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Monday, December 3, 2012 - 14:30
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Monday, December 3, 2012 - 14:30

5 'Value Trap' Lessons From the Man Who Called Enron's Troubles

Monday, December 03, 2012 2:30 PM

Most of us are taught, at an early age, that cynicism is wrong. Being distrustful of others and believing people are only motivated by self-interest is a difficult way to approach life. However, as in most everyday wisdom, there is a dramatic exception to this rule.

Being a cynic has earned hedge fund manager Jim Chanos billions of dollars over the years. He is such an adherent to the philosophy of cynicism when dealing with the financial markets, he gave his fund a Greek name for cynic -- Kynikos.

As you can imagine, the $6 billion Kynikos fund is focused on short-selling. Selling a stock you don't own in an attempt to buy it back at a profit when its price declines has cynicism written all over it. After all, what short sellers hope for is the worst.

This cynic view of the world has helped Chanos discover accounting frauds and other corporate malfeasances that generally take stocks nosediving to bankruptcy. This attitude has enabled him to short Enron right before it imploded in the largest U.S. bankruptcy scandal of all time. He also made a prescient short trade on Baldwin United in the months prior its bankruptcy spiraled.

His most recent high-profile accurate short call was Hewlett Packard (NYSE: HP). Shares are down more than 26% since he said HP had fudged the numbers on its balance sheet. Chanos is also a major bear on China. Although I disagree with him, I can't deny that his favorite Chinese short, the Agricultural Bank of China (PINK: ACGBY), is down more than 20% so far this year, compared with last year.

He calls the stocks he shorts "value traps." Here are five traits of value traps:

1. Accounting issues

2. Cyclical or overdependent on one product

3. Hindsight drives expectations

4. Famous investors/marquis management tout the stock

5. Appears cheap when using management's metric

While shorting individual stocks is a highly speculative undertaking because of high-margin costs and theoretical risk, there is a less risky way for investors to profit from Chano's short calls -- shorting the exchange-traded funds (ETFs) that have assets related to those short predictions.

And right now, Chanos is heavily short Brazil, China and Spain. He says things will get far worse in these nations before the turnaround occurs. So if you share his cynicism, then these three ETFs follow in his footsteps while providing a hedge against single-stock risk.

1. iShares MSCI Spain Index Fund (NYSE: EWP)
This ETF is weighted at 41% toward the Spanish financial sector. Banco Santander (NYSE: SAN), one of the world's largest banks, makes up almost 22% of the ETF's underlying assets. Chano recently made a compelling case as to why Banco Santander is a classic value trap. First, he says the trouble in Spain's national balance sheet will negatively affect the bank. Second, the bank's 320- billion euro exposure to the struggling Spanish real estate market will continue to pressure shares.

2. Proshares UltraShort FTSE China 25 (NYSE: FXP)
Chano's global short fund is roughly 20% made up of short bets on China. If he proves to be right about the future of the Chinese economy, then holders of this inverse ETF will benefit. Because it's leveraged, it will profit from a decline in the value of its assets. As such, it's only suitable as a short-term investment.

3. ProShares UltraShort MSCI Brazil (NYSE: BZQ)
At the Ira Sohn conference on Monday, Nov. 26, Chanos let it known that two of his favorite shorts are Brazilian giants Petrobras (NYSE: PBR) and Vale (NYSE: VALE). Together, the federal oil firm and the world's largest iron producer add up to 26% of this ETF's underlying assets. He is short Petrobras because the Brazilian government owns 64% of the company, which is a huge negative since the company is unable to obtain full market price for oil and gas, because to government interference. He is short Vale because he thinks iron ore is currently overvalued and the company is too dependent on demand from China for its business. This means signs of a slowdown in China will have negative implications in Chinese steel consumption, which would in turn affect Vale in a big way. In addition, extraction of iron ore and other basic materials are becoming more costly.

Once again, if Chanos is correct about these companies, then holders of this inverse ETF will benefit handsomely. Again, this is only suitable as a short-term investment.

Risks to Consider: Despite Chanos' stellar record on the short side, he may be dead wrong about these stocks. Even $6 billion hedge fund managers don't always get it right. I for one think Chanos is not really correct on his China short calls. China's new leadership have a pro-business stance and the country is slowly opening to outside investment. He's simply too late with his Chinese bearishness.

Action to Take --> Having said that, I agree with his calls on Spain and Brazil, given their current economic slowdown. If you share Chanos' cynicism and bearish predictions, then shorting the EWP and taking short-term long positions in the leveraged ETFs FXP and BZQ makes perfect investing sense. Yes, you could short the stocks listed directly, but using the ETFs will lessen single-stock risk.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.