Muddy waters spark more business
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Shanghai Daily, July 22, 2011
Chinese ancient wisdom says muddy waters make it easier to catch fish, and centuries later, probably nobody understands the Oriental proverb more than American Carson Block.
The 34-year-old graduate of the University of Southern California runs investment research firm Muddy Waters and the fish he has been catching are big Chinese ones.
The goal of his company's website, in his words, is to "see through appearances to a Chinese company's true worth," or in other words, to "see through opacity that can create opportunities to make money."
And that's just what he has been doing.
The Hong Kong-registered research firm, which has no fixed office or employees, has become one of the biggest detractors of Chinese companies listed in overseas markets, and its research reports are causing the share prices of those companies to tumble.
In the process, Block and his followers are raking in big money by shorting companies put in the crosshairs by Muddy Waters research.
New York-listed Chinese firm Orient Paper became the first fish hooked after Block, together with his business partner Sean Regan, released their first investment research report on June 28, 2010 - the same day Muddy Waters was registered as a firm.
Shares of the Hebei-based paper maker closed at US$8.33 that day before the bombshell hit. The Muddy Waters report strongly suggested investors sell Orient's stock, claiming that the company's sole intent in listing in the United States was "a fraud" bent on raising and misappropriating millions of dollars.
Muddy Waters forecast that the share price could eventually fall below US$1. The next day, the shares dived 13.2 percent to US$7.23.
Although the two sides have been in an escalating verbal fight ever since, Oriental has been struggling. Its shares closed at US$4.10 on Wednesday, more than a year after the release of Muddy Waters' first report.
Encouraged by what it apparently viewed as a good day's fishing, Muddy Waters turned its attention to more Chinese firms whose affairs it considered "murky" and landed on the world's largest reverse takeover.
Advice to sell
On November 10 last year, Block initiated coverage on RINO International Corp with a strong "sell" rating and a US$2.45 price target.
Block said the company, which claimed to be China's leading environmental equipment maker, cooked its books to show that revenue jumped to US$193 million from just under US$15 million. Muddy Waters alleged that RINO, in reality, was diverting tens of millions of dollars to its own use.
RINO plunged 15 percent to US$13.18 on day the report was issued. The company was subsequently delisted by Nasdaq on December 9 after failing to provide adequate information regarding the accounting allegations.
Trading of RINO stock resumed on the OTC Pink Limited market in April. The shares closed at 52 US cents on Wednesday.
China MediaExpress Holdings and Duoyuan Global Water Inc were next in Muddy Waters' line of fire. Both were delisted from Nasdaq earlier this year, after investigations were initiated following Block's reports.
In June in a report that drew international attention, Muddy Waters took aim at the accounting practices of Canadian-listed Sino-Forest, whose shares promptly fell from C$18.21 (US$19) to C$14.46. Block made a bundle shorting the stock in the lead-up to release of the report.
The share price of Sino-Forest plunged more than 86 percent in June alone due to the market impact caused by Block's reports.
So how exactly does a tiny operation like Muddy Waters manage to rattle capital markets to such an extent when larger, more prestigious Western investment researchers seem to be turning a blind eye to the risk posed by some Chinese companies?
Block explained on his company's website that Western investors and their regulatory systems are "inherently unprepared for muddy water environments."
Mandarin advantage
Harvard-educated analysts with Chinese heritage, who are hired by many world-class investment houses on the assumption that their Chinese blood gives them special insights, have little more in common with Chinese company managers than a small investor, Block claimed.
As a result, many sub-par Chinese companies find ways to game the system and trade at inflated values, he said.
If not knowing China is the biggest weakness of these New York-based analysts, knowing China may be the biggest advantage the Mandarin-speaking Block brings to risk assessment.
The finance and law major, who studied Chinese in university, came to Shanghai in 2005 and worked at local branch of Jones Day, a US-based law firm, for 15 months. In 2007, he opened a private storage house here called Love Box Self Storage, which Block said provided him with the valuable experience to "being down in the trenches of doing business in China."
Still, plenty of foreign entrepreneurs in China have gotten in the same trenches and not emerged as fraud busters.
Block's father Bill is the missing piece to the puzzle.
According to the Muddy Waters website, the junior Block turned his business interest to small overseas-listed Chinese companies because his father, who owns Los Angeles-based equity research firm W.A.B. Capital LLC, became interested in Chinese micro-caps in 2009. One of the companies his father was looking at was Orient Paper.
"He needed someone to do due diligence on Orient Paper," the younger Block once told reporters. So he decided to take on the task and went with Regan to visit Orient Paper's factory in Baoding in Hebei Province.
