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Making Money Shorting US Listed Chinese Frauds

March 17, 2011 | About:

The easiest way I’ve discovered to make money in the stock market in the past year is to wait for Muddy Waters Research to issue a sell report on a US Listed Chinese company that they believe is fraudulent and then take a short position.

I’ve seen two reports so far from them and they both turned out to be bang on.

Unfortunately for me, I didn’t take a position in either company. But in preparation for the next report from Muddy Waters I’d like to learn more about them so that I can decide whether I should be willing to act on their advice.

Here is a recent interview that the founder of Muddy Waters did with Barron’s:

Carson Block has spent the past five years seeking his fortune in China. With some Mandarin under his belt, he practiced law for a year, conducted research for hedge funds and for his father, a U.S. investor, and even started a self-storage venture. But Block, 34, seems to have hit his stride with Muddy Waters Research, an online service he launched in June 2010 to expose what he describes as misstatements and fraud at small Chinese companies trading in the U.S.

Beware This Chinese Export," Aug. 30, 2010), and the Securities and Exchange Commission now is investigating possible abuses in this market.

Orient Paper (ONP) had overstated revenue and misappropriated funds, investors lambasted his tactics and credibility, and the company disputed his findings. Undaunted, he has since issued negative reports on two more Chinese companies.

Investors who sold shares of these companies short after each report was published have reaped double-digit returns. RINO International (RINO), the subject of Block's second report, has admitted to some of the irregularities Muddy Waters cited. Its stock was delisted last fall.

During a recent visit to New York, Block met with Barron's to discuss his recommendations and the outlook for the reverse-merger market.

Barron's: In a sentence, what do you do?

Block: I am exposing what I believe are substantial frauds before they suck up more money from investors.

Why did you decide to work in China, and eventually focus on Chinese reverse-merger stocks?

At the outset of law school, I didn't think I would practice for one day. I ended up enjoying law school so much that I decided it would make me a better business person, a better entrepreneur. After law school in 2005, I went to China because I figured it would offer me more entrepreneurial opportunities. I chose Shanghai because I thought the post-legal opportunities would be better. I came across a stock that was a substantial fraud. It happened to be a reverse merger, and that is how the whole Muddy Waters saga started.

How do you define fraud?

I am exposing companies in which less than 50% of their claimed revenue actually exists. That is well beyond the realm of mistake. Fraud is a willful, material deception [entered into] for the sake of a theft. This is not just aggressive accounting. If a company is doing $100 million a year in revenue, claiming it is a manufacturer but in actuality is outsourcing production, that's also a form of fraud. And that may indicate profit margins may be different than what the company is claiming.

What we are talking about here is egregiously incorrect statements about the business, like multiplying the revenue by a factor of two or more in order to raise money from shareholders, much of which will somehow be stolen by management. Or, in certain cases, the fraud will support artificially inflated stock prices that management will take advantage of in selling their stock.

Here is the rest of the article:


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Rating: 3.0/5 (6 votes)


Superguru - 6 years ago    Report SPAM
What if we short "Chinese reverse-merger stocks" as a basket?
Paulwitt - 6 years ago    Report SPAM
I have two thumbs up for the book " Reverse Mergers" by David N. Feldman, the second edition, published by Bloomberg. I read through this book in three days, in comparison to the three weeks for the first book I reviewed; I hope that means something.

For those who don't know, a reverse merger is a technique to have companies go public without going through a formal IPO. Typically, a private company finds a public company as a shell and performs a merger, in which the shell company preserves and the private company morphs into a public company. Typically a small scale fund raising took place before, at or after the going public event.

In fact, the New York Stock Exchange (
NYX) went public this way by merging into Archipelago. Other famous examples include Texas Instruments ( TXI), Jamba Juice ( JMBA), Berkshire Hathaway ( BRK.A), Blockbuster ( BBI) and etc. The majority of the reverse mergers are micro or small companies in recent years though, and about 200 revere mergers closed each year since 2004 The above is from the Seeking Alpha website and the article is written by Chimin Sang.

*So go ahead and short the basket!
Rncarpio - 6 years ago    Report SPAM
Most of these Chinese stocks already have tremendous short interest. I toyed with the idea of shorting a couple but was unable to get a borrow - I'll leave this to the pros.
Paulwitt - 6 years ago    Report SPAM
I toyed with the idea of shorting a couple but was unable to get a borrow

That reminds me of naked short selling a few years ago. It's amazing that naked short selling was legal up to 2008. And no uptick rule. That probably contributed to the meltdown.

From Wikipedia:

Naked short selling has been illegal in the United States since 2008, as well as some other jurisdictions, as a method of driving down share prices

Mark_F - 6 years ago    Report SPAM
There are some important concerns about Carson Block. Be sure to read http://seekingalpha.com/article/219172-orient-paper-and-the-unfortunate-shady-corners-of-wall-street before deciding what action to take.

Noblepaladin - 6 years ago    Report SPAM
Muddy Waters was wrong about ONP, which was cleared by Deloitte and had their recent 10K verified by BDO (you can bet that BDO performed a very strict audit given the allegations that went around since their last audit). However, the share price is still around 52 week lows.

The problem with the strategy is that Muddy Waters is clearly working for someone. 20-30% of the float gets shorted before they appear. In CCME's case, as much as 50% of outstanding float got shorted. The Muddy Waters reports look low quality, full of innuendo and unverifiable facts such as "an expert told me" or "we talked to a sales rep". Who knows if they did or if they fabricated it all? Even though Muddy Waters happened to pick out some frauds, the claims in their reports are pretty outrageous and easily discredited. However, it doesn't change the fact that the company is committing fraud on something else. The strategy is to attack with a shotgun approach when they think there is one thing wrong. Claim that everything is wrong to draw attention.

I believe that Muddy Waters do not select companies at random. They work with big money hedge funds that short tens of millions of dollars at a time. Someone very smart with a lot of resources are calling the targets. My theory is that there is inside information being used to select targets. In CCME's case, their audit had problems long before the auditor resigned. If you look at the resignation letters, Deloitte already refused to sign off on the 10K at the beginning of March, meaning they must have had problems a month or two before then (such as in February when Citron and Muddy Waters hit).

A convenient way to mask insider trading is to have a "research firm" issue a public report. The hedge funds can claim they read the public report, which does not contain the inside information (e.g. Deloitte won't sign CCME's 10K), and then acted on the report. The report is designed to look bad/fake, so shareholders won't dump their shares. In fact, they may buy more thinking that once the allegations clear, the stock would go back up to pre-allegation levels. Many people I know brought CCME after the Muddy Waters report came out because the report looked so fake. This allows short hedge funds to pile in their shorts because the new investors betting against Muddy Waters is providing buyers on the long side. I know, sounds like conspiracy theory. However, it is not hard to do something like this, and I wouldn't be surprised at all if it is true.

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