Reviewing Due Diligence Procedures: Learning From Muddy Waters

by: Ricard

“The [investor] should expect to obtain a higher than standard yield on [his/her investments]…in repayment not for the assumption of special risk, but for the effort required to satisfy himself of the soundness of the issue." Pg. 103, Security Analysis, 1st Edition by Graham/Dodd

As a value investor, I have the peculiar habit of running into burning theaters when others are running in the opposite direction. Over my 10+ years of investing, I’ve learned that it is oftentimes safer and more prudent to wait until after the flames have stopped burning, and while the body count is being assessed, to then capitalize on an opportunity.

Given the state of Chinese stocks today and with such interesting prognostications of doom from esteemed journals (emphasis mine): “Chinese stocks are flashing warning signs. The Shanghai index has fallen 30pc since May. It is off 60pc from its peak in 2008, almost as much in real terms as Wall Street from 1929 to 1933….”

…this investor believes that this particular theater has stopped burning, and that the body count is still far from certain. It’s also no coincidence that I cited Graham and Dodd at the beginning of this post - they published Security Analysis in 1934, and in marked contrast to the apocalyptic tone of Ambrose Evans Pritchard above, Graham and Dodd experienced a dramatic change of fortune shortly afterwards:

Click to enlarge

They were able to see the value proposition inherent in the trough of a major decline and capitalized on it.

Graham and Dodd also found rampant fraud in the system during their time. Indeed Security Analysis is usually cited as the impetus for corporations to produce cash flow statements in order to reduce the likelihood of misleading earnings reports. Today, the allegations of fraud from firms such as Muddy Waters have pushed the limits of fraud off the balance sheet and into reality itself. What is striking about these allegations is the depth of the fraud and the parties that failed to uncover it – make no mistake, these allegations, if true, strike (again) at the very heart of the integrity of Wall Street.

I believe the implications stretch far beyond this sector and indeed serve to remind all investors that due diligence is every person’s responsibility, and no one can do it for you. This post aims to review due diligence procedures to minimize the risk for investors braving this sector, as well as to serve others in the form of a timely reminder of the importance of thorough due diligence.

Comparing notes

I found two excellent posts (here and here) pertaining to due diligence on Seeking Alpha – both highlight procedures most retail investors typically follow once convinced of the validity of an investment thesis. Michael J. Ray’s article highlights the process of finding ideas, looking over SEC reports, and then performing consistent follow-up on events surrounding your investment (in his case biotech). Jiang Zhang’s article was published shortly after the Muddy Waters allegations against Sino Forest went public; he provides an excellent critique of a due diligence list published by Investors’ Business Daily.

What I found interesting about the list was that it was essentially an endorsement of trust for Wall Street’s most hallowed institutions; Jiang Zhang’s commentary essentially destroys this endorsement, citing several Chinese firms as examples of the irrelevance of Wall Street institutions to the due diligence process. However, Jiang Zhang does not offer investors a solution, a new checklist upon which investors can rely to derive comfort and conviction for their holdings – this post aims to provide that checklist.

I found another approach to due diligence in the Muddy Waters reports themselves. As an individual investor, I am simply unable to match the comprehensive nature of the investigations the firm conducted on its victims; however, I can fully respect their process – it is almost picture perfect “scuttlebutt” from Philip Fisher’s book Common Stocks and Uncommon Profits. It involves not only all of the due diligence procedures that individual investors like Michael J. Ray and I follow – the firm also engages in document verification, screens for opinions from competition, tests the vigor and veracity of a business’s distribution network, and even seems to go as far as to pose as customers and place orders. This is what I deem “professional due diligence”, and I must commend Carson Block’s firm in not only engaging in it, but also in making the results public. Their reports make for rather entertaining reading – you can see the evident glee in the “not so fast!” tone that permeates their reports. Obviously their glee has a lot to do with the fortunes they made in successfully shorting their victims.

