Episode 29: Jim Chanos - Founder of Kynikos Associates

0:00This week on Generating Alpha, I'm joined by another than Jim Chanos, legendary short seller and founder of Kinnecoast Associates, widely regarded as one of the sharpest fraud and market skeptics. of the last half century. Over his decades-long career, Chanos has built a reputation for spotting red flags before the rest of the market catches on, famously uncovering Enron before its collapse and sounding the alarm on companies like Baldwin United, Tyco, Wirecard, and more recently, Carvana and MicroStrategy. Beyond individual calls, Chanos has developed a framework for identifying financial deception and understanding market cycles, grounded in rigorous research and a deep grasp of human behavior.

0:43In this conversation, we dive into his early influences, the models he uses to identify fraud, and what the media and investors often miss about bubbles and hype. We also explore how markets have changed, the dangers of groupthink, and the timeless nature of greed and leverage. I really enjoy this episode, and I hope you guys enjoy listening to it. Thank you, Jim, for coming on. I really appreciate it. Thank you for having me. I'd like to start where I always do. So let's go all the way back to your beginnings. Tell me a little bit about your childhood and upbringing in Milwaukee. What was kind of the environment like growing up and what were some early jobs or ventures you had as a teenager or as a kid?

1:22Oh, God, I'm going to bore your audience. So I grew up pretty solidly middle class in a suburb of Milwaukee, Wisconsin. I ended up doing my high school in suburban Detroit. And then when I went to college, my family moved back to Wisconsin. But my dad, my dad was one of three brothers who were partners in a family business. My mother worked as an office manager for a steel company. So again, it was sort of the American 1950s, 1960s, 1970s, greatest generation spawning the baby boomers. So in that respect, it was pretty typical. What was unusual and maybe pertinent to this interview is that my father, like a lot of Americans after World War II, discovered the stock market in the 1960s and became a very avid investor.

2:31and looking back at it and talking to him well after the fact, I might say speculator. He was buying very racy stocks, as it turns out. But the one thing he did do was sort of drill into me an interest in the stock market. I was one of those kids who loved numbers, baseball statistics. And so there's nothing better than the stock market because it's nothing but numbers. at least when you're a fourth or fifth or sixth grader. So that's what kind of got me my first sort of hooked on finance. The postscript, however, is that like a lot of investors, like my father, he pretty much got wiped out from 1968 to 74.

3:21That bear market was as bad as the crash of the 1929-30s because inflation was going up. So in real terms, the stock market dropped about as much as it did between 1929 and 1932. A lot of people don't realize that. And then went sideways for really until 1982. So it was a lost sort of almost 16, 17 years for investors who got sucked in toward the end of that bull market in the mid to late 60s. it's obvious you had like you mentioned in an early interest in the stock market but is there anything you've seen your kind of early years in your education that can explain your talent for short selling or your inclination towards short selling uh uh other than being dropped on my head at birth uh no no i i mean i i i came totally into the short side um by by really coincidence and serendipity.

4:25When I started on Wall Street, I started as an analyst for an investment bank in Chicago. And I used to have lunch with the partner down the hall who was running the retail brokerage operation. And I was far more interested in what the stock market was doing than having to turn out tables for another deal book. And so one day, a year into it or so, he pulled me aside and said, hey, I don't want to get in any trouble with the investment banking side, but some of my partners in New York and LA are going to form a retail brokerage firm. Would you like to come and do research for us. So I jumped at that chance.

5:17And one of the first companies I was asked to look for turned out to be a massive fraud. And so this was sort of right person in the right place at the right time. And there was no predisposition on my end to be a short seller or to do short research. That firm you started with the partners was called Guilford Securities. And if I'm correct, the kind of big short that you mentioned is Baldwin United. Can you tell us a little bit about that? And that was your first real short. What did you learn from it? And how did that lead to you starting Kinnikos? Yeah. So it really was. It was a fascinating story because it was a high-flying financial services company in the late 70s, early 80s.

