Jim Chanos: We're incentivized to cheat

[rogerwilco]

http://www.salon.com/2013/04/03/wall_str...t_partner/

BY LYNN STUART PARRAMORE

Jim Chanos is one of America’s best-known short-sellers, famed for his early detection of Enron’s fraudulent practices. In deciding which companies to short (short-sellers make their money when the price of a stock or security goes down), Chanos acts as a kind of financial detective, scrutinizing companies for signs of overvaluation and shady practices that fool outsiders into thinking that they are prospering when they may be on shaky financial footing. Chanos teaches a class at Yale on the history of financial fraud, instructing students in how to look for signs of cheating and criminal activity. I caught up with Chanos in his New York office to ask what’s driving the current era of rampant fraud, who is to blame, what can be done, and the ways in which fraud costs us financially and socially.

Lynn Parramore: You’re often characterized as a short-seller. How does fraud become a concern in that context?

Jim Chanos: One of things we like to say is that in virtually all cases of major financial market fraud over the past 20 years, the only people who really brought forth the fraud into the light were either internal whistleblowers, the press, and/or short-sellers. It was not the normal guardians of the marketplace – regulators, law enforcement, external auditors or people like that — that did it. It was people who had an incentive to come forward either for personal reasons or for profit to point out what was going on at the Enrons and the Sunbeams and Worldcoms. Short-sellers played an important role in the marketplace not only in terms of capping, sometimes, irrational exuberance in terms of prices, but also in ferreting out wrongdoing.

LP: Researchers have created all kinds of tools, like software to detect speech patterns associated with lying, to try to detect fraud. What are some of the best tools for catching financial fraudsters?

JC: There’s no single tool that works all the time, and some of them are kind of interesting, like the voice detection, or Bedford’s law, which looks at numbers and repetition patterns in accounting. But we have seen some models that we work with and I teach in my class– frameworks of fraud and fraud analysis – that have been helpful in looking down through the years where we’ve seen patterns continue. One is a wonderful checklist, the Seven Signs of Ethical Collapse in an organization. Some are clearly intuitive, such as a board full of one’s cronies or an obsession with making earnings forecasts. But some are not so obvious, for example, doing good to mask doing bad.

LP: Good deeds can be a sign of fraud?

JC: One of the more interesting observations in the world of fraud is that some of the most egregious frauds were some of the most philanthropic companies in their communities. In some ways, if you look at Bill Black’s theory of the corporation as both a weapon and shield (we teach a lot of Bill Black’s things in my class), you can begin to see that that would be one way in which the bad guys in corporate suites would basically use the corporation as a shield. They’d say, well, look at all the wonderful things we do in the community, how many people we employ. We give to hospitals, we give to the Little League team, and so on. Not all these things would be immediately obvious to the casual observer.

LP: You’re known for your early detection of Enron’s problems. How does a company like Enron stay in business for years? How is the fraud sustained over time?

JC: It’s one of the great questions, Lynn, and I think that in the case of Enron, there were a lot of people getting rich aiding and abetting what turned out to be to be a fraud. They may not have known it was go-to-jail fraud, as it turned out to be (and most fraud certainly does not end up in jail sentences for the perpetrators, as we know).

But if you look, for example, at the investment banks that were in on structuring the offshore vehicles that Andy Fastow used to offload bad investments from Enron the parent to these vehicles without telling Enron shareholders that he’d also given them a secret agreement that they would made good any losses by issuing Enron stock (that, by the way, was the crux of the fraud of the firm), when you see just how much in fees a lot of the banks and brokers made in these things, there’s an awfully strong incentive to look the other way and not ask the tough questions. That’s really one of the big flaws, I think, in our current market structure.

LP: What do we know about the timing of frauds? When are they most likely to happen?

JC: One of our models is the Kindleberger-Minsky model, named after Hyman Minsky and Charles Kindleberger. It’s a macro model, and basically it takes a look at various market cycles. What we find is that the greatest clustering of fraud in the financial markets occurs, as you might imagine, during and immediately after the biggest bull markets. As I like to tell my students, it’s basically a period in which people suspend their disbelief. Everybody’s getting rich and it becomes increasingly easy to sell more questionable schemes and investments to investors. Typically the major frauds are uncovered or unmasked after the markets decline, for example, Bernie Madoff or Enron, when investors need money from other losses (and often these things have a Ponzi-like nature and can’t finance themselves from a self-sustaining basis) or people simply begin to build back their sense of disbelief and begin to ask tough questions that they didn’t ask during the bull market. So we do see that the fraud cycle generally does track the broader financial market cycles we see with a little bit of a lag.