The challenge for individual investors with limited time and resources is to find a successful due diligence process that would ensure a high probability that outright frauds of the likes of Muddy Waters’ victims do not (dis)grace one’s portfolio, while at the same time would be feasible with the resources at one’s disposal. In order to overcome this challenge, I will first highlight some choice quotes from Muddy Waters’ CCME report, and then break down an adequate solution for an individual investor, if one exists. I will then provide a due diligence “checklist” that would serve to protect investors from being subject to such frauds as well as add conviction to one’s investment stance.

One thing to note before I begin is that the Muddy Waters’ CCME report contains almost as an afterthought only one page of financial statement analysis in its 20 page report– the outright fraud was simply that rampant in the firm. Another general observation is that nobody – not their auditor, not the investment bank that handled any subsequent attempts at raising capital, and neither the exchange nor the regulators in China or America - caught this fraud.

This theme of the utter irrelevance of most of the Wall Street infrastructure to easily the most important aspect of investing – due diligence – is extremely worrisome to this investor. It is a theme that is consistent with all of the reports I’ve read by Muddy Waters, and tarnishes the names of at least 3 of the Big 4 accounting firms, several investment bank / broker / proprietary-what-nots like Merrill Lynch and Piper Jaffray, and prominent stock exchanges like the TSX, Nasdaq and the NYSE. In prior cases in the US such as Enron and Worldcom, auditors were held accountable. For these China frauds, the Big 4 firms have yet to face any significant public scrutiny for their role in these frauds, to say nothing about the other institutions involved. It is questionable whether or not any of the Chinese perpetrators will be subject to American law.

Lastly, while I admire the chutzpah that is evident in Muddy Waters’ technique and research, I believe it is wrong to come to the conclusion that they are “heroes” of the investment community. True, what they did is commendable, but 1) they were highly motivated by self-interest, and 2) they are NOT a replacement for an investor’s own due diligence. This latter point is exceptionally important in this investor’s opinion.

Here is a link to the Muddy Waters CCME report.

“Seeing is not believing. “

“CCME Claims that its Top 10 Advertisers Include Large Global Brands. We Doubt this is True. Seeing is not believing in this case. It is not uncommon for small media companies in China to show ads from large prestigious brands with which they have no contract or business relationship. Usually this is done in order to impress potential advertisers. We suspect that CCME does this to a fair extent, but to impress investors.” (emphasis mine)

This theme is highlighted repeatedly in Muddy Waters’ CCME report, and is important on several levels. Those that may be exposed to the product may have no idea of any fraud in the firm’s operations or accounting. A simple eyeball check, while important, is in it of itself not nearly enough for due diligence.

In the specific case of CCME, the ads were not what they appeared to be. They also had half the buses than what they actually reported, and the quality of the revenue stream was significantly below what was stated. I.e., the buses were mostly filled with migrant workers and students than business execs shuttling to and from an airport.

“Like RINO, CCME’s “Competitors” Do Not Know the Company. We consider it to be a bad sign when a company’s reported financials would make it among the largest in its industry, yet the competition does not know much – or anything – about it. This was one of the most telling aspects of our work on RINO, and it is present again with CCME.”

I think for most investors, this is by far the most important observation to make. There is only one other entity that will do as much due diligence as a professional investor, and that is the competition. For individual investors, it is relatively easy to find consumer/trade reports of how the products from your business stand to the competition, or to see what the competition itself is thinking about your business (usually in their 10Ks or from broadcasts/articles in the media). These reports and assessments go a long way in not only determining the veracity of a business, but also in assessing the vigor of its business model. After such a comparative qualitative study, the investor can then do a more quantitative study via delving into the respective 10Ks and tearing apart the financials.

As you can see above, the competition didn’t even know CCME existed, although for many American investors looking to invest in this company – professional and otherwise - it would have been far more difficult to determine this fact.

“The purpose of this fraud is to generate earn-outs for management, and to increase the market value their stock so they can sell it. An institutional investor informed us that CCME management was quite interested in selling him approximately $50 million of their shares. In October 2010, a party closely connected to management sold nine million dollars of stock.