6:10It was run by a very charismatic CEO by the name of Morley Thompson. And when I say charismatic, he got to start selling pianos door to door for the old Baldwin Piano Company, which became Baldwin United. They diversified into insurance and annuities. And but I mean, imagine how good of a salesman you have to be to be able to sell pianos that you don't have with you anyway. Anyway, and it had announced a merger with a big mortgage insurance company out of Milwaukee called MGIC, which was a widely held growth stock. And the spread between the cash purchase price and MGIC stock trading in the market was unusually wide.

7:00And we had clients at Guilford who owned MGIC stock. So I was asked to take a look at the buyers to see why was the risk arbitrage spread so wide. And it was, you know, just I could not figure out how they were making their money. That kind of a rule that came out of that, that if you read the companies 10K three times and still can't figure out how they make their money, you know, you better dig deeper. And this Baldwin was like that. And it was very clear they were aggressively selling annuities through Wall Street, but it appeared to be at a negative spread. And so how possibly were they reporting these huge profits?

7:45Well, they were front-running the profits. They were making assumptions, and this was foreshadowing of Enron. They were basically allowed to estimate how long the annuities would stay on their books. The annuities were like investment products. They were like basically high-yielding deposits. But you had like a five-year minimum holding period, and there was withdrawal penalties if you took them out beforehand. Well, they made assumptions that these policies were going to persist for years. Then they made assumptions on what the spread would be over those years, and then they were able to take almost the entire value of that when they sold the annuity, as opposed to taking the incremental amount each and every year.

8:33And of course, that gives a dishonest management an awful lot of incentive to play with the assumptions as opposed to just book the actual cash flow P &L. And there were other twists and turns to the story. Well, by August of 82, not only did I think that there was risk the deal wouldn't go through, it looked like the equity was worthless to me anyway. I kind of came at it. And so we put a research report out literally the day the stock market bottomed, August 17th, 1982. I'll never forget it. And said that if you own the shares, you should sell them. If you're a trader or more risk-oriented, you can short them.

9:22And the stock proceeded to basically more than double on us over the next three or four months. And this was despite having evidence in the state insurance files from Arkansas, where they were domiciled, that the state was belatedly waking up to the fact that the insurance companies were probably insolvent, that they had double pledged securities as collateral, which we saw right away. And so one of the lessons, to get to your question in a long-winded way, was I realized that sometimes you can see something and it can be public and the market might still not react to it for weeks or months on end.

10:06And you have to be aware of that and you have to understand that risk in positions. Again, you can be right, your timing can be wrong. And so how do you handle that? And it was a good early lesson that as convinced I was that we were right, and we were right. The company ultimately filed for bankruptcy in early 83. But it didn't matter if the stock was going to go up 250%. And so that was a very, very good lesson early on in your career to get that in fact, You can be right. Your facts can be right. The whole street can be against you. You might be losing money for a while until the facts matter.

10:53And I think I think we see that a lot today with like more retail investors jumping into the market. You can be you can be wrong for a long time and markets can stay irrational longer than you can stay solvent. I'd love to talk a little bit about kind of the broader, broader approach to short selling. you describe different systemic models of fraud. Can you kind of take me through that? What are some examples of each in the models of fraud you teach in your class? Yeah, so I teach a class on the history of financial market fraud. It's not a class on hedge funds or short selling. Let me be clear about that.

11:29But over the last 15 years, I've taught the class, along with my partner who who originated the class with me, a man by the name of Jim Spellman, we worked on a series of models. And then over time, we've kind of come down with five systematic models that have a pretty good job at both describing and or predicting fraud. And the first is a micro model, which is well known. It's called the fraud triangle. and it says that in order for fraud to occur on a material amount from the C-suite, there has to be a pressure, there has to be opportunity, and then unless you're a financial sociopath, there has to be rationalization.

12:21So it's a triangle P-O-R. And this describes, this is a descriptive model for almost all corporate fraud of any kind of major amount that you would know or the viewers would know about. There's some sort of pressure that creates the need to do this, to cross the line. You have to have the ability to do it. And then again, unless you're a financial sociopath, you know, you'll try to rationalize it yourself. Oh, the accounting was okay. The auditor signed off on it. Or if I didn't do this, our stock would collapse because expectations were so high. whatever it might be. So that's the micro model.

