Wednesday, October 23, 2013

The Mind of a Short Seller

Jim Chanos
I was going to write a post about seeing Merrill Lynch's global strategist Michael Hartnett yesterday.

However, the Financial Times this morning carried a link to an article from the Yale Alumni Magazine about famed short seller Jim Chanos.

It's an interesting read, and so thought I would bring it to your attention.*

I have never been comfortable betting on stocks to move lower.  Shorting a stock not only requires being right on the fundamentals, but having the intestinal fortitude (and financial resources!) to have the prices move higher even though "they shouldn't".

If you buy a stock, and it moves lower initially, a true investor is not worried.  Stock prices never move in a straight line, and investing for the long term has historically been a profitable enterprise.

Not so with selling short.  Stock prices can't move lower than zero, but they can go up a great deal.

Most business school students learn the story of famed short seller Robert Wilson who once lost millions in the 1990's shorting Resorts International when he got squeezed out as the stock rose from $5 a share to $190 a share (Wilson, by the way, went on to a fabulously successful career).
Finally, I am basically an optimist by nature, so hoping something goes wrong is contrary to my personality.

Chanos is different, as this article points out.  Not only is he willing to do the analysis and legwork necessary to ferret out opportunities, but he is emotionally tough enough to be able to hang on to positions which may not work initially in his favor.

He has been fabulously successful selling stocks that he doesn't own.  After nearly losing his job early in his career when a short sale recommendation initially went higher (but eventually went to zero), Chanos today manages $5 billion, and earns millions for himself in the process.

Here's an excerpt:

Though Chanos doesn’t put it quite this way, short-selling goes against some of the most basic proclivities of the financial marketplace—not to mention human nature and, some would say, God. It is an article of faith among investors that stock averages rise over the long term, and even market professionals tend to believe that their own chosen stocks will turn out, like children in Lake Wobegon, to be above average. Moreover, for those who go long—that is, buying and holding stocks—the potential gain is limitless (at least in theory), while the potential losses are limited: once a stock hits zero, you can’t lose any more on it than you’ve already lost. The really treacherous thing about short-selling is that it works the other way around. It’s the losses that can be limitless. And the agony can go on for months or even years as a bad company, puffed skyward by a charismatic CEO and a chorus of fawning analysts, ascends into the stock market heavens.

Beyond the financial pain, short-selling also exacts a psychological toll. Stock markets are “giant positive reinforcement machines,” says Chanos, and they’re built for the sole purpose of selling stocks. “So almost everything is positive, everything is bullish.” For short-sellers, that means the rest of the market is constantly shouting (sometimes literally and in the most personal terms) that they are wrong. And studies show “that people’s rational decision-making breaks down in an environment of negative reinforcement,” says Chanos. Good short-sellers “drown it out. It means nothing to them. But I think most people can’t do that.”

*Please come back tomorrow to read about Hartnett's latest thoughts.