Betting Big On Lousy Stocks

When Jim Chanos and his friends go on spring break, there's no time for golf. Or the beach. Or fun of any kind-- unless your idea of a good time is sitting in a conference room talking about lousy investments. Each February, Chanos, a veteran Wall Street investor, picks up the tab to bring 20 of his professional-investor buddies to a luxury Miami hotel. Most of the group specialize in "short selling," in which they bet on stocks to fall, so most of their picks are companies they see heading for hard times. At last February's gathering, Chanos pitched the group on a stock you may have heard of: a high-flying energy firm called Enron. Where most investors saw a sensational investment, Chanos saw Enron as a company with a murky business model, deteriorating profit margins and some cryptic accounting footnotes. "There was no question he was on to something," says Bob Holmes, an investor who attended the conference.

Chanos's prescience has turned him into a Wall Street hero. Last week he appeared on Barron's cover as "The Guy Who Called Enron." This week he'll testify before Congress about the company's collapse. In the process, he's awakening many people to the important role served by the secretive, often-maligned breed of investors known as short sellers. Unlike traditional investors, who profit when stocks rise, short sellers borrow shares from brokerage firms, sell them on the open market and hope to repay the brokerage house with shares bought later at a lower price. It's not a technique for mom-and-pop investors, but in the wake of the Enron fiasco many shareholders have begun to think more like short sellers themselves: instead of looking for stocks poised to go up, they're hunting for the next Enron and hoping to get vulnerable stocks out of their portfolios. Last week shares of firms like Tyco, PNC and Williams Co. fell amid worries over questionable accounting practices. And as Congress continues investigating why the analysts, accountants and regulators missed Enron's problems, some experts say short sellers are emerging as a valuable source of skepticism in a market that's grown too ready to believe companies' feel-good stories. The shorts, who are often despised for profiting from investors' misery, couldn't be more pleased. Says David Tice, a Dallas-based short seller and analyst: "We like to think of ourselves as something of a truth squad."

The search for the truth can be a hard way to make a buck. Look at any chart of long-term stock-market returns. Notice how the line goes up? That means short sellers are betting against the trend--and it explains why they've tended to lose money during the bull markets of the past 20 years. Harry Strunk, a Florida investment consultant who's tracked professional short sellers' performance since the mid-'80s, says the average short investor lost money during most of the '90s (chart). Today only eight or nine pros invest exclusively on the short side, he says, down from 25 in 1990. Many of the biggest bears, including Chanos, are hedge-fund managers who balance their short positions with more traditional "long" positions that profit when stock prices increase. The result of this mix is that short sellers tend to make big profits when markets grow turbulent; in 2000, for instance, Chanos's fund earned a 47 percent return. Even if the long-term odds are against them, the pros find psychic rewards from the practice. "We're willing to stake out a contrarian position, and we get a lot of intellectual gratification from unearthing shams," says one hedge-fund manager. "We're like detectives, the good guys who ferret out the bad stuff."

Chanos has been spotting bad stocks for more than two decades. He graduated from Yale into a job as an analyst at a Chicago investment bank in 1980 and quickly gained a following by spotting problems at Baldwin United, a financial firm that eventually went bankrupt. Bob Holmes, Chanos's boss at the time, remembers his hanging big charts on the wall to explain to colleagues how Baldwin's series of complicated deals signaled trouble--a situation with some parallels to what went wrong at Enron. Colleagues say Chanos quickly showed the traits necessary to succeed as a short seller: skepticism, analytical rigor and strength of conviction. When his analysis tells him a company's ripe for a fall, Holmes says, "he's like a little puppy dog that grabs hold of your pants leg. No matter how hard you kick, he won't let go." In 1985 Chanos left to start his own firm.

He and his rivals attribute their success to old-fashioned, skeptical number-crunching. While most traditional Wall Street analysts spend time devising earnings models and schmoozing company management, short sellers focus more on balance sheets and cash-flow statements to detect signs of trouble. The tip-offs could be as subtle as movements in inventories or payments from suppliers. Some shorts draw beads on companies run by managers with a track record of pushing the accounting envelope. "If you knew Jesse James was in town and you were a cop, you'd follow him around," says one investor. A different short seller admits to hiring private eyes to do background checks on shady CEOs at obscure companies. Other experts say the biggest blowups often occur at companies like Tyco that are buying lots of other companies. Howard Schilit, a former accounting professor who sells his research on overvalued stocks to institutional investors, has picked some of his biggest winners from among such companies. "If I was going to start with a clean slate and look for the next big accounting story, I'd spend 75 percent of my time looking at acquisitive companies," he says.

Even the best short sellers make a few bad calls. During the mid-1990s Chanos bet heavily against America Online because of the way it accounted for the costs of mailing CD-ROMs to potential subscribers. Despite those worries, the stock continued to rise. "We got the numbers right, but we got the business wrong--the growth in their market was so spectacular, it overrode the accounting issues," recalls Chanos. Schilit's research team once told clients that Qualcomm stock looked ready to fall. Oops: it went up 2,600 percent during the next year. "When you're wrong, sometimes you look like the village idiot," Schilit says.

Right now, though, the short sellers have never looked smarter. So smart that Schilit and Tice, who also sells his research to institutional clients, say demand for their work is booming. Last week Schilit launched a new service tracking accounting issues at the 200 biggest U.S. companies. As the investment community grows more skeptical about regulators' ability to police the markets, some experts say Wall Street's cops could learn a thing or two from Chanos and his colleagues. "If the accounting firms and the SEC regularly checked short-sales data, it would certainly give them another trail sign" as they try to spot scams, says Kathryn Staley, author of "The Art of Short Selling." Among the shorts, there's a consensus that we're likely to see a few more accounting scandals in the months to come, but that none will be as big and spectacular as Enron's. Chanos is now shorting Tyco, Household International, Metris and Bally Total Fitness. So as Chanos and his pals prepare for their annual stock-picking retreat, which he calls "Bears in Hibernation," they might want to consider coming out of their hotel's conference room. The Enron scandal may be the short sellers' moment in the sun.