13:03The macro model is what's called the Kindle-Berger-Minsky model. It's been well known. And this is a macro model that looks at the environment that you're in and makes the observation that there are certain environments where fraud is far more endemic than other environments. Typically, after long bull markets and long financial and economic expansions, you get bigger waves of fraud being revealed in the subsequent downturn. And that kind of makes sense psychologically, because as bull markets go on and mature, people's sense of disbelief is eroded, right? They begin to believe things that are too good to be true, or to use a more current term, FOMO, right?

13:49They're suddenly saying, well, it's going up. I don't really care. As long as the price is going up, what do I care? There's all of these sort of red flags showing up. And there's a few things that distinguish this model. Number one is the biggest part is there's what's called the displacement. And that is, what is the big idea driving this market? And all the big financial bull markets of great length tend to have coalesced around one or two kind of important ideas. So in the 1920s, it was the advent of mass production, Model T cars. It was the first wave of financialization of the economy. You had the first time we had mutual funds called trusts.

14:39You had consumer lending for the very first time you could buy a refrigerator or washing machine on credit. And so consequently, the 1960s was miniaturization, the space race, a lot of other things. And then more recently, in the 90s, the dot-com era was the internet. And of course, right now, we probably say it's something around AI. And so these kinds of things get people excited. They can build narratives. You also have credit creation. that you tend to have an increasing money supply and easy credit in the macro model. And then a series of other things that we don't have time to get into. But those are the big two that you have some big idea that gets people excited and you have ease of which to invest or borrow money to invest.

15:35That tends to lead to large waves of fraudulent behavior. You've said that. Yeah, go ahead. You've said that most, this is connecting to your past idea, but you've said that most frauds are essentially Ponzi schemes at their core. And that kind of explains the idea of how the fraud cycle lags behind the financial cycle. Can you kind of elaborate on that? Yeah. So again, most of these types of frauds get revealed after the cycle turns. And then people stop believing things that are too good to be true, and they begin asking questions. And companies that are doing this then can't tend to raise money.

16:14A lot of frauds have negative cash flow or are growing by acquisition or whatever. And suddenly, the capital market shut down to these questionable companies. And it becomes increasingly difficult not only to raise new money, but to roll over existing obligations or trade credit gets pulled. And so everything that works as a positive reinforcement cycle becomes a vicious circle on the way down. And so that's what I meant by that. People will throw money at anything on the way up and will be very reticent to finance these kinds of things when times get tough. I like to say that in bull markets, promises trade at a premium and in bear markets, reality trades at a discount.

17:05So anyway, so the third model is a governance model that was basically we derived from a great book that's on our reading list called The Best Way to Rob a Bank is to Own One. It's by a guy named Bill Black, who's now a professor at University of Missouri. But in the late 80s and early 90s, he was an investigator for the federal government, FISLIC and I think Federal, I'm not sure it was Federal Home Loan Bank or the other organization he worked for. But in any case, and he came up with a set of observations of how the banking system imploded in late 80s and early 90s. and wrote this book. But the first chapter of the book has a wonderful description of how governance can be used to facilitate and then defend against fraud.

18:01And his concept is that fraudsters use the corporation as both a weapon and a shield. I think it's a really kind of interesting way to boil down a government's issue that through the use of stock options, through the use of bonus plans, you know, the financially dealings with affiliates or relatives, whatever it might be, the corporate structure is looted in many different ways. But then should trouble occur, the corporate structure then becomes a very, very good legal shield because of limited liability, because of the ability to hire experts and get opinions. I like to say that financial crimes are unlike crimes of passion or crimes of opportunity because financial crimes come with the alibis already built in.

18:52You get questionable deals signed off on by your lawyers or by your accountants. And so you have plausible deniability. And in a fraud case, intent is very hard to prove. And so the more you can layer up with people who said, well, I showed it to my consultants or my auditors and they signed off on it. You know, I wasn't trying to deceive anybody. So that's the governance model. I then took something that my good friend Bethany McLean said following Enron. And we built a model around it. And it's very descriptive, particularly in recent years. and it's what we call our legal fraud model. And it's a derivation of what we just talked about.

