Interview with Muddy Waters’ Carson Block on his his short bet against Sino Forest and other short positions from a speech at Absolute Return Symposium in New York. – below is a transcription of audio – we used good software but there might be some errors. Either way enjoy! And the slides can also be found below.
And for a good summary of the speech check out Julia La Roche of Business Insider’s coverage
Introducer: Our next speaker has profited from shorting a large number of companies in many different regions using an intense research process designed to uncover frauds and broken business models. Carson Block is a noted short seller and founder of Muddy Waters capital. He rose to prominence in 2011 when his short bet against Sino Forest brought the group’s business model and question. The firm researches accounting fraud, business fraud and fundamentally flawed companies. As well as short activist campaigns. Please welcome Carson Block.
Berkshire Hathaway’s Buffett On Diversification
In his 2014 letter preview, Buffett states that, far from being a weak choice, indexing can often achieve investor's goals far more easily than complicated picking strategies. This is a special guest post by Robert R. Johnson, Ph.D., CFA, CAIA. He is a full professor of finance at the Heider College of Business at Creighton Read More
Carson Block: First of all, thank you for having me. Wall Street has never liked short sellers but they’ve been tolerated so long as they abide by this gentlemanly code; take your position but don’t try to embarrass the company. Okay you can go out there and talk to reporters who want to cover the story but don’t go out there and shout of the top of your lungs what’s wrong the company.
The problem is, getting run over. Some of the best shorts have managements that are unethical or crooked and the problem with shorting those companies is they’ll stop at nothing in order to ramp the stock value. So it is very easy to get run over as a short seller that is not out there voicing his or her views.
A few years ago I met one of the titans of the hedge fund industry, a legendary investor, and his quote was, “I used to short more stock than any person alive. And I always did the research, but after 20 years of shorting my book net net was flat.” The reason for that is because there is so much firepower on the other side. Crooked companies will do whatever it takes to support their stock price.
I’ve seen this first hand with Sino Forest. Sino Forest actually spent $50 million trying to discredit our research. That included the chairman of the firm involving a PRC law firm, reputedly a reputable one, to put together a report that exonerated him. Now, The bankruptcy court that is dealing with Sino Forest is currently suing the chairman and has cited this report in its case. So there is a lot of firepower on the other side.
Luckily, the Internet has done a lot to level the playing field the Internet has really democratized investment research. Now when people put these ideas out on the Internet it doesn’t matter which firm they work at or where they went to school all that matters is the quality of their research. I know this very well. I left the industry in 2001 and when I started Muddy Waters in 2010 I was living in China and I was an entrepreneur. I started the first self storage company in mainland China. The plan was to start Muddy Waters, raise lots of money and become a force to be reckoned with but that didn’t happen. What actually happened was, when I started Muddy Waters I was a guy managing a self storage company in China.
One year later, Bloomberg named me one of the most influential people in finance, I was up there with Ben Bernanke, Warren Buffett and so on. So that is the power of the Internet.
It all began with a company called Oriental paper and my father who was an analyst at the time was looking at these micro-cap Chinese companies that were listed in the US. So he asked me to look at Oriental paper for him and he thought this would be a great long. The company listed a number of companies in its 10-K as its main competitors. The company manufactured the brown paper that goes in cardboard boxes. When we saw pictures of the company’s factory (as shown on slide) you can see that their equipment looks like old toys, nothing like the similar, more up to date equipment competitors were using. They had valued this equipment and $50 million. Raw materials inventory, which was literally a pile of trash, was valued at $5 million. That’s a picture (as shown on slide) of my consultant climbing the trash pile and when he came down his exact words were, “if this is worth $5 million the world is a much richer place than I ever knew”.
