You are on page 1of 60

Muddy Waters 101

Contents
How I ended up an activist short seller.
Exploring the dysfunctions of the capital
markets.
My framework approach to short selling.
Some highlights from MWs published
research.
HOW I ENDED UP AN ACTIVIST
SHORT SELLER.
Everybody can find him or herself. Dont
kid yourself about who you are.
Life and Business Lessons
Learned
Be intellectually diverse.
Never stop learning.
Aim for mistakes, learn how to manage
risk.
Learned that to understand investing in
businesses, work in or start one!
The most valuable skill of all in business
(and life)
What Disabused Me of Naivet
RWY
ATMS
ACLN
2000 2001
Seeing behind the masks of people on
Wall St.
Final domino: the auditors and ONP.
EXPLORING THE DYSFUNCTIONS
OF THE CAPITAL MARKETS.
Auditors Not Protecting
Investors
Represent the interests of their clients the
people who hire and pay them.
A profession that rewards failure.
A profession fighting against accountability.
Level 3 fair value accounting is problematic.
Audits are not clean bills of health they do
not detect fraud.
Key audit work done by juniors.
Sino-Forests Best Friend: E&Y
the majority of the accounts receivable
arising from sales of standing timber are
realized through instructing the debtors to
settle the amounts payable on standing
timber and other liabilities denominated in
Renminbi.
Translation
95%+ of companys reported gross profit in
16 years of being public never went into
the companys bank accounts!!!
Management
Incentives are often short-term.
CEOs are largely charismatic.
The more successful the CEO, often the
less willing to be held accountable.
Andrew Fastow (ENE) won CFO
Magazine Award for Excellence in 1999.
Speaking of Andrew Fastow
Ishmael from Moby Dick:
But when a man suspects any wrong, it
sometimes happens that if he be already
involved in the matter, he insensibly strives to
cover up his suspicions even from himself. And
much this way it was with me. I said nothing
and tried to think nothing.
Boards
Symbiotic relationship with CEOs.
Insulated from negligence liability by BJR,
insulated from other liability by D&O
insurance.
Many directors view directorships as
perquisites, not responsibilities.
Independent investigations often
shambolic.
Lawyers No Evidence to
Support
Represent the interests of their clients the
people who hire and pay them.
Prestigious law firms are a surprisingly
effective fig leaf.
Great at writing indecipherable prose.
Attorney-Client privilege hides innumerable
acts of corporate wrongdoing.
[Fraud] lawyers are eternal. John
Hempton
Lawyers at their Best in
China
At least 9 painful exonerations of N.
American-listed China companies.
NQ one concession from Shearman &
Sterling: Despite the Investigation Teams extensive review of
documents and data provided by sources both within and outside
the Company, the Investigation Team could not verify that the
devices it collected and copied contained all responsive information
at the time the copies were made. On many devices, the
Investigation Team observed indications that some information might
be missing, and the Companys management and staff were unable
to provide a credible explanation for what the Investigation Team
observed.
Market Research Firms Giving
Legitimacy
Sino-Forest & Jaakko Pyry
Frost & Sullivan
NQ
Tianhe
iResearch & other examples from China
China & VIEs
China is to stock fraud as Silicon Valley is
to Technology.
Investors have become complacent once
again about the risks.
No fraudster from China has ever been
meaningfully punished for defrauding N.
American investors.
China & VIEs
ListCo
(Cayman)
WFOE
OpCo /
VIE
Chairman
100%
100%
0%
Chairman
Chairman
Relatively Easy to Identify China
Company with Fraud Risk
High DSO
Few tangible assets on balance sheet
Highly acquisitive / high capex
Outsized gross margins, growth
Unique in reliance on intermediary counterparties
Often (successfully) entering new businesses
High revenue or expense concentrations with counterparties
Unexplained cash in the VIE
Business models that dont make sense (e.g., reliance on Guanxi Fairies)
Opacity especially increasing over time
Tax preferences / rates that dont hold up
MY FRAMEWORK APPROACH
TO SHORT SELLING
MWs Secret Sauce
Multi-disciplinary: combine perspectives of
attorneys, investment professionals, accountants,
entrepreneurs, and industry specialists.
Focus on Backward Looking analysis.
If we dislike the securities, answer: Does the
market have a fundamental misunderstanding
about the company?
RAX: Investors Lost in the Word Cloud
2/1/13 6/1/13
Larry Ellison on The Cloud (2009)
RAX Took Ellisons Advice
!!
##$
#%#
$&#& $&## $&#$
!"#$ &'()*(+ *, -./*01-
$'
%$
() $&## () $&#$
!"#2 &'()*(+ *, -./*01-
