Carson Block talks about China's muddy waters

Carson Block, the founder of Muddy Waters Research, is moving markets these days. Sino-Forest shares, for example, have plunged 85% since Block levelled fraud allegations against the company on June 2. He has also questioned the financial statements of China MediaExpress Holdings and Rino International Corp, to name a few of the firms he’s honed in on. He has primarily focused on companies that use reverse listings or reverse takeovers (RTOs) — a way of obtaining a listing without going through an initial public offering (IPO) by merging with an already-listed shell company. We sit down and talk to him about these companies and China’s stockmarket.

So far, Muddy Waters has focused largely on Chinese companies that have used reverse listings. But the SEC is cracking down on them and the number of companies that have used reverse listings this year has dropped. So do you think your well is drying up?
I think the issue of whether a company is an RTO is a bit overblown. There are IPOs that have slipped through the cracks as well. I’m not concerned about the well drying up — if that happens, the markets will be safer, which is a positive outcome.

After visiting Orient Paper, you wrote a scathing report questioning their accounting, and said of it: “The funniest thing was they had a large heap of scrap cardboard. They listed this on the books as raw material worth millions of dollars.” Would you say that’s the case for many of these companies — the “facts” are just stretched truth.
There’s usually a kernel of truth to these frauds — after all, they need to at least be able to put on a show for investors and auditors. We commonly see inflated capital expenditures — the target will acquire assets, but mark them up in order to divert funds. But they’ll usually have assets to show for the purchase. Keep in mind that one lie needs a hundred to cover up, so once you start pressing a company on its lies, you’ll get a lot more in return.

Your research has been described as “rumour mongering”, “reckless” and “stretching the truth”. How do you counter that?
By being right. I’ve heard the same thing every single time, save for Duoyuan Global Water, which had practically filed with the SEC to state that it’s a fraud. It’s just a fact of life if you’re publishing short-side research — you’re fighting against tremendous vested interests. You can’t do this if you have thin skin.

And how do you respond to the criticism that as a short seller you have a vested interest in seeing the stocks dive?
I absolutely do, which is why I disclose on the front page of the reports that I’m short. However, my conflict is much clearer than that of the analyst at an investment bank. How much of her bonus is related to investment banking business from the company? Investors have no way of knowing. Our model of marrying prop trading to research is one of only two that work economically — the other model of course is marrying banking to research. I think that if banks had to put their own capital behind their recommendations, we’d see a more sober approach to research.

Have you ever gone long on a Chinese stock? And, if not, can you imagine any that are worth it?
I have, but not in a while. It’s our policy not to comment on names we haven’t published on.

Would you say Chinese companies listed in Hong Kong are more likely to be “cleaner” or less fraudulent?
Yes, I believe that Hong Kong-listed companies are less fraudulent because it’s easier for Hong Kong investors, compared to US investors, to get to the truth. This is a function of knowing the language, culture and being much closer geographically.

Given the Muddy Waters name, and the proverb from which it springs [muddy waters make it easy to catch fish], will you remain only focused on Chinese companies? Or do you view all emerging markets stocks, particularly those that use reverse mergers as a means for listing, likely to be suspect?
I don’t anticipate that we’ll only focus on China, nor do I anticipate that we’ll only focus on shorts. It’s clear to me that much of the investment industry functions without reading company filings, and I think that presents opportunities for focused research shops that take the time to do their homework — albeit with a healthy dose of scepticism.