LP: One look at your Yale syllabus shows that fraud has been rife through business history. Yet for the last 20 years, many people have insisted with near-religious conviction that markets are efficient and therefore resistant to fraud. Where is this belief coming from, and why is it a problem?

JC: It rests upon an assumption that is deeply flawed, and that is that the people who are stewarding your capital in the marketplace — the boards of directors and the people that the boards hire – management — are acting not only in your best interest, but are playing by the rules all the time, so that, for example, the accounts that the company puts together for the accountants (and keep in mind, management prepares financial statement, not accountants, not the auditors) are accurate. The auditors simply review them, and that’s an important point I always stress to my class. If there are games being played, and if you read the boilerplate of any auditor’s opinion, it says “we rely on the statements of management” – and so if, again, the people in the corporate suite have ethical flaws, we have a system based on truth-telling that may not be exactly always accurate.

I point out to my class that in 1998 there was a survey– Business Week (which is owned by McGraw-Hill) and McGraw-Hill (which also owns Standard and Poor’s) had a conference for the S&P’s 500 chief financial officers. They asked these chief financial officers if they’ve ever been asked to falsify their financial statements by their superior. Now, the chief financial officer’s superior is the chief executive officer, or the chief operating officer—basically the boss. It was a stunning—of course anonymous – survey. 55 percent of the CFOs indicated they’d been asked, but did not do so. 12 percent admitted that they’d been asked and did so. And then 33 percent said they’d never been pressured to do that. In effect, only one third of the companies in the S&P’s 500 at that time did not have a CEO or COO try to pressure their financial officer to falsify financial results.

So this is agency risk writ large. Investors need to know that. They need to know that an awful lot of games are being played with the numbers and with disclosure and they’ve got to be on their guard. As Tony Soprano once said, as he exhorted his minions to redouble their efforts in the rackets, “We don’t got one of these Enron things going.”

LP: How much of the American economy do you think is built on fraudulent business models? How do we compare with other countries?

JC: Surveys have been very consistent –anonymous surveys of CFOs — and we’ve seen it in some other data we present in our class from various global entities. It appears that incidents of fraud in publicly traded corporations (globally) is somewhere in the order of 10-15 percent of the companies.

Now, that does not mean they’re all Enrons. An awful lot of fraud is, well, I didn’t reserve for bad debts and my earnings were overstated for a few quarters but then we reversed it later, and it’s probably not go-to-jail-type fraud. But it is misrepresenting numbers to the marketplace and to investors. And I think that you can still lose money if it gets revealed when you own the securities. So investors do have to have a healthy skepticism even when it comes to reasonably well-regulated markets like the U.S. and the U.K., because there are incentives, given the stock option-type compensation or the bonuses based on profitability. It gives management an awful lot of latitude to play games with accounting.

LP: Let’s talk about bubbles. Being mistaken or overly excited isn’t fraud. How do you distinguish investor euphoria from fraud? What’s the role of fraud in creating and sustaining bubbles?

JC: If we look at the recent global financial crisis, a lot of people say: why were there no prosecutions? One of the first sort of default defenses you heard over and over again is well, stupidity is not a crime, and making bad decisions is not a crime. It may certainly lead to grievous losses, but that’s the marketplace. And I agree with that 100 percent. The problem is that financial crimes, unlike crimes of passion and crimes of opportunity, come with their alibis already built in. You build a veneer of legitimacy about what you’re doing. You get accountants to sign off on what you’ve done. You don’t look at any emails or get sent any emails –- at Enron Jeff Skilling never saw any emails (so how do you run a global trading powerhouse and never use email, right?). We teach this legal concept called “willful blindness,” and that is, in some cases senior executives are cut out intentionally from controversial things because they don’t want to be able to say, well, I approved that or I saw that. Someone below them is compensated quite handsomely for taking the fall, if you will.

So we have to understand that the classic definition of fraud is intent to deceive. I am intentionally trying to tell you something that is not true, that I know is not true or I have reason to believe is a reckless disregard of the truth. That is still very difficult to prove legally. But sometimes the market renders its own judgment if the preponderance of evidence in the case of a Lehman Brothers or a Countrywide is such that the executives are not exactly being guardians of the truth.