RAX: 8/1/12 2/1/13
As of 2/1/13 RAX Outshone
AKAM
CEO Comparison
RAX AKAM
On the Same Panel (June 2013)
AKAM: Long Side Lesson?
Some MW Research Tactics
Initially analyze management at a distance we start
with a few years of conference call transcripts.
Home in on Risk Factors in annuals and prospectuses
often overlooked.
Pay close attention to taxes.
Flag any L2, L3 fair valued assets, negative goodwill,
other significant accounting profits.
Detailed KPI analyses.
Read SEC correspondence.
BLNX.LN: problems hiding in plain sight.
12/31/13 9/3/14
As of 1/14/14 Market Cap of
GBP 820 million
Some Yellow Flags
Autonomy spin-out, BOD (incl. Mike Lynch),
AIM-listed, accordingly light disclosure,
Analysts didnt seem to understand business, opaque
business model,
obfuscating answers on conference calls,
Changing KPI,
Initiatives disappearing without mention,
Heavy insider selling,
Primary market was US, but seemed obscure.
Alexa Research
Alexa Research
Alexa Research
Alexa Research
Non-Activist (i.e. Traditional)
Short Selling
Legendary investors experience.
Short only approaches vary from insurance to
sniper.
JC says short selling alpha is now 15%,
compared to 30% in late 1980s.
Difficult from a career perspective.
Tax disadvantaged.
My view: generally works best in truly
committed long short strategy.
Activist Short Selling
Definition.
An internet age phenomenon.
Massive firepower still on the other side.
Compliance and legal aspects.
Catalysts to a Successful
Directional Short
Earnings miss.
Debt becomes destabilizing.
Important product fails.
Media coverage.
Fraud shorts.
Ethical Dimensions to Short
Selling
Common criticisms.
Short selling is about property rights.
Counterbalance bubbles and fraud.
Some Short Traps
Pure valuation shorts.
Resource promotions and frauds.
Biotechs.
MLMs (does not necessarily apply to
HLF).
MW PUBLISHED RESEARCH
HIGHLIGHTS
ONP Red Flags
Nine Dragons Paper (a main competitor)
ONP Red Flags
ONP Red Flags
ONP Red Flags
PP&E supposedly worth $54.4 million.
(We believe PP&E overstatement at least
10x.)
Losing 7 8 of Top 10 clients each year,
and growing revenue over 60%.
Largest supplier constant a trading
company (owned by ONP chairman)
Claimed inventory turnover of 16.8x 32.5x,
versus China industry of 4x 8x.
ONP Auditors Missed
Physical capabilities of production
equipment was far from claimed output.
Lack of truck traffic and logistics operation.
Inflated capex spending.
ONP Auditors Missed
Garbage piles really worth $5 million
ONP Auditors Missed
Visible white scrap really worth $500,000?
ONP - Windup
Loeb & Loeb / Deloitte FAS
Attorney Client privileged
Denied access to facilities based solely
on analysis of accounting records.
Sino-Forest (TRE) June 2011
Almost $7 billion EV company that was a total fraud.
Was the granddaddy of N. American RTO frauds was a
complete fraud since listing in 1995.
E&Y Toronto was auditor, paid C$117.6 million to settle
class action.
Used Jakko Poyry valuation reports to confer
legitimacy.
OSC has charged company and 5 former execs w/
fraud, trial recently started.
Company filed for bankruptcy March 2012, attempts to
sell assets so far unsuccessful.
TRE Red Flags
Purported structure (use of AI) blatantly illegal in
China.
Claimed 55% gross margins for buying timber
from trading companies, and selling to trading
companies clear there was little value add.
Obscure and convoluted disclosure about the
majority of ARs being settled by having debtors
pay TREs APs.
Did not disclose identity of counterparties, and we
could not identify candidates of that size.
Churning portfolio at about 50% annually.
TRE What the Auditors Missed
Over 95% of gross profits never hit company
bank accounts.
Enormous amount of revenue and expenses
not supported by VAT / tax documentation.
Significant capital hole evident from SAIC
files.
Only legitimate supplier returned confirmation
form blank.
Never attempted to verify titles to assets.
Duoyuan Global Water (DGW)
April 2011
Real revenue less than $1 million vs.
reported $154.4 million.
Independent directors, CFO, law firm, and
auditor resigned after our report. SEC de-
listed DGW and DYP (another fraud)
DGW Red Flags
Zero WIP on two consecutive Dec. 31s.
(Corp Fin raised this as an issue)
WIP usually 20% - 40% of current orders.
Purported 80 distributors in 28 provinces,
with outsize margins.
DGW Red Flags
Two different PRC audit reports on two
visits
DGW Red Flags
DGW Auditors Missed
Adult daycare 80 hours surveillance with
no trucks.
Auditor had three clear errors:
DGW claimed to be making rent payments to
third party landlord when DGW actually
owned property,
OCF included proceeds from land sale,
OCF included repayment of loan to chairman.
Q&A

You might also like