So on June 28, 2010 my life changed forever because I took all of the research that I had done on Oriental paper and put it into a 30 something page report and sent it out. It was originally a small distribution list. There were about 50 people in the investment industry that I had last spoken to around nine or 10 years earlier and probably most of them knew me as Bill Block’s son. Within 48 hours the stock dropped 55%. Here’s a long-term chart of the company’s stock price and often when you short something you will see a sudden spike backup soon after the initial short thesis hits the wires. And the reason for this is is that these companies are going to fight back with everything that they have. You’ve backed them into a corner and they are going to come out swinging. And that’s why you get a ramp. The idea with a short selling campaign is that you put so much pressure on the company that things fall apart pretty quickly. Maybe it will be the fact that the auditor can no longer continue to work for the company, people might resign or stop working with the company. So that’s why you get the ramp and then the stock begins to fall again.
Today we have around 30,000 followers on Twitter and about 15,000 people signed up on the distribution list. So the Internet is a very important tool I think even more so now than the distribution list. There are algos linked to twitter accounts like those of myself that are programmed to trade as soon as the ticker is entered. Which is actually pretty scary when you think about it.
When I talk to investors there are a lot of misconceptions about what a good short is. The hallmark of my trading is we’re looking backward and most of the investment industry is trying to figure out what’s going on in the future. Much respect to those who, do but I think that’s a very hard thing to do. I want to look at the information that the company has disseminated whether it be in financial statements in transcripts and what have you. I want to ask whether that information is accurately reflecting what is really going on in the business. So you can have delta between reality and information and investors perspectives because you can have, in my opinion two different types of fraud. Actual fraud, which is the legal definition of fraud, or intellectual fraud which is based on financial engineering and generally misleading investors and there is a lot of that in this world. So there is a little bit of looking into the future but mainly we are extrapolating what the business has distributed as fact. People have asked me why don’t short biotech and it’s very difficult because you have two different sets of scientists (mine and theirs) who are arguing two different points and it’s like arguing about the existence of God. So I don’t think biotech stocks make good shorts in general.
Is an example of a financial engineering short we did last year, we weren’t in the first ones to pick this up. We are talking about Noble the Singapore commodities trader a former employee set up a research firm called Iceberg Research, which was the first to start publishing on Noble. The stock had dropped a bit but not much and we saw an opportunity to set out a granular example of just how financially engineered the company was. Most of the big points had already been covered by Iceberg. The issue with the company as they have a lot of commodity contracts and they fair value those using a loss of level II and level III models and the valuation gains that the company had taken over the years were just egregious I forget what portion of retained earnings these gains accounted for at the time of our initial interest in the company but it was a substantial portion. We found one particular transaction in Indonesia where they had brought the mine for about $500,000 and then promptly took a fair value gain of over $40 million. Then they disposed of the mine to a related party, at the time it wasn’t known that the acquirer was a related party, it was a shell company they set up. So we saw the opportunity to highlight that. And it wasn’t a big attack, just a little nudge but it’s obviously something that’s played out pretty well for us since.
We recently shorted a company in France called Groupe Casino and its parent company. This is a very complex company and we estimate its leverage at nine times but S&P has is leverage at 4.5 times. That’s the thing in some cases is difficult to even agree on leverage. And we also figured out it’s likely that they are inflating their EBITDA through related party transactions. And this is a company that is following the same pattern, I don’t have a chart here but when we came out with our thesis, management started to throw everything at it, they’ve just agreed to sell off a crown jewel asset, which is really good for our thesis— they are hollowing the company out just to pay dividends to their controlling shareholder it’s following the pattern that we’ve seen a number of times before.
This was a light-touch campaign for us, when not being aggressive activists here. We certainly think this would be a lot harder to do in 2013, now these stocks are a lot weaker, I take no credit for that, but what we’re beginning to see is that the market is now more open to these ideas. It certainly helped set Icarus’ wings on fire.