It is difficult to prosecute these cases. We’ve had the stunning admission by the Justice Department in the past month that they put into their calculus as to whether or not to prosecute crimes in the financial arena as to the systemic effect of that. My head is still reeling from that admission. Most people would agree that that’s not the Justice Department’s role. And I think it’s caused a really reasonable, serious, continued undermining of trust in our markets.

While we may have benefitted from not revealing additional fraud during the dark days of ‘08 and ’09 by indictments and so forth, I still think you have the exogenous cost effect of a lack of trust by our public and by other investors. In effect, it raises the cost of capital. It depresses valuations. If people think that the game is rigged and they’re not in on it, they’re going to put their money somewhere else. And that’s almost impossible to quantify. But you know there’s an effect.

LP: If fraud is widespread, that means the government has failed as a regulator. What are the roots of that failure? Are the tricks too hard to understand? Is it is the prosecutors? Money in politics? What’s going on?

JC: Well, there are some obvious answers to this. Let me say that one of the things I teach in my class, which is technically a history class, is that this goes in waves. As Bill Black points out, the big financial crisis – the banking crisis – prior to the last one, in the early ’90s, saw a rash of prosecutions, as did the 1930s after the Pecora Commission, where there was really a public drive to clean up the markets. But if you go back to the 1870s, and the Crédit Mobilier, which was the Enron of its day, scores of lawmakers and the standing vice president were caught with their hand in public till – being paid off by Union Pacific Railroad through their fraudulent Crédit Mobilier construction company. But there were just reprimands. No indictments. The public was outraged; similarly to today, but law enforcement and Congress at the time did not police themselves.

So we do see different public responses and legal responses to different waves of fraud. Having said all that, I think that certainly some observations would be that the concept of regulatory capture and the revolving door is a big one. I mean, how tough are you going to be on industry that you oversee if you’re going to go back into that industry every four or eight years. I think that really muddies the water in terms of getting people who really feel, like, say, a Stanley Sporkin did in the ’70s at the SEC, that wrong is wrong and we’re going to go after it.

In some ways, as much as I consider myself a Democrat, I would say that the most prompt and vigorous response to fraud we’ve seen in the last 20 years has been the Bush administration’s crackdown on Enron, Tyco and Worldcom following the revelations of these massive frauds earlier in the millennium. Despite campaign contributions, John Ashcroft’s Justice Department went after these people and put the resources and set up the task forces and brought them to justice, which is what we’ve not seen in the last five years.

So you never know. A lot depends on the mood, and really, leadership at the top to say, this is wrong and we’re going to bring these people to justice.

LP: Journalists have played a key role in exposing fraud, but they have often been complicit, too. Are the media doing their job covering fraud?

JC: It’s funny because I remember when I spoke to Bethany McClean in early 2001 about Enron, I sort of scoffed at the idea that her magazine – Fortune, at the time – would do anything because Fortune kept putting Enron at the top of its most-admired-companies list. Sometimes it just takes the journalist to actually do the work and get the story and convince a good editor that, well, no matter what we said about it in the past, this is an important story that we need to tell the public. And there are still journalists, like Bethany, out there. Jesse Eisinger is another one who does just amazing work. Jon Weil at Bloomberg –I’m happy to give these people a shout-out because I think they played an important role, and they’re read avidly, so there is a market demand for this kind of journalism—to really call it like they see it.

But journalists are human beings and organizations are filled with human beings and when the bull market gets going, you know, no one wants to be the one who says the emperor has no clothes, unless you can actually point to a smoking gun and say, well, look at this.

LP: Right now, the news is filled of reports of fraud, from companies lying to regulators to money laundering and so on. Yet the GOP is trying to abolish Dodd-Frank, which addresses fraud by providing greater protection for whistleblowers, for example. Why would they be doing this?

JC: Well, I think the best comment was from a senior Democratic senator a number of years ago, who simply and bluntly said, “The banks own this place.” I always tell the story that right after the Bear Stearns collapse in March of ’08, the heads of all the big banks and brokers, they headed down to Washington immediately in April of ’08 to talk to senators and other lawmakers and regulators.