This is less important for most retail investors interested in other sectors, but is extremely important to note for anyone attempting to invest in the non-SOE China space today. Rising stock prices not only help to legitimate a business and to lower the cost of capital, it is also the principle avenue through which a fraud pays out for the perpetrators. Access to capital markets abroad, where investors will have more trouble keeping in touch with the business’s product, provides a lot of incentive for perpetrators to do whatever it takes to “pass inspection” and pocket your money. This can even include dividends and buybacks to alleviate investor suspicions of the “soundness” of an issue. What is also of note is that fraudulent enterprises would thus have almost zero incentive to go private under any circumstance – their entire modus operandi is to con public investors into parting with their money.

Making a List, and Checking it Twice

With these points in mind, our checklist will be quite simple, and will consist of three parts:

  • 1) Reality Check
  • 2) Qualitative Analysis
  • 3) Quantitative Analysis

I believe most investors (including those like John Paulson) focus on the latter two points and take for granted the first point. This post aims to address this deficiency

Reality Check

  • Are you exposed to the products of the business?
  • Are you exposed to the business model?
  • Are you exposed to the products and business models of the competition?

Simple and obvious as this portion may be, I consider it to be by far the most important step in the due diligence process for the investor. The importance goes far beyond merely weeding out fraud, but also on a near-subconscious level allows for an investor to gauge the strength and vigor of a company’s business model better than any amounts of data gleaned from 10Ks and news articles on the subject. I believe investing to be as much a subjective art as well as an objective study of financials. In this sense, a simple reality check can tell as much about a company and its business model as all the due diligence done on 10Ks, news articles, and stock analysis combined.

Do not take this step for granted. I believe it will serve all investors extremely well to stick to the simple mantra – Invest in what you know. Consumer products are usually a very safe sector for most investors to approach due to constant exposure.

For the China sector, most investors will rightly conclude that they simply have no contact with the companies in question or their competition. Even internet companies like BIDU and SOHU are largely outside of the experiences of most American investors. While the long-term China story may be compelling, there is little question that many investors will find it difficult to stay attuned with company and sector developments outside of the earnings calls and press releases issued by the company. This is essentially the equivalent of lemmings trusting that the Pied Piper is leading them to the Promised Land.

Even though there are some ridiculously undervalued China stocks out there right now, I recommend that most, if not all, American investors avoid this space, and leave these opportunities to firms like Muddy Waters who are better able to deftly navigate these precarious shores. It is very easy to convince yourself that everything is going swimmingly even though you can’t keep an eye on the business…don’t fall into this trap. If you must wade into this sector, I recommend you do it defensively and maximize diversification. Perhaps one of the China ETFs would be helpful here.

For further reading on this simple matter, I highly recommend The Superinvestors of Graham-And-Doddsville, found here or replete with charts and graphs in the back of Graham’s book The Intelligent Investor. Buffett notes how several investors that stuck to a value-oriented strategy had similar levels of success even though they invested in wildly differing groups of stocks. It is this investor’s opinion that they succeeded not only because of a rigorous application of value-style investing, but also because they invested in what they knew. This also is evident in Buffett’s famed apprehension of most tech stocks (although he has certainly stuck his hand in the cookie jar on multiple occasions).

Qualitative Analysis

  • Have you studied the product?
  • Have you studied the business model?
  • Have you studied the competition?
  • Do you know what factors would constitute a fundamental change in how the company or its competition does business?
  • How long have they been in business?
  • What are others thinking of the business and sector? (analysts’ opinions)

There is a lot of overlap with doing a reality check and quantitative analysis when looking at the qualitative aspects of a company. Here an investor would make a judgment call based on his exposure to a company’s product or business model.

This is usually the fun part of investing. You get to look at how things work, you’re treated to snazzy presentations and sparkly glowy props, and you get to read exciting stories about how Colonel Sanders created that secret recipe of 11 herbs and spices, or how Tesla makes the best cars…ever. Read the news, look and listen to company presentations, read Seeking Alpha! And don’t forget to keep up with your investment.

Again, for most China stocks, it will be next to impossible for someone in America to do any substantial qualitative analysis unless they rely heavily on assessments by management and press releases. Don’t be a lemming!

