Short-seller Carson Block, the founder of Muddy Waters Research, spoke about how he spots his short targets at the Absolute Return Symposium in New York.
“Establishment Wall Street has never liked short-sellers,” he said at the beginning of his presentation.
“But they tolerated them so long as they abided by this gentlemanly code — ‘You can take your position, but don’t overtly try and embarrass the company. OK, we get it, you’ll talk to reporters and see if they will pick up the story, but don’t go out there and shout at the top of your lungs what’s wrong with the company.'”
That’s how you get run over, according to Block.
“Some of the best shorts are, of course, the companies where management are unethical or crooked. And the problem with shorting those companies is they will stop with nothing in order to ramp the stock on you. So it is very easy to get run over as a short-seller who’s not out there voicing his or her views.”
Block is what you would call an “activist” short-seller. He does in-depth research, takes a position, and publicly releases a report explaining his thesis. Not all of his activist short campaigns are like that. Sometimes he’ll speak about a company at a conference or just Tweet and not post a slidedeck on his website. That’s what he refers to as a “light touch” campaign.
Block is perhaps most famous for targeting Chinese companies he believes are frauds.
He’s best known for his takedown of Sino-Forest in 2011, which ultimately led hedge fund billionaire John Paulson to lose millions and eventually sell out of the stock. Sino-Forest, which Block said was overstating its timber holdings, eventually ended up filing for bankruptcy.
According to Block, Sino-Forest spent over $50 million to try to discredit his research.
“There is a lot of firepower on the other side,” Block said.
During his talk, he shared some of the things he looks for in his short targets in the following slides.
He focuses on the past, not the future.
“A hallmark of my analysis — we’re looking backward. Most of the investment industry is trying to figure out what’s going to happen in the future….what I want to do is I want to look at the information that the company has disseminated…and ask whether that information is accurately reflecting what’s really going on in the business,” Block said.
He added that he doesn’t like to short biotech companies because it’s like arguing over the existence of God.
Block also looks at the management’s behaviour.
“I’ve also thought of it as regression analysis in a way,” Block said. “Bad companies will do some very strange things from time to time and they always have an explanation. And I’ll look at that explanation and think, ‘That doesn’t make sense…is there an explanation that’s better? Are they committing fraud?…Is the company having a liquidity issue?’ I’m always trying to search for a better explanation from strange decisions the company might make.”
For his research, he’ll go through transcripts from the oldest to the newest. One red flag that tells him something might be going on is if management is constantly changing the key performance indicators by which the measure themselves.
The beginnings of a short-selling career
In 2010, Block was living in Shanghai where he managed a self-storage company.
In January 2010, Block’s dad, Bill Block, the founder of Los Angeles-based research firm WAB Capital, asked him to visit Orient Paper in the Hebei province. Block’s father analysed companies and published research.
Block told Richard Teitelbaum in the book “The Most Dangerous Trade” that he immediately noticed many red flags about the company during his visit.
For example, the conditions of the road didn’t indicate there was much truck traffic coming from the factory. There was a massive pile of used paper outside the factory valued at $5 million by the company. The factory used outdated machinery that Block characterised as “old toys.” Also, the CEO giving Block a tour of the facility couldn’t seem to answer simple questions about the business.
Afterwards, Block decided he would short the stock and publish a negative report that would go out via email. That’s how Muddy Waters Research began. On June 28, 2010, Muddy Waters initiated a strong sell on ONP. Since then, the stock has collapsed more than 84%.
Now, Orient Paper trades at about $1.28 per share.
Block recently launched a hedge fund, Muddy Waters Capital.
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