As we now know, what they didn’t ask for was forgiveness for their misdeeds or perhaps forbearance on capital until they could get their house in order or to work with the regulators on what was obviously a massive credit crunch coming. No, what they asked for was two things. They asked for the accounting rules to be liberalized on their hard-to-value assets and for short-sellers to be cracked down on. That was their focus, and, by the way, both happened. There were short-selling bans shortly thereafter and the accounting profession, at the urging of Washington, changed, liberalized, the rules on hard-to-value assets in March of ’09. They got what they wanted, and this tells you something.

It really is amazing to the extent that lawmakers, despite all the evidence that major legislative initiatives that banks have asked for in the last 50 years have generally been harmful to the public purse, they’ve generally gotten what they’ve asked for. You can’t be too cynical.

LP: Will Dodd-Frank really have an impact?

JC: Well, again, banks have gotten into all kinds of trouble throughout their history—with rigorous regulation and not-so-rigorous regulation. It’s the nature of the beast. But things like the Volcker Rule make common sense – that we should not put taxpayers at risk for trading activities, for example. But the banks have made a very strong case that most of what they’re doing can be seen as a hedge in one way or another, and some other part of their business, so therefore it’s not trading. I think all of those activities should be done at the holding company and not at the deposit-taking institutions. That’s a simple way to handle this.

I know banking is complex, but so are $700 billion bailouts. And I think there needs to be a sense by depositors and taxpayers who want a safe place to put their money that the deposit-taking institution is regulated tightly and insured properly, and that if banks want to do venture capital lending, private equity investments, hedge fund investments, or derivatives contracts, they can do so in an investment arm that is not as regulated or protected by insurance schemes. It’s seems to me to be common sense, but yet you have armies of lobbyists who will argue vociferously the opposite.

LP: What’s the role of the SEC in preventing and detecting fraud?

JC: The SEC has long held, for example, that short-selling plays an important role because of not only price discovery but also the fraud detection aspect, and they’ve always been pretty vocal about that. But the SEC is outgunned. The markets have grown much, much greater than their budget’s ability to police the markets. They also, you have to remember, have no criminal prosecution powers. That’s the Justice Department, and fraud, by definition is a crime. So you have the 10b-5 rules under the SEC, which are civil, but in fact, in much of this I lay much of the problems about fraud that we have at the feet of the Justice Department, not the SEC, because again, you need to prosecute, and that’s just not happening.

The SEC answers to Congress budget-wise, and this raises certain issues. I think generally when the SEC has gotten involved, they do a good job. But it’s tough, and they’re behind the curve. I think that’s more due to issues of budget and others than to lack of willingness to take on things. I think that they’re doing the best they can but they don’t have the resources.

LP: What are the economic and social impacts of fraud that worry you the most?

JC: The few things that jump out are obviously fraud at institutions that are backed by the taxpayer. Because there you’ve brought someone to the table that doesn’t know they’re at the table – in effect, the public or a small depositor. When the U.S. has to come to the rescue of these big institutions where clearly games were being played, we all lose. If I’m a hedge fund manager or investor, or if I’m a day trader, I understand the risks I’m taking. I’m a big boy, ok? And if I don’t do my work and someone pulls the wool over my eyes, well, shame on me.

But if my aunt in Okauchee Lake ends up having to foot the bill for Countrywide or Lehman Brothers or AIG, that’s not fair. And again, we get to a basic level of fairness. Is that eroded? Is trust in our market eroded because people think the game is rigged? Quite frankly, despite the recovery in the stock market, I think there is still an ongoing perception by the public that the game is rigged, and that my restaurant went out of business, and I didn’t get bailed out, but the guys on Wall Street did and they’re making bigger bonuses than ever. They got to start over with my money, but my restaurant didn’t. And that’s really a sense of fairness, I think, that continues to erode in this country. That’s number one.

Number two, I think that the costs for fraud tend to also disproportionately positively affect the wealthiest people in the country. So it also, in a weird way, increases the income inequality issue, and I think that’s something that’s beyond the purview of me in this interview, but it’s something I think that policy makers should keep in mind, because again, the people taking the biggest risks and taking the biggest paychecks and bonuses — if they had been hedge fund mangers, they would have been wiped out, and that’s that. End of game. But because they were doing it in too-big-to-fail institutions, they got to keep playing. In a weird way it is the antithesis of the free market. The free market would have taken these people out a long time ago. But, in fact, the subsidized market that we have, where the taxpayer stands behind all these bad decisions and the bad accounting, continues to exacerbate the income inequality issues.