Carson Block told reporters later that when they arrived there, the first thing that greeted them was an abandoned gate and a row of dilapidated storage and dormitory.
He suggested to his father that they should short the company.
W.A.B. Capital specializes in research on small cap companies. It sells its research to a network of institutional investors and often gets paid in stocks and warrants of the companies it researches - a sort of insurance policy that aligns its interests with those of any investors who purchase stakes in the companies as a result of its research, according to W.A.B's website.
Scott Rubin, an American investor, said in an e-mail interview with Economy & Nation Weekly that he had a talk with Bill Block in February and was told that Carson Block's company has "very strong connections in China, including auditors, manufacturers, marketing and financial professionals."
Rubin, in his interview with the Guangzhou-based Chinese magazine, said the elder Block "mentioned that Muddy Waters is well-connected with many hedge funds and is inclined to short back-door listed Chinese firms like RINO."
Massive profits
The magazine cited unidentified industry insiders as saying that hedge funds short stocks after receiving Muddy Waters' research reports and then help Block drag down the share price as much as possible, which could lead to "extraordinarily huge profits" for both sides.
The waters grow murkier by the month.
Orient Paper said in a statement in January 2010 that two foreigners who claimed to be representatives from W.A.B Capital, visited the company and requested "a large amount of cash or stocks in the company" in exchange for a positive research report.
The company said it declined the request.
The allegation was backed up by Rick Pearson, another American investor and a contributor to TheStreet Inc, a US-based leading digital financial media company.
Pearson said in an opinion piece posted on The Street website that he visited Orient Paper's facilities in China at the same time the two Muddy Waters researchers were there. The company claimed they had pitched for money in return for a "strong buy" recommendation.
"It is my opinion that the purpose of the visit was not to find out information on the company but rather to simply 'check the box' and say that they had visited the company to lend credibility to their report," Pearson wrote.
Pearson was long on Orient Paper stock at the time of the article's publication on July 1.
Carson Block denied the allegation of any wrongdoing, but he did say that the original plan was to offer W.A.B. Capital's standard research services to Orient Paper.
Bill Block, meanwhile, continues to stand behind his son, saying he is proud of Carson's achievement in protecting the interests of investors, even as his own personal profile has grown.
"Let's put it this way," Block said of his son, "he's risen above obscurity."
It was the Sino-Forest issue that really catapulted Muddy Waters to worldwide attention because some pretty heavyweight institutional investors had their money in the company.
Sino-Forest, one of China's leading commercial forest plantation operators, went public in Toronto in 1995 and attracted some big Wall Street money. Among the investors was John A. Paulson, founder of hedge fund Paulson & Co, which made billions during the financial crisis by placing bets against the subprime mortgage market.
Paulson, who sold his entire Sino-Forest stake in June after the Muddy Waters report collapsed the company's worth, is estimated to have racked up a paper loss of more than US$700 million on the investment.
Part of the money went into the pocket of Block, who had shorted the stock and who cited the famous line from the movie "Wall Street" on his website: "Money itself isn't lost or made; it's simply transferred from one perception to another. Like magic."
Corporate fraud ninja
It is unclear how much Block has gained from shorting Chinese company shares. Going short means that an investor bets a share price will fall, by borrowing the shares at a higher price and then repaying the "debt" with stock bought at a lower price.
That means the more the share prices of the Chinese firms fall, the more Block gains.
Block has been described by the US media as a "corporate fraud ninja." Shorting shares is successful only if his fishing trips are. Otherwise, he stands to lose big sums.
Spreadtrum Communications Inc, the latest US-listed Chinese company targeted by Muddy Waters, struck back soon after a "sell" report was issued on June 28. The Shanghai-based firm called Muddy Waters' accusations of "misstatements" in its financial accounts "groundless."
Shares in Spreadtrum, a chip design company, slid more than 30 percent the day after Muddy Waters raised concerns about its 2010 and 2011 accounts. But then buyers returned to the shares, and by the close of trading, the stock was down only 3.5 percent.
The next three days, Spreadtrum shares rose more than 35 percent after the company held a press conference to rebut the allegations in no uncertain terms and address investor concerns.
Block admitted, in a subsequent interview with Bloomberg News, that he got it wrong with Spreadtrum.
Muddy Waters can't be legally held to account under US laws unless there's proof that the company is deliberately trying to mislead investors and force share prices lower.
Carson Block puts a clear disclaimer on the front page of every report released by Muddy Waters: Use of the company's research is at the investor's own risk because Muddy Waters, along with its clients and partners, have a short position in the stock covered in the report.
Carson Block told Barron's that he expects to make more short calls, and maybe even a few long ones, on China shares this year.
He also disclosed that he will be taking fishing trips to other emerging markets, including Latin America.
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