"Transparency is a friend of short sellers and an enemy of bad companies" | Outlook Business
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Photographs by Dawid Bilski

Masterspeak 2015

"Transparency is a friend of short sellers and an enemy of bad companies"
Muddy Waters Research founder Carson Block is the reclusive crusader who digs up accounting frauds

N Mahalakshmi & Rajesh Padmashali

Carson Block’s life could make for a blockbuster script: a combination of Jerry Maguire meets Breaking Bad. Getting initiated into the stock market in his teens through his father, Block learnt the hard way that things are not as rosy as they are made out to be and CFOs can lie looking at you in the eye. Around the year 2000, Block decided to chuck his investment banking job and join his father full-time at his research outfit that mainly covered micro-caps.

His experience with micro-cap frauds, his foundation in law, and finally witnessing Chinese con jobs provided him the right ingredients to model Muddy Waters Research, which digs up accounting frauds. Incidentally, the firm’s name is derived from an old Chinese proverb that says, “Muddy waters make it easy to catch fish.” When the pond water is clear, the fish dives away and is difficult to catch, but if you kick up the silt beneath, the fish rises to the top and you can catch it easily as it hesitates to dive into muddy waters. With his iron will, grit and critical thinking, Block is constantly kicking up silt for muddy managements. 

Is there a market in the world where short sellers have a level playing field? 

There is no market where the playing field is leveled for short sellers. Companies have so much money to spend supporting their stock, and almost the entire investment industry depends upon selling the dream to investors of stocks going up. Besides, companies and investment banks make political contributions. It is not even close to a level playing field anywhere in the world. Though the closest that it can get to a level playing field is the US. Transparency is a friend of short sellers and an enemy of bad companies. The US requires companies to disclose more than any other jurisdiction. So, there is more information that you can get here that can help you develop a short thesis. But then there is a big difference in tax treatment between profit on short selling and profit on long buying. 

You inherently have this knack of looking at things critically, looking at the downside of things. But is there a way of developing critical thinking across investments? 

Critical thinking and your temperament certainly help when you act as a short seller. I have always personally enjoyed doing things that were unpopular and involved challenging authority. I have always had this temperament, which is to look at what I am being told, and just think about it from different angles, and ask, does this make sense, is this right? In the early part of my career because I was exposed only to long side thinking, initially I learned that if the stock goes down and there are rumours of something bad, or there are short sellers propagating bad things about the company, you are supposed to call the CEO or the CFO and ask, “Hey, is there anything wrong?”

And they might tell you nothing is wrong, that everything is great. That is all you can do. Now, that was backfiring on me several times. But I became really good at avoiding losses or avoiding bad situations. I wasn’t great at finding the long side opportunities though. Through those experiences it just became hard for me to see the really rosy scenario. It was a lot easier for me to pick out the risks and the problems. My father and I started to have conflicts then. So, I stopped working with my father, and he said, maybe, I should look into short selling because I seemed to have that mentality.

Then, my education as a lawyer and my experience in China taught me a lot, although it also cost me a lot. I came across my first China fraud by accident. My father wanted to go long on some of these Chinese companies listed in the US. I had been out of the market for nine years, I didn’t know there was a fraud problem, I thought auditors actually had some sort of anti-fraud function. So, when my father asked me to take a look at this company called Orient Paper, I was shocked.

I had never seen anything like this. It was like a total zero — real revenue of $2 million or $3 million against the reported $100 million. I was able to see it only because of all the experiences I had till then. The company’s SEC filings told me that there was real problem in the company, but it didn’t tell me that the company was really an empty box. I looked at what they were paying for land prices — Chinese land prices were massively inflated, so you could tell. I looked at their largest supplier — it was some trading company. Of their top ten customers, each of them would change every year, but they were still growing revenue 40%. Things were obvious to me, but without that ground level experience in China, I may not have been able to pick those things out.

China was and probably still is the most egregious corner of the global capital markets. But it is really just the micro chasm of stuff that is going on globally. In the US, and in western Europe, companies don’t necessarily have to commit fraud in order to massively mislead investors. In Enron, it is not the fraud that brought it down but stretching accounting standards to the maximum. That is a major problem that still exists in the capital markets.

Do you have a checklist for evaluating companies? 

I don’t have a checklist because every company is different from the other. But one of the first things I look at is free cash flow. Has free cash flow consistently been negative? If a company is public for 16 years and has never once generated free cash flow, it’s not a good sign. But then you have companies such as Enron that were able to create operating cash flow from what was really financing cash flow. When I first look at a company, I want to scan the major line items on the balance sheet and understand what those biggest dollar values are. Usually if you have a fraud — the fraud is generally to improve the income statement — you are generally going to see signs of that on the balance sheet. So, something on the balance sheet has to blow out unless they are able to forge their cash. In China and in India too, that is reasonably possible. Like Satyam forged cash balances. But usually cash balances are the hardest thing to forge. 