LP: How does too-big-to-fail create fraud, and would breaking up the big banks be helpful in addressing it?

JC: Well, as we now know from Lanny Breuer and Eric Holder, too-big-to-fail is also too-big-to-jail. We now have admissions by the federal government that, in fact, this behavior was not extensively examined or investigated because of systemic issues.

It raises an interesting point, doesn’t it? Because if now, as the senior member of a bank, or the board of a bank, I know that there are no criminal penalities for breaking the rules, don’t I have a fiduciary responsibility to my shareholders to actually play fast and loose? Because if I get caught, that’s just the cost of doing business? I know it’s a frightening thought, but if carried to its logical extreme—if truly people believe that because of their size, they can’t be prosecuted, it actually brings forth a new issue of moral hazard extreme: illegal behavior.

That’s why equality under the law is an important concept – one that is being violated now.

[Temperament]

Put it very simply, if a Management of a company needs to or wants to, the AR can always be "adjusted" to look good. i believe almost every company does it from time to time; just short off really committing a fraud. Of course there are many companies really committing a fraud until they are exposed sooner or later. Think of S-CHIPs???

[rogerwilco]

Another interview with Chanos, imho the bold paragraph is the most interesting part of the interview

http://online.barrons.com/article/SB5000...rticle%3D0

A Short Story for a Long Winter's Night
By LAWRENCE C. STRAUSS
SATURDAY, DECEMBER 22, 2012

Short seller Jim Chanos sees big trouble brewing among leveraged natural-gas producers. Why he still views China as a bubble and is wary of Brazil's Petrobras and Vale, too

Jim Chanos has made a very nice living and a big reputation out of seeing what others overlook, particularly when it comes to overvalued companies. The prominent short seller's big wins include sniffing out problems at Enron, Tyco, and WorldCom in the early 2000s before those companies imploded. Chanos figures that if he and his colleagues get two-thirds of their picks right, they are doing very well. This year, as equity markets have rallied, the two short funds he runs are down slightly, versus an 18% decline through November for short sellers tracked by the Dow Jones Credit Suisse Hedge Fund Index. Chanos, 55 years old, founded his own firm, Kynikos Associates, in 1985 and currently oversees about $6 billion of assets. He remains bearish on China, and more recently has been taking a skeptical view of leveraged natural-gas exploration-and-production companies. Barron's sat down with Chanos recently at his midtown Manhattan office.

Barron's : Let's start with your big-picture view.

Chanos: As we went into 2012, we thought, from an investment point of view, that the U.S. was the best house in a bad neighborhood. Since then, pretty much all of the bad neighborhoods have done well, including the U.S., whereas people were pretty cautious a year ago and were looking at the world as a glass half-empty. They are now pretty ebullient and see the world as a glass half-full. So we are seeing opportunities in names that we had covered earlier this year or in 2011 or 2010. We are seeing lots of new ideas on the short side, both in the U.S. and globally, and generally we have a lot to do. The world has come around to the view that the central banks generally are omnipotent and have solved all the world's problems, but we are a little bit less sanguine on that point of view.

Barron's : What's wrong with that view?

Chanos: The central banks, like any committee, may get something right, and they may get something wrong. But they are not right all the time. And investing one's capital on the basis of where central banks are planning their policy moves is a little bit frightening.

Barron's : Because there is too much liquidity?

Chanos: Well, liquidity is a double-edged sword. It can raise asset prices. But it can also create overcapacity, overconfidence, and overvaluations. Right now, it is on the road to doing all three.

Barron's : You mentioned that you are seeing opportunities in names that you covered. What do you mean by that?

Chanos: There are lots of things that we've actually made a fair amount of money on in 2010 and 2011 that we took off the sheets, but that we are now looking at again, because many of them have doubled and tripled again.

Barron's : What are some of the common mistakes that you see value investors making?

Chanos: Value investing is just one tool in an investor's arsenal. All things being equal, one would prefer to buy stocks cheaply than dearly. But I'm afraid that too many value investors stop the process by just looking at valuation and, in effect, looking at the rear-view and side mirrors, not through the windshield. You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.

