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Crisis Talk — Carson Block, CIO of Muddy Waters: ‘If capitalism breaks, it’s capitalists who broke it’

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By Silas Brown
27 May 2020

Muddy Waters has fostered a fearsome reputation as a credible, thorough and forceful short seller whose explosive reports are a danger to anyone harbouring a stake in its intended target. Carson Block, its founder and chief investment officer, told GlobalCapital he has never been wrong about a company he’s shorted, though that doesn’t mean he’s made money from every position he has held. According to Block, monetary policies intended to stimulate markets through financial crises actually corrode them, and stifle accountability for serious failures in corporate governance.

Carson Block sharpened his teeth shorting Chinese companies with listings in the US and Canada roughly a decade ago. He was living in Shanghai in the early 2010s, having left investment banking and started a self-storage company in China, and he stumbled across a firm called Orient Paper. 

After protracted research into the Chinese paper producer, which was listed in New York at the time, he believed it had overstated its assets by at least 10 times.

Block shorted the company and released a damning report in June 2010. The paper had more of an impact than Block was expecting, and the stock dropped 55% in the days following publication.

Curiously, Block did not actually make anything from his first short. This was for two reasons: he did not have much money at the time, but also did not fully know how to trade options. But the episode gave him a taste for sniffing out corporate corruption and, ultimately, making money from it.

Muddy Waters claimed its first serious scalp in 2011 with Sino-Forest, a Toronto-listed Chinese tree plantation owner backed by American billionaire John Paulson. In a 40 page report he declared it a “multi-billion dollar Ponzi scheme” that was “committing fraud from the very beginning.”

This led to a suspension of trading and the company filing for bankruptcy protection. Five years later, the Ontario Securities Commission ruled that four senior managers, including its co-founder and former CEO Allen Chan, and Sino-Forest itself had committed fraud.

Block rails against poor corporate governance in China, taking particular umbrage at guanxi, an Eastern philosophy that credits the power of social networks, or, as Block has put it, "it’s not what you know but who you know". He says this is often used to justify mismanagement.

So damaging are his reports to a target’s share price that whole indices can be impacted by a mere whiff of Muddy Waters.

Block was due to speak at a conference in Hong Kong on June 6, 2017, and he went on Bloomberg TV the day before. The interviewer, sensing a short was to be announced the following day, asked Carson to say which company was the target. He refused, but said that it was a Hong Kong-listed stock. This pronouncement triggered a drop in the entire Hang Seng Index.

Block is not known for pulling punches. He recorded a video of himself confronting someone Block claimed was pretending to be a journalist for the Wall Street Journal in order to get a meeting with him.

At a faux awards ceremony Muddy Waters held last year, called The Fidouchies, to "honour the most egregious achievements in financial malfeasance", Block hired the American porn star who had an affair with US president Donald Trump, Stormy Daniels, to announce who won the prize for being "the regulator with the limpest dick". 

The award, incidentally, went to the US Drug Enforcement Administration.

Block set his sights on the UK last year. Scathing reports into UK-listed firms Burford Capital and NMC Health brought Muddy Waters into greater focus in European capital markets. In this interview, Block discusses the European bans on short selling, which he is predictably critical of, as well as the UK having an attractive climate for short seller activism.  

GlobalCapital: Does a pandemic, and a global knock to share prices, help or hinder the job of a short seller?

Carson Block, Muddy Waters: Intuitively a pandemic is a good thing for short sellers generally, but it turns out, maybe not. We focus on activist short selling; if a company is in our book it’s because there’s a short activist angle to it.

We are very sceptical of the world and we don’t think the right people are in charge of it. We’ve been cognisant of massive amounts of risk building up in the financial system, especially all the debt piled onto balance sheets, coupled with less liquidity as investment banks are less active dealers [than they were in the past].

By early March there was a clear disconnect between what the virus would do in terms of its spread plus the impact it will have on demand versus what equity investors seemed to be thinking. We noted a US bank survey of its institutional clients in late February in which a large majority of them did not expect a recession. We were talking to each other internally and saying the market just doesn’t get this — all of these years of ultra-stimulative monetary policy has anaesthetised equity and credit investors to risk.

So we put on a number of non-activist short positions in credit and equities and March was one of the easiest months we’ve ever had. We generated real return but didn’t have to go out and trade punches to get it.

But then you started to get responses from central banks, and now we’re back in this really strange land where asset prices just do not make sense to us. Credit costs are too low relative to risk on balance sheets, yet the cost of credit remains very low.

On the credit side, it is return-free risk and on equities there’s a disconnect between the state of the real economy and the state of markets.

And how has this affected your strategy?

We were planning on relocating our entire firm to New York City this summer with the idea of gradually growing our business into other strategies: sort of niche, boutique, high edge strategies.

But in March we began talking about how there might be a much bigger opportunity in long-short equities. I was saying that maybe valuations will get really attractive and this will be the next big buying opportunity, something I haven’t said in a long time.

