This Famous Short Seller Is Destroying Alpha

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Famed short seller Jim Chanos of Kynikos Associates was at this year's CNBC Delivering Alpha conference. He started the conference with…

Good afternoon everybody, welcome to this part of the conference, Destroying Alpha.

Chanos' newest short idea is the machinery giant Caterpillar (NYSE: CAT). Despite being an American stable and a Dow-30 stock, Chanos believes the company has too much exposure to the wrong products at the wrong place in the cycle. 

Caterpillar is the world's largest maker of earth-moving equipment, which you probably already know, but it's also the biggest maker of electric power generators/engines and mining equipment. The company's equipment can be found in nearly every country across the world, with nearly 70% of its revenue generated from outside of North America. 

However, revenue is expected to fall 8% in 2013 after solid 10% growth in 2012. The company lowered expectations due to poor mining sales for 2013. Specifically, the company expects sales related to mining machines to fall 50% from 2012 levels, while sales from the Bucyrus acquisition are expected to fall 15%. Speaking of the Bucyrus acquisition, Chanos believes the accounting is too aggressive and that earnings could be lower. 

Chanos also got a big win earlier this week when Caterpillar reported fiscal 2Q results. The company posted EPS of $1.45 compared to consensus of $1.70; profits were down 43% year-over-year. 

Even still, 1Q backlog was $20.4 billion, flat year-over-year. If you can look through the near-term pressures, the longer term could be bright for the company. Analysts expect the company to grow EPS at an annualized 20% over the next five years, putting its PEG ratio at a low 0.6. 

The counter play

While I can understand, to some degree, Chanos' enthusiasm to short Caterpillar, I think investors could make a long bet on one of Caterpillar's major peers and see solid returns. Deere (NYSE: DE) is this counter play. Deere is the world's biggest producer of farm equipment, and is a large maker of construction machinery and lawn and garden equipment. The agricultural and turf segment makes up 75% of the company's revenue. This segment makes tractors, loaders, and cotton harvesters. 

Revenue is expected to be up 8% in fiscal 2013, and another 5% in 2014, after a 13% rise in 2013. The big tailwind for Deere should be a bustling farm economy. Farmers are expected to harvest a total of 14.4 billion bushels of corn according to S&P, up 34% annually.

Deere also has a solid balance sheet and cash flow, helping support its 2.5% dividend yield. Deere recently hiked its quarterly dividend by over 10% to $0.51. What's more is that the equipment maker hopes to boost its dividend payout ratio to between 25% to 35%, compared to just 25% currently. 

Tech short 

One of Chanos' other big shorts is Hewlett-Packard (NYSE: HPQ). Chanos has been calling HP the ultimate value trap for over a year. HP is the maker of printers, servers and PCs. Chanos was sure to point out that the server business will not save HP nor Dell

HP's revenue is expected to be down 5.8% in fiscal 2013, and down another 1% in 2014. The PC industry is being killed by cannibalization from tablets and mobile devices, where HP doesn't have a position in the mobile market. However, the company is looking to software/services to grow earnings. There are also growth opportunities in cloud computing. 

HP is hoping that its enterprise business segment, accounting for nearly 50% of revenue, will help grow earnings as it tries to shake its over dependence on the PC market. Enterprise storage is included in this segment and made up 17% of 2012 sales, and enterprise services was 28%. These segments should also get a boost from the expected rise in company IT budgets as the economy rebounds. 

Even with the near-term pressures, the company is still generating solid free cash flow (FCF). Over the trailing-12 months, the company generated FCF of over $11 billion, a free cash flow yield of over 20%. 

All in all

The bottom line is that Chanos thinks one of the largest companies in the S&P 500 and major equipment company is a short. The thing about shorting Caterpillar is that investors must also pay out the 2.8% dividend yield. While the interim might be uneasy for Caterpillar, I am not comfortable enough with Chanos' short thesis to jump on the short side. 

Meanwhile, I think Deere could be a solid bet for investors. The company could even gain some market share from Caterpillar's struggles. But the biggest benefit will be related to a strong global farming market. 

As for Chanos' other big short, HP, I again am not overly excited about shorting the stock. Although the computer industry is struggling, HP is trading at a mere 7 times earnings, well below Dell's 12.2 times. Although I would not want to be short HP, I wouldn't be long either.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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