One the things I want to leave you with is something that is certainly underappreciated by investors and that’s management behaviour. I’ve often thought about it in terms of regression and analysis in a way. Companies will do some very strange things from time to time, and they always have an explanation. We often look at the explanation and think, that just doesn’t make sense and we think, is there an explanation that would fit the scenario better. For example, is the explanation helping them commit fraud or they trying to work their way around fraudulent figures, or is the company having a liquidity issue. So I’m always trying to look for better explanations for the big surprising decisions that companies make. One way to uncover and gain more insight into management’s way of thinking is to analyse historical transcripts. I think that makes up around 70% of our research. You want to read from the oldest possible to the newest possible, ideally in as few sittings as possible if you can. You can detect a lot of things that are pretty interesting this way when you have deceptive managements. When think that tells me if a company is kind of funky is when management keeps changing the performance metrics with which they measure themselves. It’s amazing how some analysts never call managements out on this. I’ve seen it before when management has come out with a new initiative every quarter and forget about it on the next call— that’s a pretty good measure of incompetence. We also like to see what questions management of evades. You can learn a lot about the management from the Q&A session. For example, if management is always choosing the same analysts to ask questions, and these analysts always start the question with something like, “hey guys great quarter!” That an indication that management is being deceptive and trying to manage the call. We do look at the questions they don’t answer, which is almost like saying hey look here, look at this!
A great example of how management behavior can broadcast an underlying problem is Eike Batista. When I first saw this guy speak at an event in Brazil, his audience was almost entirely Brazilian and he had this strange obsession with Carlos Slim he kept saying Carlos better watch out as he gave his talk. I’ve never met Carlos Slim but I remember thinking, does he ever care about Batista? And when Batista was speaking, everything was about scale we’re going to have the biggest this and we can have the biggest that but nothing was about profits. His group with about $40 billion market capitalisation had negative EBITDA and almost no revenue. And I remember watching this guy and thinking this will be a great short. Unfortunately, I didn’t act on it before it fell apart.
Here’s a company that we shorted but didn’t really go public on it. Blinkx is an AIM listed company that does online advertising. The numbers were great and the numbers were real—as far as we could tell. The issue was, as we suspected, was that the company was defrauding its clients, the business was built on click fraud. If you look through the transcripts the behavioral traits that indicated something was up were clear. It was clear that the analysts questioning the company didn’t really understand the business and they would ask questions, basic questions, to try and figure out how the company actually made money. But management would never give them a straight answer. They always came up with responses that were full of buzzwords. There was a real issue. It was surprising that analysts still had conviction buys on this thing.
I talk about light-touch campaigns quite a bit, and one of the areas where light-touch is really interesting is credit.
I remember in 2013 I was at a conference and I had five minutes to talk about an idea. I talked about how we were short the debt of Stan Chart. I gave a talk on Friday and the next week the bank’s credit spreads blew out. I think we’re going to be doing some more credit based shorts going forward.
Q&A with Carson Block
Now going to open it up to questions:
Q: in light of the market rout you could argue that the market is now doing your work for you. Has your strategy now changed as market sell-off?
Carson Block: I guess it’s a common misconception that people have that I care about what the market’s doing. I don’t. We only really have risk on on names that we are public about. Sometimes you get beta moves but I think a good activist short is short in any market environment.
Q: could you comment on where you might have got it wrong before and some of the pitfalls in your strategy.
Carson Block: I’m sure most people in this room know that being right and making money are not two things that always happen so we have to be right. With these companies that want to bring regulators in and savage their critics, the penalty for not being right is very high. I believe the biggest disappointment I’ve had, in terms of our campaigns, is American Tower. The research we did was excellent and I’m happy to tell that to people who question it. The number one thing that went wrong here was that we were massively front run and that’s a big risk in this business. It hasn’t screwed up any other campaign apart from AMT. We were massively front run by people who brought a bunch of puts just before we went public and there was a mass of covering right when we came out with this so the stock really didn’t move on day one or day to this was a big problem because we had some very serious allegations. For example, we found in one transaction around $250 million went missing and we think it’s reasonable to suspect that certain people at AMT had something to do with this. Now, I think that if that stock had closed down 4% or 5% on that day I think the board would have had to react completely differently I think they would have had to take these allegations seriously and I think people would have been fired and the stock would be at a completely different price level to what we see today. The other thing I learned from AMT, when I started this business our reports were about 30 pages long, but with AMT we had a big kitchensink report—it was around 90 pages. But I think people struggle to read all and the three main issues we want to get across sort of got lost in a volume of data so that’s why today in general are reports, we try to keep 20 to 30 pages, so I think there was a communications error on my part as well the stopped us from profiting from AMT.