So, in the past, value investors looked at declining free cash flows and put some discount rate on that. And then they got a value, and then they would say, "Gee, there is the possibility of a call-option value of the business inherent to all its other opportunities. So, if I can buy it at some discount to that present value, I'm in good shape." But we've seen time and time again where the cash flows do not gradually decline. Nor do managements seem very willing to pay out cash flows when they are in a declining business. They often use them to make acquisitions, trying to save the business on a Hail Mary basis. The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That's true whether you look at companies like Eastman Kodak [ticker: EKDKQ], or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but.

Barron's : Let's turn to China, on which you have been bearish since late 2009.

Chanos: We haven't changed our thinking much at all on China. Our view is twofold. There is a credit bubble going on in China, and they have an unsustainable economic model. That yields you all kinds of interesting possible ideas, whether it is in the property market, the steel sector, or in all kinds of areas where they are just simply building more of it, even though there are no economic returns. Take a look at China's steel sector; it will be unprofitable in 2012, and yet they are adding more and more capacity. So, because China is obsessed with GDP [gross domestic product], and Western investors and observers are also obsessed with China's growth, China has an investment-driven model where they simply want to produce GDP growth. So they stick a shovel in the ground and build another bridge or highway. They can continue showing GDP growth, as long as there is credit to support that investment. The problem is that most of these investments, at this point, do not generate an economic return and haven't for a while. So you have the dichotomy of a country growing its GDP but destroying wealth. I view it as a stock that's rapidly growing, but whose earnings are below its cost of capital. Any finance professor would tell you that's a company that is liquidating and going to run into the wall. That's what China is doing. But it can go on for a while.

Barron's : What are some of the companies in China that you are shorting?

Chanos: We would be short pretty much all of the large banks. We have talked about Agricultural Bank of China [601288.China] publicly, but I would stay clear of all of them. They are all going to have issues. I would also avoid the property developers, the Chinese steel sector, and the Chinese cement sector.

Barron's : What are people missing about the U.S. shale explosion?

Chanos: Well, it is good in some ways. It is good for the U.S. economy. It is good for employment. But it is deflationary for lots of energy assets, not least of which is natural gas itself and similar energy-related assets like coal. So everybody is drilling, many people because they have to, due to the terms of their leases. And even at prices that, heretofore, a lot of people felt were uneconomical—$3 per Mcf [1,000 cubic feet]—they are still drilling away. So the law of unintended consequences has worked both ways. It has been a boon for manufacturing in the U.S. It has been a boon for certain regional employment. But it has been deflationary for the leveraged natural-gas E&P companies that actually bought acreage when gas was $8 to $10 per Mcf, and they are now facing a reality of $3 to $4. And it probably has been quite deflationary, on the margin, for the thermal-coal companies that really compete now with natural gas. That was a bit of an unintended consequence of the fracking boom. So while we talk about the environmental efficacy of fracking, we see a benefit that less coal is being burned. But on the other hand, for every job that we add in natural gas in the U.S., we are maybe losing half a job in the coal industry.

Barron's : Which companies are most vulnerable?

Chanos: The vulnerability is certainly in the thermal-coal producers. They have issues with the EPA [U.S. Environmental Protection Agency] regulations, as well as the economics. But I would avoid the leveraged natural-gas companies like the plague. The fellows who leveraged up to buy lots of properties five, six, or seven years ago are now all trying to sell them. So, they were buyers at $8 to $10 [per Mcf], and they are sellers at $3 to $4. And the problem with a number of these companies is that because of the contractual nature of their leases, which a lot of people didn't understand, they are obligated to keep drilling. So their costs don't seem to decline as fast as their revenues do. But because they use oxymoronic at full-cost accounting, which let's you capitalize everything on your P&L [profit-and-loss statement], the earnings statements don't look so bad. But the cash-flow statements are a disaster.

Barron's : So, when they capitalize those assets, they go on the balance sheet as an asset?

Chanos: Exactly. It is capitalized, and the companies take these big-bath write-offs later. Of course, it ignores the write-offs, but what they really ought to be doing is depreciate these assets all along.

Barron's : But it makes a company's P&L look better initially?

