.31. At least the
company is honest about the absurd move The stock should have a skull and crossbones at Fidelity.
Just praying for more borrow to open up. Target price - $6 fast

— Citron Research (@CitronResearch) October 2, 2018

Citron then proceeded to slap a $6 target price on the stock, implying 54% downside on Tuesday’s
closing price. It added, “IGC has raised money 3 times in 3 weeks at an average price of $3.31,”
analysts wrote on Twitter. “At least the company is honest about the absurd move. The stock should
have a skull and crossbones at Fidelity. Just praying for more borrow to open up. Target price - $6
fast.”
Maryland-based IGC consists of a legacy infrastructure business that operates in India, Hong Kong
and Malaysia, and it expanded into the cannabis industry in 2013. The company, whose flagship
product is Hyalolex, a treatment for Alzheimer’s disease, claims to have four products that it is
readying for medical trials.

IGC’s shares have been on the rise since it announced that it had moved into the Cannabis beverage
market on September 25. The company said it signed a distribution and partnership agreement for
several products including a sugar free, energy drink called "Nitro G." In its press release announcing
the deal, IGC did not name the company it partnered with. (See also: This Marijuana Stock Is Up
Almost 300% Since It Announced a CBD-Infused Drink.)

Investors have been poking holes in IGC online, uploading photos they claim is of the address listed
on the company’s 10-K filing. The Google Street View images from September 2017 show a small
suburban home that’s called Arbol House, a child care center that Google lists as permanently
closed.

Cannabis investor Jason Spatafora, who is also bearish on the stock, recently pointed out that CEO
Ram Mukunda and his wife sold a large number of shares in August.

Fraser Perring
Works for Viceroy Research