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I’ve been investing my own capital in equities for quite a while now. I was perfectly content to invest through a variety of mutual funds until I actually started talking to investment counselors who were providing me advice on which funds to buy. After a few conversations, I realized that these “experts” knew less than I did about investing and that was scary because I was fully aware that I was just a dumb kid. I’m still one of those two things.

When I realized that my investment counselors weren’t so sharp I started looking into the funds that they were recommending. At which point I realized that most of the professional fund managers weren’t adding much value either. Most funds that I looked at were basically closet index funds with a hefty fee attached to them. Job preservation investing, not highest risk adjusted return investing.

So I stopped giving my hard earned savings to others to grow for me and started doing it myself. And by doing so I also started learning the hard way from my own mistakes.

One mistake that I learned early that I have never repeated again is holding on to a stock for too long once news breaks that raises questions about the credibility of management. Over the past year, I have followed the short selling recommendations of the controversial Carson Block of Muddy Waters.

Now, I can’t say I’m a fan of the guy. But what can’t be disputed is that there is a lot of substance behind his claims:

- On June 28, 2010 Muddy Waters issued a strong sell on Orient Paper Inc. (ONP); at the time the stock price was $8.40, it is now $3.08.

- On November 10, 2010 Muddy Waters issued a strong sell on Rino International (OTC:RINO); at the time it was trading at $14, it has been delisted and is a zero.

- On February 3, 2011 Muddy Waters issued a strong sell on China MediaExpress (OTCPK:CCME); at the time the stock price $23, it now trades on the pink sheets for 3 dimes and a nickel.

- On April 4, 2011 Muddy Waters issued a strong sell on Duoyuan Global Water (DGW); at the time the stock price was $6, the stock hasn’t traded since April 19

- On June 2, 2011 Muddy Waters issued a strong sell on Sino-Forest (OTC:SNOFF); at the time the stock price was $20, today it is $1.16 on the pink sheets and halted in Toronto.

Take your time and go through that list. A person could have made a lot of money following the advice of Muddy Waters.

And in my experience it isn’t just Muddy Waters who gets it right. When there are serious accusations about a company you are invested in being a fraud, the vast majority of the time there is merit to those accusations. Where there is smoke there is fire and the right move is to sell as quickly as possible and protect your capital. It is hard to admit that you have been duped, but swallow your pride and do it.

I’m talking from personal experience. In 2001 I owned shares in a company called ACLN Ltd. It traded on the NYSE and appeared to represent a great value proposition. The company was barely valued at more than the cash on its balance sheet and that balance sheet had been audited by BDO Dunwoody which is not a Mom and Pop accounting firm.

Allegations of fraud were brought forward in the media undoubtedly supplied by short sellers. With an accounting background myself, I figured that there was no way that an auditor could screw up the audit of the cash balances on the company balance sheet, so I talked myself into believing that it was impossible for these allegations to be true. In fact, I would argue with anyone who said otherwise. How could a company with cash balances that have been verified by auditors not at least be worth the same amount as that cash ?

Long story short, the company was a fraud, the auditors clearly incompetent (at best) and the stock a zero. A painful lesson that I haven’t forgotten.

While these short sellers who uncover these frauds aren’t always the most likable of sorts, they do a lot of due diligence, generally a lot more than you find on the long side of trades. It isn’t just novice investors who get fooled, John Paulson was a large shareholder of Sino-Forest when the Muddy Waters report came out. He has more money at his disposal to investigate investment ideas than some countries do.

Do yourself a favor and learn from my mistake and from Sino-Forest and the companies above. Play the percentages if a company you own suddenly is outed as a fraud and sell first, ask questions later.

Successful investing is all about avoiding mistakes. And the best way to avoid mistakes is to learn about which potential mistakes exist. And the best way in this case is to learn from the mistakes of others, not by making your own.

Source: Sino-Forest Teaches Us A Valuable Lesson