So, I am looking for what the blowouts on the balance sheets are. Fixed assets are kind of obvious. Why are they engaging in all this capex? Because sometimes you read about the company and know that the factory is not close to full capacity but they are constantly expanding. They are purchasing land far away from the factories. These are the first things to look at.

Then, I try to create a mental map of the flow of funds and materials in a business. I am looking for what I call choke points. What are the things that I can learn from to verify whether the business is as big as it claims to be at least on the topline? Maybe it has far fewer employees than it claims. Now, if it claims to be running three shifts, seven days a week, and we go and watch the factory and we see only one shift, or counting trucks in and out of the factory gate, gauging web traffic if it is an online business, all that is easy stuff. Some of them are always arguable. The companies always have their defence, but then you can figure it out.

What is it about pointing out financial fraud that appeals to you?

It is like a puzzle that you have to unravel. The way the process works is that at some point, relatively early on, I will start with the thesis and then try to validate it internally. Everything from that point forward is building a case that we prove to the market, because the market is much more trusting of the companies than we are. That is where 70% of the time and effort goes in, and it is fun. It is not just unravelling this puzzle. It is about figuring out how did they do this? How are they hiding it? But then it is also very competitive, in the sense that the management or whoever is committing the fraud has tried to cover it up and now these guys are my opponents. I am trying to expose them. That is something I enjoy. 

On the flipside most investors, including most short sellers, are building spreadsheets and trying to figure out what is going to happen in two or three quarters — whether the margin will expand next quarter or not etc. I can do that. But I just feel that is so mundane. In this line of work we are basically trawling the sewers of the world’s financial system. We get a lot of information flowing. 

Are there categories, in terms of different kinds of frauds?

I would say most companies in the west, and Satyam falls into this category too...you have a real business but the business gets into trouble. There is pressure on management. Their numbers start to look bad. “We had a little problem this quarter, maybe we can just do this and everything will be okay.” These frauds come to light when the business doesn’t turn around and then you just have to keep digging the hole bigger and bigger every quarter. That is how a lot of frauds really occur.

There are also companies that are from the very beginning intended to be frauds, but that is more of a China phenomena. You have a category of companies in the US that is always intended to fleece investors of money, but those we call pump-and-dump, not frauds. It is like you buy a computer from HP and put out a press release saying that you have a partnership with HP, pump up your stock price, sell your stock and then it falls apart. But that is not a fraud because they are never reporting numbers that are wrong. They are reporting just a $100,000 in annual revenue, but they are leading investors to believe that in three years it is going to be $300 million or so.

I am generally not interested in those because I am not really interested in figuring out the future — that is also a sucker’s game. The best people figure out the future correctly 60% of the time with respect to company performance. So, what we do is we look backwards and we are checking if the market has misinterpreted history. And we can bring a clear interpretation and say this is what these numbers really mean —they could be fraudulent or misleading. 

Would you agree that the payoff in calling stock manipulation is much better because you have dreams to sell and if you thwart the dream the story might go bust very quickly? To establish financial fraud might be much tougher, and the payoff not commensurate? 

Actually, I would disagree. For example, if you were to really get investors to change their mind about a biotech stock, you have to argue about the science. Investors don’t understand the science anyway. We could get in a really good consultant. It could be our consultant versus theirs, but investors are not going to follow that discussion anyway.

Again, mining stocks are also very difficult because the company is telling you what is on the ground and maybe we have a very good indication that they are massively exaggerating that, but how do you really prove that or that their extraction costs are higher. Those are very tough arguments to win. The analogy that I make going back to religion is like debating the existence of god. Does this drug have potential or not is a very tough argument to win. It is easier to look at numbers or something objective and say that there is something wrong with this.

The only reason margins are this high is because they have been transacting with themselves and this has been piling up in an off-balance sheet entity and things like that. That to me is a much easier argument to win. It is still not easy. In general, we only focus on companies that have a decent amount of institutional ownership because institutions will understand our argument.

Is short selling a sustainable strategy?

I would differentiate between our model, which is actively short selling, and traditional short selling, which is short it and don’t talk about it. Let me first cover traditional. There are two philosophies to that. One philosophy is if I want something that is a hedge to general market conditions. To be really cynical, there are hedge funds that want to have a short book just so that they can justify being paid 2 and 20 [2% of total assets as management fee and 20% of profit earned] versus a mutual fund. So, they have a short book to try to hedge out a long exposure. 