We really started to think that this could be quite transformational to our business. But then along came the Federal Reserve and the ECB and every other central bank in tow, and now we’re looking at the equities and saying God, once again we’re back to the land where things don’t make sense and they really don’t make sense.

I have gone from more prosaic concerns to much bigger societal and systemic ones, like do capital markets perform a useful function in society anymore? Their role is to allocate capital efficiently but we’re so uncomfortable with them doing that since the financial crisis. What we have seen since the financial crisis is there is no political willingness to dial back emergency measures, even a decade after they were imposed.

If you look at this through that framework, this is really dangerous. The Fed is now going to be buying bond ETFs — I mean, what the fuck? People have said for years that bond ETFs were risky and there was not enough liquidity in the underlying.

I now spend more time thinking ‘what is the point of all of this then, honestly?’. I also wonder about the resentment the 90-odd percent of Americans who don’t own financial assets will have when the dust settles. If equity markets have lofty valuations but everybody else has taken a major hit — including a third of the workforce unemployed — what’s that going to do from a political perspective?

Two sentences keep going through my mind:

Capitalism is at risk. But if capitalism breaks, it’s capitalists who broke it.

Capitalism is not supposed to work this way. I’m not advocating for austerity and for no emergency monetary policies but what really gets under my skin is that we went into 2020 still having emergency policies in effect from the last crisis. Now the central banks are getting more creative and when I look at this, and the distortion to asset prices, it makes me think the future of markets is maybe one of public utility but it is not about allocating capital efficiently.

There was a ban on short selling in several European countries — like Austria, Belgium, France, Greece and Spain. What’s your position on banning short selling?

I thought it was a solution in search of a problem at best and, at worst, it exacerbated the fall in stock prices.

There’s a few things to say. The Fed’s research into the last crisis on EU short bans as well as US bans on short selling financials concluded it did not impact stock prices — so it wasn’t positive or negative in that sense — but it did impact liquidity and trading costs.

We’re in an environment where liquidity is the big issue. You don’t want market panics and therefore a lack of liquidity, so when European countries reimposed the short ban it was really dangerous, and I think those countries hurt their markets. Investors want to seek out real markets and banning short selling makes you look like a non-market. In fact, it’s interesting that Germany didn’t impose a short ban. Perhaps it was because the Wirecard debacle was still in their minds.

Does your reputation precede you? Presumably you keep your name out of the share borrowing but there are a series of brokers that must know who you are when they’re asking to borrow shares on your behalf. If I was an institutional investor and I found out Muddy Waters was trying to borrow my shares I would say no and perhaps question whether I should own the shares in the first place.

Where we’re active, there isn’t really a capability to directly borrow from a security lender.

We go to a counterparty who is facing a counterparty to the lender and our counterparties are not supposed to say they are borrowing on behalf of Muddy Waters.

Have you ever been wrong about a company you’ve shorted?

The answer to your question is going to come off poorly at first, but the answer is no. This sounds like a bold statement. What non-activist short sellers do is sort of short melting ice cubes.

What we do as short activists is research the past. We ask three questions: the information the company releases to the market – is it materially correct? Is it accurate? If it's not, we’re interested.

Then, is the information materially complete? This question is all about lies of omission.

Third question: is the market misunderstanding the information the company’s putting out?

So what we do is go back and figure out what really happened; what the company’s not telling you and how they’re manipulating perceptions.

Then we lay it out for investors to play it out.

But this thesis is actually not a good non-activist short thesis. If you were to short a fraud as a non-activist, you’d lose a lot of money before you made money. These days, you need to be an activist and say it is a fraud.

But to return to your question, it’s hard to be wrong when researching the past, it’s hard to be wrong about facts.

When people talk about being right or wrong in investing, it’s usually the stock going up in the future or down. We steer clear of those pronouncements. What I hope you understand by now is I don’t have faith in markets valuing stocks efficiently.

But not every company we’ve said we’re short has gone down in value. In fact, some have absolutely ripped. For example, our work on American Tower was some of the best research we ever did but that’s a stock whose investors don’t care.

Are there times when investors haven’t cared? Yes, absolutely, but it’s a minority of times.

We’re a group of naturally sceptical and cynical people but one of the things that deepens the cynicism is when we’re looking at a company that has problems and we think, you know what, nobody will care, so it’s not an actionable thesis.

You mentioned Wirecard, the German fintech company, earlier. What's your position on Germany and its regulators, companies and financial markets? 

I’ve taken to calling Frankfurt the “Moscow on the Main [river]”. There’s a deliberate willingness to look the other way to market transgressions from companies, as long as they are employers in the country.

The rest of the world views Germany as very law abiding, but high trust environments often foster some of the greatest misbehaviours. There’s an assumption you can trust everyone.

It’s fertile ground to do the wrong thing as nobody’s going to question it. When Germany acted to protect Wirecard, that’s hardcore stuff — something that China or Russia would do, and I don’t think I’m being hyperbolic.

