James Chanos is well known for his specialization in short-selling. One of the best known examples was his prediction on the fall of Enron Corp, before it filled for bankruptcy in 2001. In order to understand how he made his prediction here is an excerpt from a prepared statement that he gave at a Panel Discussion: “Hedge Fund Strategies and Market Participation”, in 2003:
An Example of Research Based Short Selling: Enron10
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.
10. This section of testimony is drawn largely from testimony that I presented before the Committee on Energy and Commerce, United States House of Representatives, “Lessons Learned From Enron’s Collapse: Auditing the Accounting Industry;” February 6, 2002.
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