Thinking Like a Short-Seller

With the collapse of Enron still in the news and on our minds, we’re remindedu00e2u20ac”as we have been so many times in the pastu00e2u20ac”that the mighty fall, that things that look too good to be true usually are, that brilliant minds and greedy souls are not mutually exclusive, that rarely do major companies with breakthrough technologies and little competition spring full-blown into our market economy.

Which brings us to the short-sellers. “The shorts” have gotten a bad rap over the last couple of decades. They were the naysayers who doubted the strength of the bull market, dragging it down with negative reports of companies and industries. They were shadowy figures, so went the story, who floated groundless rumors of incompetence and accounting shenanigansu00e2u20ac”rumors that could sink a stock faster than the announcement of an earnings restatement.

It’s interesting, then, to see how prescient have been the shorts in seeing, sometimes months before the regulators and most of the ever-buoyant money managers, that something, as my grandmother might say, was rotten in Denmark.

While Enron stock was still soaring, and long before Arthur Andersen figured out that a company paying $1 million a week in accounting fees should be a real business, two analysts were skeptical. James Chanos, who runs Kynikos Associates in New York, and John Olson, of the Sanders Morris Harris Group in Houston, were virtually alone among analysts who questioned the business model. Olson saw a good trading company, but little else. Enron was nothing more, Chanos argued, than a risky hedge fund, not a company worthy of a stratospheric multiple. Those who wanted to believeu00e2u20ac”and most didu00e2u20ac”ignored Chanos and the handful of others who smelled swamp gas. Employees and bullish investors lost billions. The shorts profited handsomely.

So what’s the message for directors? We should think like short-sellers. Go beyond the financials. If Arthur Andersen can preside over an Enron (and, for that matter, a Waste Management earnings restatement and a Sunbeam/Al Dunlap disaster), then so can your local blue-ribbon accounting firm. Just because a CEO heads the Rotary Club or the hospital board, he can still be a crook. If you can’t make sense of a business model, don’t go along with it just because it seems it’s too complex for you to judge intelligently.

And if someone says to you, when you express reservations about a loan or a business relationship, that you “just don’t understand the business,” that’s precisely the time not to back off. Chances are you’re onto a great short, in stock market parlance, or a loan the bank shouldn’t make, if you’re a director.