Then you have a smaller group of short sellers who are actually trying to profitably short companies. That is a much smaller group and it is very hard. Because when you make money on a short, it is generally all at once. You are going to have to sit and live with your short for a long time before you get the correction if you are correct. So, as a traditional short seller you build a number of tiny short positions — 1%, 2% and sometimes 3% of capital. You have to do a lot of work on each one. It is a very resource intensive and tough business. And you are always trying to get the timing right as close to the catalyst as possible. That is so hard. Usually, people pick the most common catalyst, which is an earnings miss. So, your model is, “The next quarter is actually going to be worse than everybody else thinks.” Not a game I like to play because I just don’t like the odds. 

Now, what we do by communicating publicly is an entirely different business model. I find this interesting because it takes some of the things that are so painful and so difficult about short selling out of the equation. What makes it hard, however, is the threat of lawsuits, dealing with the regulators and so on. Plus the threats — we have people who try to hack us because they want to find out what we are working on. It brings what I call a whole lot of brain damage. But you have to deal with that as it is a part of the business model. We are not the smartest people out there. But the thing is a lot of funds will sell short and try to actually make profits on it. If they are going to short frauds recognising that they are going to lose a lot of money before they make money, it is part of the deal. What I am trying to arbitrage with this business model is the willingness to take punches. 

If the company is going to sue me, I will get sued. I will sit across with the regulator and I will look him in the eye and I will explain why this thing is a problem at a company. It is just that I have got a higher tolerance for bullshit. That is why I can do this model. 

What about the traditional short selling approach?

On the traditional short selling model, the trap that a lot of people fall into is that they look for the worst companies they can. They will, maybe, have only 20 or 25 of those on the short side. When you have a year like 2013, these are high beta names. Those are the names that go up the most. They are also the most heavily shorted and everybody covers. That is not a sustainable model. You get carried out. Maybe you will have four-five decent years but you will blow up half of it. The only way to do it sustainably is to do what Jim Chanos has done. He has been in the business as a short-only fund for around 30 years. Even if you are a long-only fund, that is an incredible amount of time to be in the business.

His philosophy is these are 1% to 2% decisions. The average market cap is $4 billion. So it shouldn’t be super high beta. When you have to do good quality research, that is how you look at it. The other thing that he does is smart, and this is something that guys who get blown up are not really thinking hard — if a company has debt, it can make your thesis real. If you are shorting a biotech firm and it doesn’t have debt, it is going to keep doing equity financing and nobody cares that the thing is going to blow up 500% anyway. It is hard for your thesis to be made real. But when a company has debt, that is a much better position to be in.

As far as our model is concerned, the day that we don’t have anything to do will be the day that there will be no more wrongdoing in the capital markets. So as long as people are doing bad things and breaking rules this model can be sustained. Now what makes it potentially unsustainable for me is it is a very intense business model where we get into street fights with companies. These are guys with a lot of resources. They send investigators to look at me. They call me names and I call them names. Then you have got the media, which is sometimes our friend and other times not. These are things that take a lot out of you. It takes a lot of energy to do this. Is this model sustainable for me personally? No. But I am fine now. At some point in the future if I don’t find a way to dial back the intensity, that is really the ceiling on this. It is reasonable to expect that I can burn out. 

Does timing have a disproportionate role in shaping return in short selling?

Well, in general, because you want to have as little driving the stock up as possible, you ideally want to get in just before there is a catalyst. Our research processes are several months long. So, it is not like we can control the timing much. I would like to put on a trade when there is or no event that we are worried about that can shake things up. That is the ideal time to put on a trade. But when we are done with the report and it is ready to go there is always some reason that we don’t like the timing. In a lot of ways, I would say that I am actually quite conservative. I think for a lot of people it is really hard to believe that when you look at this business model.

But there is a real conservative streak in terms of risk and managing risk within me. So I will always find a reason to hate that particular time to do the report. But then the question I will ask myself is, “Will I hate next month or two weeks from now more?” Usually, the answer is potentially I will. So this is the best time to do it. We are confident about our thesis. Every time we do this we have got this big gap to jump. Sort of like Evel Knievel looking down the canyon and thinking, “Holy shit, are we really ready for this?” But at the end of the day, we say, this is the model we have been successful with so far, it is time to hit the throttle and do it.

 So the moment you are done with the research, do you put out the report as quickly as possible? 

Not as quickly as possible but when it is done. Usually, I don’t sit on a report or put it in inventory because there is always the fear that we will miss the trade. We have competitors as well. Somebody else can write on it before we write on it and then all of our time and effort and money is gone. I feel it is usually best not to let these things sit. If something in the middle of our research changes then we may stop a bit. A couple of years ago we were working on a company.

We were only about three weeks away from a report. We had done a lot of work on the company and a very large, very well-known, very sharp-elbowed activist investor went long on the company at over 5%. The day we saw that filing was the day we knew our project as done. I wasn’t able to go to war with this guy because I felt like he can make my life miserable. We have had that happen once. That is one of the reasons, why when we finish a report I never love the timing, but if you want to minimise the uncertainty of something else going wrong, you want to get it out there.

