Inside the Skin of a Short-Seller

Investors can learn from successful short-sellers like Jim Chanos, who's known for correctly betting on major meltdowns at companies like Enron

Jim Chanos says short-selling is a lot like getting thrown into the interrogation room.

For Chanos, the billionaire hedge fund manager who has made a name betting on mega-meltdowns at companies such as Enron and Conseco (CNO), it takes a certain kind of investor to withstand the heat of CEOs and analysts who insist that short-sellers—those market players who profit by making bets that the value of a stock or other asset will decline—are economic toxins or misguided ne'er-do-wells. And, just like those who crack under the pressure of incessant questioning from the authorities, many would-be short-sellers can't withstand Wall Street's disapproval. "Most people's rational decision-making just eventually breaks down," he says. "You're guilty until proven innocent."

It takes a unique—if not slightly masochistic—investing psychology to engage in the art of shortistry, but that hasn't stopped an increasing number of investors from giving it a try. As of June 13, the number of shares held short on the New York Stock Exchange was a record 17.6 billion, up more than 37% since January. But it's not easy to pull off. As more investors hope to salvage their portfolios with the Standard & Poor's 500-stock index, down more than 18% from its October 2007 high, by taking the short way, they can learn a lot from the psychological approach and analytical habits of successful short-sellers.

Because market indexes generally rise at a slower and steadier rate during a bull run than they drop in a recession, short-sellers need to have uncommon patience—and capital—to endure as market bubbles build up. When short-sellers recognize flaws in a company's accounting methods or pinpoint overvalued stocks, often "there's a lot of pain and a lot of bleeding" while they wait for the rest of the market to recognize it, says Todd Salamone, director of trading at Schaeffer's Investment Research.

Chanos' experience is a good example. In 1982, as an analyst for a boutique investment firm in Chicago, Chanos recommended shorting the stock of piano maker Baldwin-United when the share price was around $24, since he believed the company had vastly overvalued its annuity business and overstated its earnings. The stock marched almost to $50 before a regulatory investigation finally spooked investors and sent the company into bankruptcy. Chanos profited. "You'll go for days and weeks losing," he says. "Then you make it all at once."

Limitless Loss

That's why it's a risky business. While the maximum amount a long investor will lose is 100% of the initial investment, a short position has no limit on loss. For instance, a short-seller who sells a stock at $5 and sees it climb to $25 has to pay $20—four times his initial investment—to close out the position. As such, shortists must have a higher risk threshold, says Dr. Frank Murtha of Market Psych, a consulting group that pairs psychology and finance.

"A lot of people who fail in short-selling can't handle the emotional weight," he says. "And the market can stay irrational longer than they can stay solvent." For example, the final rally at the height of the late-1990s/early 2000 dot-com bubble was probably caused by scared investors who were buying back stock to cover their initial short position, says Salamone.

To sniff out market bubbles, short-sellers need to have a natural skepticism toward the hot air that inflates stock prices in the first place. They're hard to convince. "It takes someone who really questions the conventional wisdom," says David Tice, manager of the short-selling Prudent Bear Fund (BEARX), who predicted everything from the upheaval at Tyco International (TYC) to the subprime fallout in August. Many times that means differentiating yourself as an investor when Wall Street is "drumming and cheerleading," he says.

Take the mortgage bubble. When Wall Street banks were securitizing risky mortgages and prepackaging them for profit at the peak of the housing boom in 2005, hedge fund manager John Paulson of Paulson & Co. set up two funds to bet against the overvalued subprime mortgages that have bludgeoned banks' balance sheets since August. The windfall? In 2007 Paulson's funds were up $15 billion over the previous year.

Many of the problems that unfold in a downturn exhibit early warning signs, but only dogged skeptics detect them. "A lot of people willingly keep their blinders on," says Chanos.

It's a Lonely Job

And, oh yes, short-sellers have to be right. Shunning conventional wisdom is only profitable if conventional wisdom eventually recognizes you're correct. It didn't work out so well for Tennessee investment manager Jon Hankins, who shorted Google (GOOG) stock in 2005, a year in which the share price more than doubled. Last month, Hankins received a 36-month prison sentence for covering up his huge losses on Google to the fund's clients.

To become confident shortists, investors should carefully read all SEC filings and listen to the earnings conference calls of every company they own, says Chanos. "You'd be surprised how often in a great collapse people on Wall Street really didn't do the work, didn't read the footnotes, or just relied on what management was saying," he says.

Investors also need to remember that a good company does not equate to a good stock and vice versa, says Tice. When a company produces healthy earnings, it can inflate expectations and spike the price to unsustainable levels. Pay more attention to things like vague accounting terms or executives who treat short-sellers as whipping boys for a falling stock.

Above all, be comfortable being a contrarian. Says Tice: "I've realized it can be a lonely career."

See's slide show for a look at some well-known short sellers on Wall Street.

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