Chanos: It makes the earnings look better until you take the big bath, which, of course, everybody disregards. But take a look at BHP Billiton [BHP], which bought properties a year and a half ago from Chesapeake Energy [CHK]. BHP already wrote those off, and they wrote them off by half. So you have a big operator selling to a well-heeled natural-resource company that comes in and realizes, "Gee, these leases aren't worth what we thought they were." So that whole sector is going to be problematic and full of minefields for the next year.

Barron's : Can you name some of those companies?

Chanos: Let's just say that if you look at the leveraged guys who were buying lots of properties five years ago that are trying to sell them aggressively now, it is a pretty good bet we're short them.

Barron's : You've also been shorting two Brazilian companies, Vale [VALE], the world's largest producer of iron ore, and Petrobras [PBR], the energy outfit. What's your thesis?

Chanos: With Vale, it is just a giant bet that the construction bubble goes on forever in China.

Barron's : The stock hasn't done well this year, down about 5%.

Chanos: It has been a good performer on the short side. You have to understand that for a lot of the mining companies in Brazil and Australia, the model has changed. In the past, the governments, to develop jobs, would work hand-in-hand with these companies to build port facilities, railheads, and other infrastructure to help them export this stuff. Now it is almost the opposite. Not only do the companies have to pay for all this stuff themselves, but the government adds extra taxes and sees it as sort of a patrimony. So the business model has changed dramatically for a lot of the extraction-type companies, Vale being one of them.

Barron's : What about Petrobras, whose shares have fallen about 17% this year?

Chanos: We call it Brazil's ATM because you have a state energy giant that cannot charge full-market prices downstream for its gasoline or its diesel fuel, which subsidize the consumers of Brazil. And yet Petrobras has to incur all of the increasingly expensive costs of finding oil offshore. In the past 12 months, Petrobras had cash flow of roughly $30 billion, capex [capital expenditures] of roughly $40 billion, and declining revenue and production. It is not a good business for outside shareholders. It is, in effect, a national utility where the outside investors are being asked to finance it.

Barron's : Could you talk about a mistake you made and what you learned from it?

Chanos: At the dawn of the digital age, when we shorted AOL [AOL] back in 1996, it basically went up eightfold on us. Although it didn't put us out of business, it certainly caught our attention. We learned about timing. Interestingly, as Time Warner [TWX] found out later, the accounting issues were actually very real. Their churn was actually much higher than they were letting on. But we also had a healthy regard for the ability of corporations to be gullible and to fall for the same hot trends as everyone else. You can never get the timing exactly right, even if you are right on the fundamentals, ultimately. But on the other hand, you can be very, very right and still lose lots of money, so you have to construct your portfolio accordingly and never let one position ever be too large. That was a good lesson, and it probably saved us a lot of money.

Barron's : Thanks, Jim.

[specuvestor]

My response to your word in bold as per my earlier posting in another thread:

"Value trap remains the dividing line between true value investors that looks at businesses, vs those that just look at cheap valuations"

It is not value investing is faulty... it is that the followers do not understand it sufficiently yet. Kodak, Blockbuster and newspapers had a business model issue forced by the environment which decimated their moat.

Real time we see Apple having this issue... though Apple is also affected by the Android environment, I would think it is more affected by their internal change in business model after the demise of the visionary CEO to an operational CEO.

[rogerwilco]

"Value trap remains the dividing line between true value investors that looks at businesses, vs those that just look at cheap valuations"

Specuvestor, i slightly disagree, if i'm not mistaken Ben Graham and Walter Schloss, both considered as value investor, actually don't look at businesses much. They focus more on cheap valuations but they compensate by demanding higher margin of safety (focusing on the balance sheet more than the income statement) and diversify by holding less concentrated portfolio (Buffett said Walter can hold around 100 stocks).

In the end, i think what matters most is what you said yourself in your post on another thread :
"there are many road to Rome. Key is to stick to a style that one is comfortable; in terms of risk, expertise, time effort etc"

[Temperament]

i like to put things as simple as possible as i don't have much education. In the stock markets i always believe what they say, "Any "animals" can make money except the lemmings and pigs. Ha! Ha!

[rogerwilco]

"Any "animals" can make money

... as long as they have the right temperament

[Temperament]

"Any "animals" can make money

... as long as they have the right temperament

Yeh! WB tell me so. And i believe. i also believe that it's so because after all God is Fair in HIS OWN WAYS.
Shalom.
Amen.

[a74henry]

Dishonesty will not build a sustainable business. The success is short.