Jim Chanos: Value Traps

Jim Chanos of Kynikos Associates, is speaking at the Value Investing Congress, and he is talking about value traps and how to identify them. Some of the ways to spot value traps are that the company appears to be using management metrics, not conventional metrics. It could have marquis or famous investors, and may very well be cyclical or overly dependent on one product. It may also be reliant on a government "put", perhaps in a key industry, or be deemed too big to fail. It may also have accounting issues. Technological obsolescence (minicomputers, Eastman Kodak EK, video rental) is a major factor of a company being a value trap. Chanos said that in every major market meltdown, there is always a "smart" or well known investor who is in the stock, and that person may very well make mistakes. A new "superstar" CEO should not be seen as a savior. Sometimes new CEOs have incentives that are not aligned with yours, and often they have an incentive to "trash the stock" to get a lower option price. If a company is cheap on management's metrics, such as EBITDA, free cash flow, while ignoring restructuring charges it could be at the risk of your investment. Cable TV, Eastman Kodak EK, Blockbuster, and Tyco TYC have been examples of this in the past. Published financial statements have to be taken with a grain of salt, particularly if management keeps pointing to a specific metric. Accounting issues are also a sign of a value trap. If the accounting is confusing, it might be best to stay away. Chanos cited Bally Total Fitness as an example "Nonsensical GAAP" is also another accounting issue. Subprime lenders have been examples of this in the past. He talked about the subprime lenders of 1997-1998, such as "The Money Store." Growth by acquisition is another major sign of a value trap. Tyco is an example, and roll-ups are examples as well. If you write down salable inventories and collectible receivables, and write up insurance policies, they will bleed the insurance policies into earnings. In Tyco's last year of business, it bought $20 billion worth of businesses, and put $21 billion of goodwill on its books. It said that these businesses have never made a dime. Level 3 assets are also a sign of a value trap. Specifically for financials, he believes that some of these companies are not being honest with analysts. Some value traps are liquidating trusts, and integrated oil companies. The cost of producing and developing is up for the major companies, as it becomes harder to find a barrel of oil. You can see this with Petrobras PBR and BP BP. He mentioned specifically Exxon Mobil XOM as a potential value trap, but you can see it with other integrated oil companies. Chanos cited GameStop GME as a value trap, as digital video distribution continues to grow. He said there are a lot of value investors in the name, and it has many stores, and is hard to compete with the digital method of distribution. For profit colleges are also a value trap. He specifically mentioned ITT Education Services ESI, as it is poorly positioned. The industry is supposedly very well thought of on Capitol Hill, but Republicans have started to back away from this industry. This industry does not have the political cover that a lot of the bulls think it does. 90% of its assistance comes from the U.S. taxpayer, with increasing looks for austerity. Chanos also mentioned commodity guys, specifically iron ore. Iron ore is now down to $150 or $160 in the spot market, but that is well off the highs. It historically was in the $30 range. He specifically mentioned Vale VALE as a potential value trap. He also spoke about Chinese state banks, as China has been more in the news recently, as the attention on Europe's fiscal crisis is at heightened levels. Chinese banks are instruments of state policy, but are not to maximize shareholder value. It is in their charters to be instruments of state policy. In the last twelve years, Chinese banks have been recapitalized twice, in 1998 and 2004. The banks were not bailed out, but were recapitalized. The government set up asset manager companies to purchase the bad debt on the banks book, and issued bonds to pay for them. The banks bought the bonds, and when the bonds became due, the bonds were rolled over for another ten years. The bonds are on the books at par. In the case of Agricultural Bank of China, Chanos believes this might be 50% of the banks' capital. The increase in debt resides mostly at the biggest four banks in China.