19:45And in the legal fraud model, everything the company does is technically legal, but yet there's an intent to deceive. And that's a really, really important idea. Enron, they went after Enron, not for accounting fraud or stealing. they went after Enron for lying to shareholders, which was easier to prove, even though there was massive accounting fraud and looting. And so because everything got signed off of by the board, by their law firm and by their accountants. So it is very hard to go to a jury and tell them with a straight face that these guys were doing all these bad things and stealing money and cooking the books when a bunch of experts have opined and signed off on it beforehand.

20:40But that does not mean that you're not going to be defrauded and lose money. It just might mean that no one's going to go to jail for it. And that's a really important point I try to make to my students. Very hard to prosecute financial fraud cases. And then the last one is an ethical checklist from a woman named Marianne Jennings from a wonderful book called The Seven Signs of Ethical Collapse. And she took a look in her work at hundreds and hundreds of frauds, both in the corporate world and nonprofit, and boiled down a lot of what happened in a simple seven-point checklist. and so we've used that checklist as one of our models because it's very, very descriptive and very, very handy.

21:32And it's things like innovation like no other company, which gets back to our macro model, the concept of the displacement. Youngins and a larger-than-life CEO. So typically a celebrity CEO. Sam Bacon and Fried. A young staff. Well, I can think of a few others right now, but yes. And the one that my class always seems to my students always seem to like is goodness in some areas atones for evil in others. And it turns out that fraudulent companies tend to be some of the most charitable companies and some of the most respected companies in their communities. And they work on that. So anyway, so those are the five models and they do a pretty good job.

22:19Yeah. Yeah. I find all those fascinating. You've kind of said over your career that as you, as you progress in your career, you've leaned more and more towards the idea that a talented short seller is more inherent. It can't really be taught. You can be a good analyst, but being a good short seller is something more inherent. What inherent characteristics make up a good short seller? Yeah. So the example I basically use, the sort of description for that idea is really that the concept of negative reinforcement is very difficult for humans. that most people, and I don't know a lot about you, but I'm guessing, including you, are a product of positive reinforcement in society, whether within the family or in your schools or other activities.

23:14And you're told to basically work hard, pay attention, and then sort of climb the rungs of achievement. And that's done, for the most part, with some exceptions, like the military and others, through positive reinforcement. But human beings, it's been shown study after study, do not perform well in environments of negative reinforcement, where you're constantly being browbeaten or physically beaten. I mean, the ultimate example would be an interrogation where they try to break down your willingness to hide the truth. And so the corollary to that is, I pointed out, Wall Street is a giant positive reinforcement machine.

23:59Every company is going to beat their numbers. Every company is going to have great new products. The CEOs on CNBC, they're a takeover candidate. There's all kinds of spin. So if you're long securities, you're constantly in this sort of, I call it the Muzak. We used to play music in elevators from the Muzak. It's like the Muzak in the background. It's always bullish. And it's always why everything is great. Because Wall Street's in the business of selling your securities, right? And that's fine. But if you're a short seller, you are basically turning on your computer every day and firing up things and being told you're wrong in a number of your positions every morning.

24:47You know, the stock's going to beat their earnings. This company is going to announce a new product on Investor Day, whatever it might be. And 95 % to 99 % of it's noise. It's already priced in. but it's there and you got to pay attention to it. Now, if you're long stocks, you don't think twice about that. That's just the way it is. But if you're short stocks, you're constantly being told you're an idiot, right? Didn't you know this? Don't you know that Tesla's going to have robots in the year 2030 that are cleaning our houses? And don't you know that whatever. And so not everyone performs really at their best in an environment of negative reinforcement.

25:34And so in my 40 years of training analysts, and, you know, I kind of can tell pretty early on which analysts, you know, they all can do the work. But I can also see some analysts, as time goes on, they just never get comfortable with the idea that they're coming up with a set of numbers and pointing out certain aspects to me of the company's business or their numbers or whatever. But yet, you know, everybody else is saying something else. And then there are those that just simply say, okay, they can be saying that, but I have my facts here. And I think that that these are these are accurate and and people are smoking something over there and um and you don't want people to be contrarian for the sake of being contrarian yeah but when the stock goes against you it's interesting to see how how those people react and for some people they just cave uh well stocks up i must be wrong and i always tell them that's my issue i'm the portfolio manager.

