Has Carson Block finally overreached? Or did the heavily hyped short-seller execute the game plan exactly as it was conceived?
Last week I wrote about the downfall of Sino-Forest (SNOFF.PK), a China-based timber harvester reduced to a stump by damaging (and pretty damning) accounting allegations from Block, the Hong Kong short-seller doing business as Muddy Waters Research.
Sino-Forest was the largest company Block had targeted to date, and the one that seemingly had sealed his reputation. Before famous hedge-fund landshark John Paulson sold his entire Sino-Forest stake—at a $720 million loss—Block and Muddy Waters were routinely referred to as “little known.”
Afterwards, having taken lunch money from the biggest bully on the block, Block was quickly promoted in the media to “noted.”
Demoralized investors in other beaten-down Chinese stocks quaked at the thought that their ugly duckling would be next. My bird, the Chinese chip maker Spreadtrum (SPRD), spiraled lower with the rest of the mud-splattered flock, but otherwise didn’t stand out.
An upstart fabless chip designer (look, Ma, no plants), it’s been busy taking share from a Taiwanese rival in the market for the cheap guts of cut-rate phones. (The iPhone is nice and all, but much of China and the emerging world talks on simple handsets peddled by scores of anonymous manufacturers.)
Spreadtrum has curried favor with Beijing as a symbol of China’s growing technological expertise, and also passed muster with Silver Lake Partners, a leading US venture-capital firm that bought a modest stake a year ago.
It operates in an industry far more transparent than the remote Chinese forests that were Sino-Forest’s main assets. Until last week, Spreadtrum seemed to be suffering from nothing worse than guilt by association.
But the stock kept going down, even after the company unveiled a buyback equal to 15% of the shares outstanding. Short interest doubled since the beginning of the month, and options traders started loading up on single-digit July puts—this for a stock trading in the teens and covered by a dozen analysts collectively convinced that the shares are worth more than $25.
Bearish posters on the stock’s Yahoo message board used put buying to incite more fear.
“When somebody tells you they will be bombing your village beginning tomorrow it might be appropriate to take a brief holiday,” warned one. “I have no idea if this is a great company or a disaster, but I do know that the name is in someone's bombsights and they are heading this way.”
The gunship adorned with Block’s pirate flag showed up the next day, in the guise of an open letter from Block to Spreadtrum chairman Leo Li. In it, Block informed Li that he had initiated a short position in Spreadtrum shares, because of “a high risk of material misstatement in the reported financials.”
The stock had run up from a low of 73 cents in late 2008 (shortly before Li took over) to a high of $24 this past February. By Tuesday, that was down to $13 or so.
And then Block released his open letter with its ominous talk of misstatements and pointed questions, sending the shares into freefall. Within 30 minutes, the stock was down 33% on the day, to $8 and change, on record volume. It was another Chinese chainsaw massacre, another fraud exposed.
Only a funny thing happened on the way to the morgue. When people actually managed to get through to the jammed Muddy Waters Web site and download the supposed smoking gun, all they found was insinuations and questions borne of a fishing expedition.
There was no evidence of wrongdoing presented, and none of the claimed gumshoe work Block had deployed to devastating effect against his other targets. The gunship proved to be armed with nothing more lethal than propaganda leaflets.
So, almost immediately after cratering, the stock began a relentless rise that pushed it back into the green within 90 minutes. And though it finished the day 3.5% lower—on earth-shattering volume—a lot of the fear seemed to have been washed away.
Before Wednesday’s market open in New York, the company held a conference call, dismissed the allegations (just like several supportive analysts had done a day earlier), and instituted a modest dividend while sticking with the buyback pledge. The stock bounced 10% in the ensuing session.
From Tuesday’s low to Wednesday’s early-morning high, it rose 68%.
Maybe that was the plan all along. Muddy Waters has been accused by one analyst of “pre-marketing” its takedown of Sino-Forest to hedge funds, and knowledge of its impending attack against that stock appears to have leaked into the market well in advance—as was the case with Spreadtrum.
Muddy Waters hasn’t bothered to deny this claim, nor would it be illegal for it to share its opinions with whoever it chooses. But its public targeting of a company on which it clearly doesn’t have the goods should be a red flag.
By Wednesday, Block was lamely claiming that the Spreadtrum expose-that-wasn’t had been intended “to give investors a look at our internal process, and let them see how we approach the earlier stages of our research.” Apparently, that’s done by querying the CEO via an open letter.
By Thursday, Block was reportedly traveling and incommunicado for two weeks, after attracting the attention of Hong Kong regulators.
Everyone has the right to ask pertinent questions, and to buy, sell, or short as one sees fit. On the other hand, lighting matches in a tinder-dry forest—and then claiming you were only trying to see better—smacks of duplicity.
Carson Block is what happens when the initial conceit that “they are just like us” swings to the opposite and equally unrealistic extreme of “they are all crooks and cheaters.” His Web site preys on the cultural distrust. Only Muddy Waters can decipher the alien Chinese brain for the American rubes, it seems to argue.
Investing in little-known companies half a world away was never going to be a walk in the park. China’s a tough and amoral place to do business.
But it’s produced plenty of legitimately successful companies, from Baidu.com (BIDU), to Ctrip (CTRP), to PetroChina (PTR). I believe Spreadtrum will prove another such long-term investment, even more so since Block aired his agenda.
Disclosure: As mentioned earlier, I remain long Spreadtrum shares.