What is the starting point for research? Is there an element of timing there? 

Because of our platform, most ideas are actually from other investors. We take each thesis and depending upon how interesting it is, we will look into it. The vast majority of the stuff we get I just don’t find that interesting. There are a lot of people coming to us with stuff that is more fundamental based. We like the element of wrongdoing if not outright fraud, essentially financially engineering statements and misleading shareholders. Because the big threshold question for us when evaluating every idea is: what doesn’t the market already know. The company has lot of debt and they are brushing up against the covenant ceilings, so we think they are going to blow the covenants. So what? Anybody who looks at the balance sheet can figure that out. Tell me something that I can’t figure out in ten minutes looking at the financials. That is what we are usually looking for. If a lot of the company’s sales are to an off-balance sheet entity that it controls, then that is interesting and we want to look into that.

Given that you do block trades and that you can’t get the timing right, how do you protect your downside?

We have put information out into the market place. If the market place thinks the information is good then the stock reacts and we make money. If the market doesn’t think it is good information then we don’t make money. Basically, we are trying to catalyse revaluation. We are concerned and we think about the timing of how we trade. It is all around our releasing of the report.

But how do you protect your downside because you can’t perfectly time the correction?

We hit what we call peak risk just before we come out with the report. I want to have as little risk on ahead of the report. Now once we put the report out it is tough to say what the outcome is because ultimately for us to get the long term win it usually depends upon somebody doing the right thing, maybe shareholders looking at it more closely. But in a bubble market, people are not that skeptical and they don’t want to hear the bad news. It is out of our hands. That is the difference from long side activism.

A long side activist is trying to improve the company’s governance, its operations and strategy. There is an ongoing battle there. You kind of prevail on the board to make some changes. If not, you go to large shareholders etc. It is kind of a chess game. With us, the outcome is almost predetermined when you put the report out. We can come out with a follow-up. The company will respond. We will follow up the responses etc. But at the end of the day, after the first report, it is largely out of our hands. Unless we can put a company in a situation where they are really handcuffed as to how much more fraud they could commit or get the auditor or board members to resign, it is hard. We don’t control that. 

Are there any do’s and don’ts that you follow?

Every time I publish a report, I assume two things. One is that the company is going to sue me and I am going to face a hostile regulator. I have only been sued twice. I have never had to file a response. But I assume that I will be sued. And I have never faced a regulator that is hostile. But when I say hostile there are political forces behind the scenes pushing them to come down on us. So, every word that I write in the report has to be written to that standard of, “Can I support this in court?”, “Can I support this in front of a regulator?” We always know more than we publish. To put a material fact into a report, I want to make sure it is rock-solid. Generally, that is getting corroboration from some independent sources or something that is incontrovertible. 

What have been your top learnings thus far?

There were lessons in everything I did. When I wrote Orient Paper, I didn’t expect it to get that much of attention. There were certain things that I could have done that I think would have ensured that the company would have been delisted in the first instance. I didn’t want to spend the money and the time. In this case I learnt that you have to be ready, you have to try and crush your opponent. It was a bloody battle. They came back and lied and said that my father and I tried to extort money from them and all that. When you put somebody in the corner, their gloves are coming off, they are going to try everything they can to discredit you and take you down. You have to understand that this is not a gentlemen’s game. 

I have spoken to some people who have asked me about Bill Ackman’s duel with Herbalife. Ackman has gone actively after their business trying to dissuade people from becoming distributors. People have asked me what I think about it. I have said from a moral perspective, I have no problem with it because I know what these companies do. They are not playing by the rules. I don’t have a moral problem with trying to chop their business out from underneath them. My issue is that it is just another level of legal risk to try to go after and interfere with their business. That is a legal risk that I haven’t been comfortable with till date. My point is you really have to be prepared to get into a bloody battle when you try to crush them. 

With China Media Express, I learnt how blatantly unpopular bad news is. We got to win there but only after the auditor resigned. It took a while. The vitriol directed towards me until the moment the auditor resigned and called the company a fraud in his resignation letter, was confounding. Up until then, I was just trying to figure out what the public’s attitude is. Why aren’t they mad at the management? What it taught me was that as far as retail investors are concerned, it is like they are holding lottery tickets. And when I expose these companies, they feel like we are grabbing the lottery tickets out of their hand and tearing them up and throwing them on the ground. That is the emotion that they feel. 

When you think about it, Sino-Forest took a lot of nerve because they spent over $50 million to try and discredit our work. These are the resources available to the other side. The truth needs to be a really powerful weapon in order to deal with stuff like that. I knew this would be a big deal in Canada because this was such a big company for them. Pretty much everybody in Canada owns the company in some form, whether it is a pension fund or whoever else. Fortunately, the regulator, the Ontario Securities Commission, had an open mind and was willing to do a lot of hard work. That one took a lot of gumption. 

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