26:44I'm the one that makes a decision whether it goes in or out or the size of the decision. I want you to give me facts and opinions on facts so I can make the judgment. And others are like, well, okay, stock's up. Maybe we should trim, but I still think this thing's going to zero and here's why. And so the first group will always still be good analysts, but it might not be on the short side might not be their calling. And there's all kinds of asymmetries on the short side. That's the biggest asymmetry, is the behavioral finance symmetry of positive reinforcement versus negative reinforcement.

27:27As I've been kind of wanting to ask you this question, because I haven't interviewed a short seller before, but as downside on the short side is unlimited, obviously, how do you personally think about risk? How do you think about sizing? How do you think about risk in your own portfolio? Yeah. So you spend a lot of time on it at the portfolio level. Short positions tend to be more volatile than most long positions or indices. And our strategy from the mid-90s to recently was to basically be long indices and be short idiosyncratic names. But you, again, have to understand quantitatively what that means.

28:10You don't want to be long 100 % of the S &P and short 100 % of a set of radioactive names whose volatility might be 2x the market. So you have to understand the trading risks you're taking. You then have to understand the discrete risks in each position. So we historically had a 5 % limit. No one position could ever be more than 5 % of the portfolio. Typically, 4 % was the practical limit in recent years. And so, and historically, we typically had 50 trades on 50 names plus or minus 10, so 40 to 60 names. So each position, while ostensibly being theoretically 2%, was actually less than that because they had a beta of more than one.

29:05So a position size, an average position size might be 1.5%. So it's why I always sort of chuckle inwardly when people say, oh, well, you know, you were short Tesla in 2020 and ruined you. We were short 3%, 4%. And we have to keep trimming it, sadly. But same thing when we were famously short America Online in the late 90s. It did the same thing Tesla did. It went up 12x. and it's not fun, but if it's a 1 % position and you keep trimming it, it's just going to give you a couple of bad years, but it's not going to carry you out on a stretcher. So you have to be mindful. You have to look at things like concentration, industry concentration risk.

29:53You don't want to be entirely a dot-com short fund in 1998. You need some diversification. And then there's also a capitalization. Historically, our portfolio tended to be a mid-cap and large-cap portfolio. Most short sellers historically have been small-cap and mid-cap. and so those types of portfolios will act very differently then you have to understand that so there's a lot of things that go into that mix but a good short seller professional short seller spends a lot of time trying to understand those things and again a misconception if you're on social media whatever is that every short seller is just short one name yeah oh well he talks about tesla 100 % of his portfolio must be Tesla.

30:49Well, I don't talk about 35 or 40 of my 50 names, so probably not. If I were to pick a random company today and print out its annual report, where would fraud be most likely to manifest itself? Actually, you don't have to print out the annual report these days. One of the things I've been saying is that people ask me, well, where is the fraud now? And I said, well, for a large case, it's staring us right in the face with the use of and the misuse of pro forma numbers. I think that's the that's the worst of what we're seeing in terms of materiality. So the quarterlies. Yeah. They're press releases and what they announce.

31:35What did we earn and what did we earn on an adjusted basis where we eliminate all the stuff we don't like? And some of that's legitimate, but an awful lot of it isn't. I point out IBM, I think, has taken restructuring charges for 10 of the last 12 years or something like that. If you're doing it 10 of the last 12 years, it's not non-recurring. And so you have to kind of look at this. Share-based compensation now routinely, particularly in tech companies, is added back. I have no idea for the life of me why, but it is. It's compensation. You're diluting your shareholders by issuing them stock, issuing employee stock.

32:19That's a cost, but it's added back. And so we're seeing more and more of that, and investors have gotten more and more used to it. It's one of the areas I do think the SEC has fallen down on, and I'm loathe to criticize the SEC because I think they have their hands full with lots of things. But this is one area that years ago they said they were going to crack down on. They were going to basically tell companies, as they should, that pro forma adjustments should be noted, like in the footnotes or as an addendum. You should not lead with your pro formas. But now that's, everyone ignores that. And so companies just report their adjusted numbers right there in the first couple of paragraphs.