US investors have lost their way and are way too tolerant of this type of behaviour, too.  I have a decent amount of respect for the UK’s focus on market regulation and governance. It’s still more like an old boys club than the US, and there are a lot of people who don’t want to rock the boat as they went to the same school as this chap and what have you. But there’s a real value placed on dissenting voices.

(Wirecard, when asked by GlobalCapital about Block's position, replied: "that's a statement we can't understand. In our view, the regulator BaFin in Germany takes much more massive action against individual market participants than the FCA in the UK. How many convictions has the FCA obtained against market participants in the past 10 years?")

You shorted two UK-listed firms in 2019, Burford Capital and NMC Health. Is there anything specific to the UK stock markets that make it fertile ground for a short seller? 

It’s not that the UK has a greater share of problematic companies as a percentage of its capitalisation. I’m actually complimentary about the UK in several respects and it’s a good market for what we do.

There are problematic companies everywhere but in the UK there is less tolerance for corporate shenanigans and misleading accounting. This may be to do with the Carillion scandal but I feel like the UK, based on engagements with investors and the media there, has a willingness to listen to sceptics and there’s more indignation about devious practices.

How spoilt for choice are you, when you look through the listings across the world? Are there companies that you simply haven’t got round to shorting? Is there an abundance of companies out there to short?

It’s tough to compare us to other short sellers as we don’t do fundamental based short selling, apart from March which was an exception. Most of the positions we put on in March were companies that we were suspicious of beforehand but that didn’t make the cut for short activism.

Our bread and butter is looking for companies with some element of deception, misrepresentation, outright lying or fraud by management. That somewhat correlates to bull markets.

We were eleven years in and there were so many corporate excesses. I saw 2012-2019 as an era with little opportunity for real growth, so company managements wanted to fake growth. There was value-destructive M&A and then playing accounting games to make it look value-accretive. All the while, top managers were getting very wealthy.

Managements were doing things that maybe weren’t illegal but were definitely unethical in terms of their reporting, but it was greatly rewarding to them and long investors were cheering them on. The environment became really toxic from a governance, transparency and reporting perspective. We went into 2020 thinking there was no shortage of excess committed by management across the world.

The flip side was this, however. The bar for what investors cared about in terms of a short activist thesis was getting higher and higher. Each year it became harder to get people to care about a company hollowing itself out.

In March, we began wondering if companies committing these excesses will use coronavirus as an excuse to wipe the slate clean. But then there was April and May and everybody became coked up metaphorically in the financial markets, or on angel dust or who knows what analogical drugs — I haven’t seen this before, but it’s some cocktail of narcotics.

Now, I’m not sure how much people care about risk. The lesson has been reinforced that if everybody makes a big enough mistake, then it’s not a mistake. We don’t know whether these valuations are a permanent state of affairs or it’s just like Looney Toons with the coyote off the cliff: all he has to do is look down and realise he’s off the cliff and then he falls.

Which are the countries where corporate governance is strong — the laws and the accounting standards, culture, education or training are better and the way they behave less prone to fraud? Are there cities on a hill? In essence, can you create a climate where fraud doesn’t happen and short selling is therefore less likely to exist?

At the risk of sounding like a blowhard, the answer is no but it’s a function of the times.

As I said earlier, monetary policies strive to stimulate asset prices which have led to a corrosive environment. This is most in display in the US market, the most developed and liquid market in the world.

I look at Japan and it has abysmal governance, and I don’t just mean they won’t listen to American activists who say you need to pay dividends. When I look at Japanese corporates there’s so much fraud, but I mean it’s a strange brand of fraud, in that it’s often not for self-enrichment but rather to protect the company. The Olympus scandal, for example, was not atypical.

A lot of companies in Japan have massive losses and they cover it up. Then you become the CEO, and they open up the books to you and, you know, do you want to be the person who exposes it and cuts off credit and lays off a bunch of workers? What do you want to do with it? Japan has horrible governance and is the second most liquid market in the world. You have to remember, Japan began this asset stimulus long before any other market did.

I think there’s a correlation between central bank influence on asset prices and corporate corrosion.

You have strong views on Chinese companies and I’m interested in what you think about other investors who buy US-listed Chinese stocks. Do you think investors simply disagree with you and believe their figures?

These companies report whatever they want to report for the most part.

I think you can classify outside investors in Chinese companies in two buckets: investors who are in on the joke and investors who aren’t. The smart money is in on the joke and they know that US-listed Chinese companies are frauds. But they think it’s a good thing, as if it's a fraud it is not going to miss their numbers.

The only time when these guys get punished is when one of these China frauds realises they have to start looking human every now and then and have some disappointment built into their numbers. So the game there for smart money is to have good relationships with company insiders who can hint to you that they are about to look human.

But the dumb money just thinks they’re reporting accurately until proven otherwise, and they’re not in on the joke. This is painful for someone like me — watching dumb money make money but for the wrong reasons. I’d have more respect if they understood these companies make it up. But when people start to speak about these numbers as if they’re real numbers, I’d rather go look at a drywall catalogue than have that conversation.


By Silas Brown
27 May 2020