Quantitative Analysis

  • Earnings yield – P/E
  • Dividend yield – payout ratio
  • Enterprise yield – this includes debt analysis, ROIC
  • Yield per product – margins
  • Comparative yield – compare to competition and to other sectors
  • Yield over time – PEG
  • Historical yield
  • “Real” yield – P/FCF
  • Tangible book (all intangibles are zeroed out)
  • Interest coverage
  • Current/Quick ratios
  • Overall capitalization

Quantitative Analysis contrasts sharply with qualitative analysis; many people run for the hills when faced with a 200 page 10K – these people should not be investing. The numbers tell a story, and it is every investor’s responsibility to understand that story. This list is not by any means comprehensive, and many investors will seek to add or subtract their own quantitative measures.

I know that whatever I say here about this type of analysis is going to pale in comparison to the source of my investment philosophy; I will not be able to match in any respect the 700 pages written in Security Analysis. What I will say is that investing is like a ball game… keep your eye on the ball. The ball is yield. Keeping your eye on the ball will generally make you a much better player than otherwise.

Any and all significant quantitative analysis should be easily traceable to the bottom line, i.e. yield. If not, it is useless, and you are spinning your wheels. A great example of this kind of folly is to put faith in increasing revenues when you have decreasing or negative margins. This was par for the course during the dot com boom.

The latter four bullet points deal with when you or the company drops the ball. Having a satisfactory margin of safety allows for the game to continue, and will protect you from what usually is your worst enemy – yourself. Many investors, especially this one, tend to get carried away with the latest and greatest investment proposition – having a margin of safety tends to minimize market contractions that may threaten your principle.

This type of analysis will not protect you from outright fraud. What it will protect you against are rosy projections from CEOs and press releases, which are typically much more dangerous and insidious than even the muddiest of Chinese waters.

For ease of reference, the complete list:

Reality Check

  • Are you exposed to the products of the business?
  • Are you exposed to the business model?
  • Are you exposed to the products and business models of the competition?

Qualitative Analysis

  • Have you studied the product?
  • Have you studied the business model?
  • Have you studied the competition?
  • Do you know what factors would constitute a fundamental change in how the company or its competition does business?
  • How long have they been in business?
  • What are others thinking of the business and sector?

Quantitative Analysis

  • Earnings yield
  • Dividend yield
  • Enterprise yield
  • Yield per product
  • Comparative yield
  • Yield over time
  • Historical yield
  • “Real” yield
  • Tangible book
  • Interest coverage
  • Current/Quick ratios
  • Overall capitalization

Time spent on each section

  • Reality Check: 5-10 seconds, whenever exposed to the product or its competition
  • Qualitative Analysis: initially 10 minutes to a couple hours, then about an hour per week
  • Quantitative Analysis: initially several hours to days, then 10 minutes to an hour every quarter, and several hours on the annual report

This list is just a recommendation and is by no means authoritative. This investor found himself extremely apprehensive about entering the China space, and sought to refresh himself on the importance of adequate due diligence. He hopes that you have benefited from his analysis.

Just to emphasize the irrelevance of Wall Street to the due diligence process, some final choice quotes:

“I’ve started to think of investment banks and the investment banking industry as just manufacturers of financial products,” he said. “They have to keep bringing new product to market, and in a situation where there’s so much pressure to do that, you’re definitely going to have poor financial product that gets brought to market.”

- Carson Block, CEO Muddy Waters

“Why did it take a guy like Carson Block to reveal this?” said Robert Lawton, managing partner of Catoosa Fund LP, a Los Angeles-based hedge fund which lost money on China MediaExpress. “You have people like Paulson and Greenberg, who you would believe did their research before they took a position in these stocks. What did they miss in advance of buying stocks that it took Block a couple of months and a staff of 10 to uncover? If I had been invested with Paulson and Greenberg I would be furious.”

(Personally, I would be furious if I had been invested with Robert Lawton. What value-added is his hedge fund bringing to the table anyway?)

Bottom line, no one is going to do your due diligence. Don't be a lemming. Wait for the fire to burn out before running into the theater. Good luck with your investments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.